8. Costs You Can Deduct
or Capitalize

Important Change for 2002

The deduction for qualified environmental cleanup (remediation) costs was scheduled to expire for costs paid or incurred after 2001. It has been extended to include costs you pay or incur before 2004. For more information on the environmental cleanup cost deduction, see Environmental Cleanup Costs, later.

Introduction

This chapter discusses two ways of treating certain costs - deduction or capitalization.

You generally deduct a cost as a current business expense by subtracting it from your income in either the year you incur it or the year you pay it.

If you capitalize a cost, you may be able to recover it over a period of years through periodic deductions for amortization, depletion, or depreciation. When you capitalize a cost, you add it to the basis of property to which it relates.

A partnership, corporation, estate, or trust makes the choice to deduct or capitalize the costs discussed in this chapter except for exploration costs for mineral deposits. Each individual partner, shareholder, or beneficiary chooses whether to deduct or capitalize exploration costs.

You may be subject to the alternative minimum tax (AMT) if you deduct any of the expenses discussed in this chapter, other than carrying charges and the costs of removing architectural barriers and retired assets.

For more information on the alternative minimum tax, see the instructions for one of the following forms.

• Form 6251, Alternative Minimum Tax - Individuals.
• Form 4626, Alternative Minimum Tax - Corporations.

Topics

This chapter discusses:

• Carrying charges
• Research and experimental costs
• Intangible drilling costs
• Exploration costs
• Development costs
• Circulation costs
• Environmental cleanup costs
• Retired asset removal costs
• Barrier removal costs

Useful Items You may want to see:

Publication

• 544   Sales and Other Dispositions of Assets

Form (and Instructions)

• 3468   Investment Credit
• 8826   Disabled Access Credit

See chapter 14 for information about getting publications and forms.

Carrying Charges

Carrying charges include the taxes and interest you pay to carry or develop real property or to carry, transport, or install personal property. Certain carrying charges must be capitalized under the uniform capitalization rules. (For information on capitalization of interest, see chapter 5.) You can choose to capitalize carrying charges not subject to the uniform capitalization rules, but only if they are otherwise deductible.

You can choose to capitalize carrying charges separately for each project you have and for each type of carrying charge. For unimproved and unproductive real property, your choice is good for only 1 year. You must decide whether to capitalize carrying charges each year the property remains unimproved and unproductive. For other real property, your choice to capitalize carrying charges remains in effect until construction or development is completed. For personal property, your choice is effective until the date you install or first use it, whichever is later.

How to make the choice.   To make the choice to capitalize a carrying charge, write a statement saying which charges you choose to capitalize. Attach it to your original tax return for the year the choice is to be effective. However, if you timely filed your return for the year without making the choice, you can still make the choice by filing an amended return within 6 months of the due date of the return (excluding extensions). Attach the statement to the amended return and write Filed pursuant to section 301.9100-2 on the statement. File the amended return at the same address you filed the original return.

Research and Experimental Costs

The costs of research and experimentation are generally capital expenses. However, you can choose to deduct these costs as a current business expense. Your choice to deduct these costs is binding for the year it is made and for all later years unless you get IRS approval to make a change.

If you meet certain requirements, you may choose to defer and amortize research and experimental costs. For information on choosing to defer and amortize these costs, see Research and Experimental Costs in chapter 9.

Research and experimental costs defined.   Research and experimental costs are reasonable costs you incur in your trade or business for activities intended to provide information that would eliminate uncertainty about the development or improvement of a product. Uncertainty exists if the information available to you does not establish how to develop or improve a product or the appropriate design of a product. Whether costs qualify as research and experimental costs depends on the nature of the activity to which the costs relate rather than on the nature of the product or improvement being developed or the level of technological advancement.

The costs of obtaining a patent, including attorneys' fees paid or incurred in making and perfecting a patent application, are research and experimental costs. However, costs paid or incurred to obtain another's patent are not research and experimental costs. For more information on costs paid or incurred to obtain another's patent, see Section 197 Intangibles in chapter 9.

Product.   The term product includes any of the following items.

• Formula.
• Invention.
• Patent.
• Pilot model.
• Process.
• Technique.
• Property similar to the items listed above.

It also includes products used by you in your trade or business or held for sale, lease, or license.

Costs not included.   Research and experimental costs do not include expenses for any of the following activities.

