How Do Same-Year Tax Deductions Work for Capital Expenditures (CapEx)?

Capital expenditures (CapEx) are defined by the Internal Revenue Service (IRS) as "the costs of acquisition, construction, or erection of buildings, machinery and equipment, furniture, and fixtures, and similar property having a useful life substantially beyond the taxable year." The property can represent either physical assets, such as computers and vehicles, or intangible ones, such as patents and copyrights.

Because CapEx assets are likely to be useful for an extended period of time, the IRS generally expects them to be depreciated and deducted over a number of years—unless they qualify for a Section 179 deduction and the business elects to deduct them in that manner. Here is how tax deductions work in the same year that the property was purchased.

Understanding Capital Expenditures (CapEx) vs. Operating Expenses (OpEx)

CapEx are often used by companies and other organizations to fund new projects and investments for the future. Very generally speaking, CapEx is company spending that is meant to provide long-term benefits to be captured over a number of periods in the future. For example, constructing a new warehouse is CapEx because that warehouse will benefit the company in the future.

Operating expenses (OpEx), by contrast, include assets that are expected to be fully utilized within the year of purchase. As such, they are treated differently for tax purposes. The IRS puts it this way: "Generally, you can deduct the full amount of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense." For instance, if you're renting that warehouse from above, that monthly payment you make is OpEx because the rent you pay only benefits the current period.

Office supplies and wages are two other common examples of OpEx. These costs don't represent investments but are necessary to meet the needs of a business in its ordinary day-to-day operations.

How Tax Deductions for Capital Expenditures Work

While OpEx can be fully deducted in the year they are incured, CapEx must generally be deducted over a period of years, using the accounting procedure known as depreciation. Different types of assets can be written off over different time spans.

Again, tangible capital expenditures that qualify under Section 179 are an exception, as explained in the next section below.

The IRS generally requires that businesses use the Modified Accelerated Cost Recovery System (MACRS) of depreciation for property placed into service after 1986. The MACRS provides for two different depreciation methods: the general depreciation system (GDS) and the alternative depreciation system (ADS). The GDS, which is more common, allows businesses to depreciate assets over a shorter period of time, taking larger deductions in the early years, while the ADS depreciates assets at the same rate each year and over a longer time period.

The IRS has specific rules regarding the number of years over which an asset may be written off, which can differ depending on whether the company is using GDS or ADS. For example, cars and light trucks are depreciated over a five-year period under both methods, while office equipment is depreciated over seven years under GDS and 10 years under ADS.

Special Considerations

How much a business can deduct for the first year also depends on when during the year the asset was placed in service. The IRS provides this example of $10,000 worth of office furniture placed into service on August 11: Using GDS, the business could deduct 14.29%, or $1,429, for the first (partial) year. In the next (full) year it could deduct $2,449, followed by $1,749 the following year, $1,249 the year after that, and so on. For the final year it could deduct the remaining depreciation of $446.

If the business instead decided to use ADS to depreciate its office furniture, it would be able to deduct $500 for the first (partial) year, then $1,000 for each year after that, until the final year, when only the last $500 would remain to be deducted.

Deductions for intangible assets are treated somewhat differently for tax purposes. If the asset qualifies as a Section 197 intangible (such as a patent or copyright), it must generally be amortized, or written off, over a 15-year period. Otherwise, it can be depreciated over its useful life. In both cases, businesses will generally use a straight-line method, writing off a like amount each year. As with tangible assets, the first (as well as last) year may result in a lower deduction, depending on when the asset was placed in service. For certain intangible assets, businesses can also use an alternative depreciation technique known as the income forecast method.

Exceptions Under Section 179

Certain types of CapEx are 100% deductible during the first year under the rules for Section 179 (not to be confused with Section 197, above). Section 179 refers to a tax deduction in the United States Internal Revenue Code that allows businesses to deduct the full purchase price of qualifying equipment and/or software purchased or financed during the tax year. It's often used as an incentive for businesses to invest in themselves by purchasing equipment or software, as it allows them to deduct the full cost upfront rather than depreciating it over several years. This deduction is subject to certain limitations and rules set by the IRS.

Only tangible property qualifies for this full first-year deduction. Some eligible examples are machinery and equipment and off-the-shelf computer software. In addition, the IRS caps section 179 deductions at a certain annual amount. For the 2023 tax year, for example, the maximum deduction is $1.16 million.

The Bottom Line

With certain exceptions, capital expenditures or CapEx generally can't be deducted in full from your taxes in a single year. Instead, they are deducted over the useful life of that particular asset or some other assigned time period. Because CapEx usually represent substantial outlays of cash, reducing a a company's cash flow or even requiring it to take on new debt, businesses need to plan for them carefully, taking into account the value and timing of the applicable tax deductions.