For federal income tax purposes, the concepts of amortization and capitalization go hand-in-hand. Capitalization refers to the process of accumulating the costs you incur to acquire and improve tangible and intangible assets. Amortization refers to the process of claiming annual deductions for a portion of the costs you capitalize. However, amortization isn’t available for your personal assets; rather, it applies to property you use in a business or for investment purposes.
Capitalizing Asset Costs
When the IRS requires you to capitalize the cost of an asset, this means you cannot claim an immediate deduction for the entire expense in the year you incur it. Instead, you keep track of all costs and take annual deductions through amortization or depreciation spread out over a number of years. To illustrate, suppose you operate a business and decide to purchase an existing patent from an inventor for $75,000. Your purchase price is not a deductible expense, meaning you can’t report a deduction for $75,000 on your business return. The reasoning behind this treatment is because the tax law assumes that the patent has a useful life beyond the current year. And since it’s an intangible asset, you can recover the patent’s cost through annual amortization deductions.
Assets to Amortize
The concept of amortization and depreciation are similar. Depreciation allows you to recover the costs you capitalize to purchase most tangible business assets, such as equipment and real estate. However, amortization covers specific types of asset costs, such as your business start-up costs, leases you enter into for business property, the expense of conducting research and development that relates to your business and all section 197 intangibles.
Section 197 Intangibles
Internal Revenue Code Sec. 197 intangibles account for a substantial portion of the assets for which businesses claim amortization deductions. However, it never includes the value of intangibles your business creates. Intangible assets under IRC 197 include the cost of goodwill when you purchase an existing business, such as paying a premium for a company’s reputation and earnings history rather than a specific asset. Section 197 also covers the cost of obtaining government licenses and permits, franchises, trademarks, patents and copyrights.
How to Amortize
Calculating your annual amortization deduction is straightforward because the IRS allows you to claim deductions in equal amounts over 180 months, or 15 years. For example, the patent your business purchases for $75,000 yields annual amortization deductions of $5,000. Each year you claim an amortization deduction, you must provide details for each asset on Form 4562 and attach it to the tax return. However, if you incur start-up or organizational expenses prior to officially opening your business, the IRS allows you to accelerate your deduction for these costs by claiming an immediate deduction for up to $5,000 in the first year the business operates. This is only permissible if your total start-up or organizational costs are $50,000 or less. Any amount you are unable to deduct in the first year is deductible over the 180-month amortization period.
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