When it comes to properly handling assets and the costs of doing business, the words “expense” or “write off” are often used loosely. They are also used incorrectly, which isn’t problematic in casual conversation, but when those misunderstandings creep into a business owners’ books, issues can arise, and opportunities can be missed. This is especially true when considering the benefits of a cost segregation study, which can uncover valuable tax savings opportunities that may otherwise be overlooked. Interested in learning more? Schedule a call!
First, let’s nail down definitions.
Capitalize
Refers to the process of recording an expense or investment as an asset on the balance sheet rather than as an immediate expense on the income statement. Typically, assets that are capitalized include long-term investments such as property, plant, and equipment, as well as significant improvements or renovations that extend the useful life of existing assets. Additionally, intangible assets like patents and trademarks, and major development costs for software or research projects, are often capitalized.
Expense
Refers to a cost incurred in the process of earning revenue, which is deducted from income on the income statement to determine net profit or loss. Costs that are immediately expensed rather than capitalized typically include routine maintenance and repairs, administrative expenses, advertising costs, and other minor or short-term expenditures. These do not significantly enhance the value or extend the useful life of an asset. Additionally, costs associated with training, supplies, and minor improvements are generally expensed immediately.
Summary
To summarize, an “expense” is a cost that is immediately deducted from income on the income statement. Meanwhile, “capitalize” refers to recording a cost as an asset to be depreciated or amortized over time. Therefore, the difference between an item that is expensed immediately and an item that is capitalized and depreciated, is time.
As an example, when a business buys supplies, like a pack of pencils, that purchase is immediately expensed. The pencils provide short term value, and it would not materially impact the business to slowly expense the cost as those pencils are depleted.
However, if a business buys a new computer, that cost is not immediately expensed. The expected life of computer is 5 years according to MACRS. Therefore, the cost is capitalized, or in other words, recorded to the balance sheet. Every year the computer’s value is reduced by 1/5th its cost in the form of depreciation. That amount is expensed and deducted. Over the course of the entire five-year useful life of the computer, the total value is eventually expensed and “written off” the books. In the end, the pencils and the computer were both fully expensed. The only difference was time. By correctly capitalizing or expensing items, the accounting most accurately reflects the reality of value derived from these items.
So how does this relate to cost segregation?
Real estate is treated similarly to the computer in our previous example. The costs to acquire or build a property is typically capitalized and depreciated over 27.5 or 39 years. Residential buildings have a 27.5-year depreciable life, and commercial buildings have a 39-year depreciable life.
However, buildings are not monoliths. Within a building are discreet building systems and components which have depreciable lives as discreet as they are. If left as a single unit, an entire building is capitalized and depreciated over 39 years, despite containing components that should be capitalized as 5, 7 and 15-year assets and expensed quicker.
A quality cost segregation study will properly segregate these 5, 7 and 15- year assets into IRS approved tax lives. This allows for accelerated depreciation and shorter depreciation, or expensing, periods for the building. Larger expenses now mean fewer taxes paid and increased cash flow for the business.
