Although you generally cannot take a current deduction for a capital expense, you may be able to take deductions for the amount you spend through depreciation, amortization, or depletion. These allow you to deduct part of your cost each year over a number of years. In this way you are able to “recover” your capital expense. See Amortization (chapter 9) and Depletion (chapter 10) in this publication. For information on depreciation, see Publication 946.

When you go into business, treat all costs you had to get your business started as capital expenses.

Usually you recover costs for a particular asset through depreciation. Generally, you cannot recover other costs until you sell the business or otherwise go out of business. However, you can choose to amortize certain costs for setting up your business. See Going Into Business in chapter 9 for more information on business start-up costs.

If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories.

If you are a corporation and your attempt to go into a new trade or business is not successful, you may be able to deduct all investigatory costs as a loss.

The costs of any assets acquired during your unsuccessful attempt to go into business are a part of your basis in the assets. You cannot take a deduction for these costs. You will recover the costs of these assets when you dispose of them.

Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. This applies even if some of the work would by itself be classified as repairs.

You cannot deduct the cost of a replacement that stops deterioration and adds to the life of your property. Capitalize that cost and depreciate it.

Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition. However, if your equipment has a major overhaul, capitalize and depreciate the expense.

You usually capitalize the cost of a motor vehicle you buy to use in your business. You can recover its cost through annual deductions for depreciation.

There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. See Publication 463.

Repairs you make to your business vehicle are deductible expenses. However, amounts you pay to recondition and overhaul a business vehicle are capital expenses.

The costs of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. The cost of maintaining a private road on your business property is a deductible expense.

Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year.

Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition and not add to its life is a deductible expense.

The cost of changing from one heating system to another is a capital expense.

If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation.

To qualify to claim expenses for the business use of your home, you must meet the following tests.

You generally do not have to meet the exclusive use test for the part of your home that you regularly use in either of the following ways.

Your home office qualifies as your principal place of business if you meet the following requirements.

Alternatively, if you use your home exclusively and regularly for your business, but your home office does not qualify as your principal place of business based on the previous rules, you determine your principal place of business based on the following factors.

For more information, see Publication 587.

If you use your car in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on mileage. Only your expenses for the miles you drove the car for business are deductible as business expenses.

You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. Instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. For 2003, the standard mileage rate is 36 cents a mile for all business miles driven.

If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate. You can use the nonbusiness part of the personal property tax to determine your deduction for taxes on Schedule A (Form 1040) if you itemize your deductions.

For more information on car expenses and the rules for using the standard mileage rate, see Publication 463.

If you recover part of an expense in the same tax year for which you would have claimed a deduction, reduce your expense deduction by the amount of the recovery. If you have a recovery in a later year, include the recovered amount in income. However, if part of the deduction for the expense did not reduce your tax, you do not have to include all the recovery in income. Exclude the part that did not reduce your tax.

For more information on recoveries and the tax benefit rule, see Publication 525.

If you provide services to pay a business expense, the amount you can deduct is the amount you spend to provide the services. It is not what you would have paid in cash.

Similarly, if you pay a business expense in goods or other property, you can deduct only the amount the property costs you. If these costs are included in the cost of goods sold, do not deduct them as a business expense.

If your deductions for an investment or business activity are more than the income it brings in, you have a net loss. There may be limits on how much, if any, of the loss you can use to offset income from other sources.

If you do not carry on your business activity with the intention of making a profit, you cannot use a loss from it to offset other income. See Not-for-Profit Activities, later.

Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have “at risk” in the activity. You are “at risk” in any activity for the following items.

For more information, see Publication 925.

Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate during the year, or a rental activity. In general, deductions for losses from passive activities only offset your income from passive activities. You cannot use any excess deductions to offset your other income. In addition, passive activity credits can only offset the tax on net passive income. Any excess loss or credits are carried over to later years. For more information, see Publication 925.

If your deductions are more than your income for the year, you may have a “net operating loss.” You can use a net operating loss to lower your taxes in other years. See Publication 536 for more information. See Publication 542 for information about net operating losses of corporations.

Under the cash method of accounting, you generally deduct business expenses in the tax year you actually paid them, even if you incurred them in an earlier year.

Under an accrual method of accounting, you generally deduct business expenses when both of the following apply.

You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.

You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Under the cash method, you can deduct a contested liability only in the year you pay the liability. Under an accrual method, you can deduct contested liabilities, such as taxes (except foreign or U.S. possession income, war profits, and excess profits taxes), in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. However, to take the deduction in the year of payment or transfer, you must meet certain conditions. See Contested Liability in Publication 538 for more information.

Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not paid them. However, if you and the person you owe are related and the person uses the cash method of accounting, you must pay the expense before you can deduct it. The deduction by an accrual method payer is allowed when the corresponding amount is includible in income by the related cash method payee. See Related Persons in Publication 538.

An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity is more than the deductions for it.

If a taxpayer dies before the end of the 5-year (or 7-year) period, the period ends on the date of the taxpayer's death.

If your business or investment activity passes this 3- (or 2-) years-of-profit test, presume it is carried on for profit. This means the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption in every case, unless the IRS shows it is not valid.

If you are starting an activity and do not have 3 (or 2) years showing a profit, you may want to elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test.

You can choose to do this by filing Form 5213. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity.

The benefit gained by making this choice is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in 3 (or 2) out of the first 5 (or 7) years you carry on the activity. If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year in the 5-year (or 7-year) period with a loss.

Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.

You must file Form 5213 within 3 years after the due date of your return for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity.

Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines of Schedule A (Form 1040). You can deduct a casualty loss on property you own for personal use only to the extent it is more than $100 and all these losses are more than 10% of your adjusted gross income. See Publication 547 for more information on casualty losses. For the limits that apply to mortgage interest, see Publication 936.

Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than the deductions you take (or could take) under the first category. Most business deductions, such as those for advertising, insurance premiums, interest, utilities, wages, etc., belong in this category.

Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity is more than deductions you take (or could take) under the first two categories. The deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Where more than one asset is involved, divide depreciation and these other deductions proportionally among those assets.

Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). They are subject to the 2%-of-adjusted-gross-income limit. See Publication 529 for information on this limit.

If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder's or partner's distributive shares.

If you have several undertakings, each may be a separate activity or several undertakings may be one activity. The following are the most significant facts and circumstances in making this determination.

The IRS will generally accept your characterization of several undertakings as one activity, or more than one activity, if supported by facts and circumstances.

If you are carrying on two or more different activities, keep the deductions and income from each one separate. Figure separately whether each is a not-for-profit activity. Then figure the limit on deductions and losses separately for each activity that is not for profit.