Capitalize or Expense? Depreciate or Not?

An important issue when setting up assets on your books is determining the correct treatment:

1. Capitalize and depreciate
   
2. Capitalize and do not  depreciate
   
3. Expense

Improperly categorizing an asset can cause potential problems if there is ever an audit, as well as a misrepresentation of financial statements. The only way to know how to correctly categorize an asset is to ask yourself certain questions:

1. Is the asset used in your trade or business, or is it held for the production of income?
   
2. Does the asset have a useful life of more than one year?
   
3. Will the asset wear out or lose value over time?
   
4. Is the asset fully installed and ready for use?

Answering these questions will assist you in correctly classifying your assets.

Capitalize and Depreciate
Capitalize and depreciate an asset if all  of the following are true:

1. The asset is used in your trade or business, or held for the production of income
   
2. The asset has a useful life of more than one year (and costs a material amount)
   
3. The asset will wear out or lose value over time
   
4. The asset is fully installed and ready for use

Capitalize and Do Not Depreciate
Capitalize, but do not depreciate, the asset if both of the following are true:

1. The asset is neither used in your trade or business nor held for the production of income, and
   
2. The asset has a useful life of more than one year (and is a material amount).

Capitalize, but do not depreciate, the asset if it is used in your trade or business or held for the production of income, has a life of more than one year, and either of the following is true:

1. The asset will neither wear out nor lose value over time, or
   
2. The asset is neither fully installed nor ready for use.

Expense
Expense the asset if either of the following is true:

1. The asset has a useful life of less than one year, or
   
2. The asset costs an immaterial amount.

Obviously, there is a lot to think about. There are often unusual situations where the answer to even these simple questions is not that simple. Below are the results of two private IRS rulings that deal with unusual situations. Although you cannot cite them if you ever undergo an audit yourself, you can use them to learn how the IRS may potentially rule in a similar case.

What is considered to be inventory may surprise you!
Yes, we all know that inventory is not depreciable. Inventory would fail the first question above, i.e., inventory is neither used in your trade or business, nor is it held for the production of income. Furthermore, it will not wear out, and it should not lose value over time.

However, what if your company took something normally held for resale and did actually use it in its business? This is just what a furniture manufacturer did. The company took several pieces of furniture from inventory and used it for display in its showrooms. This model furniture remained on display for approximately three years and then was sold to customers.

The company was depreciating this display furniture using a 5-year MACRS recovery period. It stopped depreciating it when the furniture was returned to inventory or sold.

In a field service advice memorandum, the IRS stated that the furniture was ineligible for depreciation. One of its reasons was that the furniture that was sold was still in very good condition (although the company disagreed). Depreciation can only be used for property that is subject to wear or obsolescence. Because the furniture was eventually sold at a profit, it should still be treated as inventory and taken into account through cost of goods sold.

The IRS also thought that the above was similar to the circumstances of Revenue Ruling 89-25. In this ruling, it was decided that model homes could not be depreciated. The fact that the houses were temporarily not available for resale did not mean they were depreciable. Eventually, the houses were sold and, in fact, they were sold at a profit.

The IRS did concede that if the furniture was intended to remain on display past its useful life or if it would be later sold at a loss, then its decision might have been different.

If maintenance extends an asset's life, it still may be deductible!
Once you’ve categorized an asset, it is possible that you may incur further expense related to that asset. The rule that usually governs is that if an additional expenditure to an asset lengthens the asset’s life, increases the asset’s value, or adapts the asset for a different use, such expenditure is capitalized, rather than expensed.

In a recent private ruling, the IRS determined that the cost of cleaning, sanding, and painting the hull of a ship is a fully deductible repair expense. This is so even though such maintenance extends the life of the ship for several years.

Summary
Whether or not you should capitalize or expense an asset may not be the only decision that you need to make. If you determine that an asset should be capitalized, you are then faced with the question of whether it should be depreciated or not. Asking yourself the basic questions above, however, should assist you in making your determination for the correct handling of your assets. Naturally, there are always exceptions and special circumstances in individual cases.