One of the principles underlying the tax rules for deductions is that your income for the year should be offset only by those expenses incurred during the year that contributed to earning that income.

This fairly simple and straightforward rule becomes more complicated when you incur an expense that will benefit your business for more than a year. It may seem as though this shouldn't really be a problem, because everything should come out even in the end. However, because taxes are computed on an annual basis, permitting you to reduce taxable income by the amount you spent to acquire an asset that will be useful beyond the year of acquisition isn't allowed. From the government's perspective, you would be unreasonably reducing income in the year of acquisition.

So, instead of letting you currently deduct your outlay for items of a more permanent nature (that is, items that will benefit your business beyond the current year), the tax rules provide that such expenditures generally must be capitalized.

If you add floor space to your facility or purchase a new delivery vehicle, you've acquired an asset that will benefit your business for a number of years. If you were allowed to deduct the full cost of such an asset in the year you acquired it, you'd effectively be understating your income during that first year and overstating your income during all the subsequent years that you use the asset in your business.

What does it mean to "capitalize" an expense? Well, apart from the fact that it means the expense is not fully deductible this year, the act of capitalizing an expense is just an exercise in bookkeeping. The asset becomes a capital asset, against which you can take depreciation deductions each year.

For now, let's just say that for tax purposes, you'll eventually recover the benefits of a capital expense through (1) annual depreciation deductions for the property and/or (2) a reduced amount of taxable gain or an increased amount of taxable loss when you sell or otherwise dispose of the property.

Although these two results are helpful, they are usually not as good as a current deduction in full for the expenses paid. Unfortunately, you normally won't have a choice as to how to treat a given expense. With certain exceptions, the tax rules specify whether an expense must be capitalized or is deductible.

• What is a capital expenditure - to help you decide, we provide some more detailed explanations and criteria.
• Common capital expenses - we also provide an extensive list of items that should be treated as capital expenses.