• Advertising or promotions.
• Consumer surveys.
• Efficiency surveys.
• Management studies.
• Quality control testing.
• Research in connection with literary, historical, or similar projects.
• The acquisition of another's patent, model, production, or process.

When and how to choose.   You make the choice to deduct research and experimental costs by deducting them on your tax return for the year in which you first pay or incur research and experimental costs. If you do not make the choice to deduct research and experimental costs in the first year in which you pay or incur the costs, you can deduct the costs in a later year only with approval from the IRS.

IF you . . .	THEN . . .
choose to deduct research and experimental costs as a current business expense	deduct all research and experimental costs in the first year you pay or incur the costs and all later years.
do not deduct research and experimental costs as a current business expense	if you meet the requirements, amortize them over at least 60 months, starting with the month you first receive an economic benefit from the research. See Research and Experimental Costs in chapter 9.

Research credit.   If you pay or incur qualified research expenses, you may be able to take the research credit. For more information about the research credit, see the instructions to Form 6765, Credit for Increasing Research Activities.

Intangible Drilling Costs

The costs of developing oil, gas, or geothermal wells are ordinarily capital expenditures. You can usually recover them through depreciation or depletion. However, you can choose to deduct intangible drilling costs (IDCs) as a current business expense. These are certain drilling and development costs for wells in the United States in which you hold an operating or working interest. You can deduct only costs for drilling or preparing a well for the production of oil, gas, or geothermal steam or hot water.

You can choose to deduct only the costs of items with no salvage value. These include wages, fuel, repairs, hauling, and supplies related to drilling wells and preparing them for production. Your cost for any drilling or development work done by contractors under any form of contract is also an IDC. However, see Amounts paid to contractor that must be capitalized, next.

You can also choose to deduct the cost of drilling bore holes to determine the location and delineation of offshore hydrocarbon deposits if the shaft is capable of conducting hydrocarbons to the surface on completion. It does not matter whether there is any intent to produce hydrocarbons.

If you do not choose to deduct your IDCs as a current business expense, you can choose to deduct them over the 60-month period beginning with the month they were paid or incurred.

Amounts paid to contractor that must be capitalized.   Amounts paid to a contractor must be capitalized if they are either:

• Amounts properly allocable to the cost of depreciable property, or
• Amounts paid only out of production or proceeds from production if these amounts are depletable income to the recipient.

How to make the choice.   You choose to deduct IDCs as a current business expense by taking the deduction on your income tax return for the first tax year you have eligible costs. No formal statement is required. If you file Schedule C (Form 1040), enter these costs under Other expenses.

For oil and gas wells, your choice is binding for the year it is made and for all later years. For geothermal wells, your choice can be revoked by the filing of an amended return on which you do not take the deduction. You can file the amended return for the year up to the normal time of expiration for filing a claim for credit or refund, generally, within 3 years after the date you filed the original return or within 2 years after the date you paid the tax, whichever is later.

Energy credit for costs of geothermal wells.   If you capitalize the drilling and development costs of geothermal wells that you place in service during the tax year, you may be able to claim a business energy credit. See Form 3468 for more information.

Nonproductive well.   If you capitalize your IDCs, you have another option if the well is nonproductive. You can deduct the IDCs of the nonproductive well as an ordinary loss. You must indicate and clearly state your choice on your tax return for the year the well is completed. Once made, the choice for oil and gas wells is binding for all later years. You can revoke your choice for a geothermal well by filing an amended return that does not claim the loss.

Costs incurred outside the United States.   You cannot deduct as a current business expense all the IDCs paid or incurred for an oil, gas, or geothermal well located outside the United States. However, you can choose to include the costs in the adjusted basis of the well to figure depletion or depreciation. If you do not make this choice, you can deduct the costs over the 10-year period beginning with the tax year in which you paid or incurred them. These rules do not apply to a nonproductive well.

Exploration Costs

The costs of determining the existence, location, extent, or quality of any mineral deposit are ordinarily capital expenditures if the costs lead to the development of a mine. You recover these costs through depletion as the mineral is removed from the ground. However, you can choose to deduct domestic exploration costs paid or incurred before the development stage began (except those for oil, gas, and geothermal wells).

How to make the choice.   You choose to deduct exploration costs by taking the deduction on your income tax return, or on an amended income tax return, for the first tax year for which you wish to deduct the costs paid or incurred during the tax year. Your return must adequately describe and identify each property or mine, and clearly state how much is being deducted for each one. The choice applies to the tax year you make this choice and all later tax years.

