Capitalization and amortization are not mutually exclusive terms for purposes of federal income taxes. When an asset is capitalized, it means that instead of claiming an immediate deduction, you recover its purchase price, or the cost of creating the asset, over a number of years. However, an amortized asset is merely one type of capitalized asset to which these rules apply.
There are certain types of business expenses that relate to the acquisition or creation of an asset that’s useful to the business over a number of years. In contrast, a deductible business expense, such as an office utility bill, is fully deductible in the year you incur it since it only provides benefits to the business for a period of time that generally begins and ends within one year. However, when you purchase computers for the office, these assets are generally useful for multiple tax years, which is why the IRS requires you to capitalize the costs rather than claim a full deduction in the year of purchase.
Asset Tax Basis
Every asset, whether tangible or intangible, that the IRS requires to be capitalized will have a tax basis. Tax basis represents your total cost to acquire, construct or create an asset, and also represents the total amount of deductions you can claim over the applicable recovery period for the asset. For example, if you purchase the legal rights to use an existing trademark in your business, although intangible, it still constitutes an asset that you must capitalize. In this case, the tax basis will include the price you pay to the owner of the trademark for the license. Moreover, your tax basis in the trademark license will include additional acquisition costs that aren’t part of its purchase price, such as the fees you pay to a law firm to draft the licensing agreement.
Amortizing Capitalized Assets
Amortization is a type of recovery period that only applies to specific groups of assets. Pursuant to the amortization tax rules, the IRS requires that you recover the cost of an asset subject to amortization over a 15-year period and in equal amounts. For example, if an asset subject to amortization costs your business $15,000 to acquire, you can claim a $1,000 amortization deduction on each of the next 15 tax returns. However, if you purchase the asset on July 1, you can claim a $500 deduction in that year, the full $1,000 deduction on each of the successive 14 tax returns and a final $500 deduction on the 16th tax return.
Assets Subject to Amortization
You should note that amortization doesn’t apply to any tangible asset you purchase for the business, such as real estate, business machinery and computers. These assets are capitalized, but are subject to depreciation rather than amortization. Amortization applies to assets that are intangible, such as business start-up costs, patents, copyrights, trademarks and franchise licenses.
- IRS: Publication 535 - Business Expenses
- IRS: Publication 551 - Basis of Assets
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Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.