Partnerships.   Each partner, not the partnership, chooses whether to capitalize or to deduct that partner's share of exploration costs.

Reduced corporate deductions for exploration costs.   A corporation (other than an S corporation) can deduct only 70% of its domestic exploration costs. It must capitalize the remaining 30% of costs and amortize them over the 60-month period starting with the month the exploration costs are paid or incurred. A corporation may also elect to capitalize and amortize mining exploration costs over a 10-year period. For more information on this method of amortization, see section 59(e) of the Internal Revenue Code.

The 30% the corporation capitalizes cannot be added to its basis in the property to figure cost depletion. However, the amount amortized is treated as additional depreciation and is subject to recapture as ordinary income on a disposition of the property. See Section 1250 Property under Depreciation Recapture in chapter 3 of Publication 544.

These rules also apply to the deduction of development costs by corporations. See Development Costs, later.

Recapture of exploration expenses.   When your mine reaches the producing stage, you must recapture any exploration costs you chose to deduct. Use either of the following methods.

• Method 1 - Include the deducted costs in gross income for the tax year the mine reaches the producing stage. Your choice must be clearly indicated on the return. Increase your adjusted basis in the mine by the amount included in income. Generally, you must choose this recapture method by the due date (including extensions) of your return. However, if you timely filed your return for the year without making the choice, you can still make the choice by filing an amended return within 6 months of the due date of the return (excluding extensions). Make the choice on your amended return and write Filed pursuant to section 301.9100-2 on the form where you are including the income. File the amended return at the same address you filed the original return.
• Method 2 - Do not claim any depletion deduction for the tax year the mine reaches the producing stage and any later tax years until the depletion you would have deducted equals the exploration costs you deducted.

You also must recapture deducted exploration costs if you receive a bonus or royalty from mine property before it reaches the producing stage. Do not claim any depletion deduction for the tax year you receive the bonus or royalty and any later tax years, until the depletion you would have deducted equals the exploration costs you deducted.

Generally, if you dispose of the mine before you have fully recaptured the exploration costs you deducted, recapture the balance by treating all or part of your gain as ordinary income.

Under these circumstances, you generally treat as ordinary income all of your gain if it is less than your adjusted exploration costs with respect to the mine. If your gain is more than your adjusted exploration costs, treat as ordinary income only a part of your gain, up to the amount of your adjusted exploration costs.

Foreign exploration costs.   If you pay or incur exploration costs for a mine or other natural deposit located outside the United States, you cannot deduct all the costs in the current year. You can choose to include the costs (other than for an oil, gas, or geothermal well) in the adjusted basis of the mineral property to figure cost depletion. (Cost depletion is discussed in chapter 10.) If you do not make this choice, you must deduct the costs over the 10-year period beginning with the tax year in which you pay or incur them. These rules also apply to foreign development costs.

Development Costs

You can deduct costs paid or incurred during the tax year for developing a mine or any other natural deposit (other than an oil or gas well) located in the United States. These costs must be paid or incurred after the discovery of ores or minerals in commercially marketable quantities. Development costs include those incurred for you by a contractor. Also, development costs include depreciation on improvements used in the development of ores or minerals. They do not include costs for the acquisition or improvement of depreciable property.

Instead of deducting development costs in the year paid or incurred, you can choose to treat them as deferred expenses and deduct them ratably as the units of produced ores or minerals benefited by the expenses are sold. This choice applies each tax year to expenses paid or incurred in that year. Once made, the choice is binding for the year and cannot be revoked for any reason.

How to make the choice.   The choice to deduct development costs ratably as the ores or minerals are sold must be made for each mine or other natural deposit by a clear indication on your return or by a statement filed with the IRS office where you file your return. Generally, you must make the choice by the due date of the return (including extensions). However, if you timely filed your return for the year without making the choice, you can still make the choice by filing an amended return within 6 months of the due date of the return (excluding extensions). Clearly indicate the choice on your amended return and write Filed pursuant to section 301.9100-2. File the amended return at the same address you filed the original return.

Foreign development costs.   The rules discussed earlier for foreign exploration costs apply to foreign development costs.

Reduced corporate deductions for development costs.   The rules discussed earlier for reduced corporate deductions for exploration costs also apply to corporate deductions for development costs.

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