How to Calculate Capital Allowances for a Business

Capital allowances, often referred to as tax depreciation in the United States, provide businesses a way to recover the cost of certain assets over time. This tax relief encourages businesses to invest in long-term assets that contribute to their operations and growth.

Qualifying Assets and Expenditure

Capital allowances apply to specific types of expenditures and assets used in a business or for income-producing activities. A fundamental distinction exists between capital expenditure and revenue expenditure. Capital expenditures are investments in long-term assets expected to provide benefits for more than one year, such as equipment, buildings, and machinery. These assets are capitalized, meaning their cost is recorded on the balance sheet and then expensed over time through depreciation.

Conversely, revenue expenditures are short-term operating costs consumed within the current accounting period, such as rent, salaries, and utility bills. These are fully deductible as expenses in the year they are incurred. Only capital expenditures on qualifying property are eligible for capital allowances.

Common examples of assets that qualify for capital allowances include machinery, vehicles, office equipment, computers, and certain fixtures within buildings. The property must be owned by the taxpayer, used in a business or income-producing activity, have a determinable useful life, and be expected to last more than one year. Both new and used property can qualify for these deductions, depending on the specific allowance. Land, personal-use property, and assets not used to produce income are generally not depreciable.

Information Needed for Calculation

Calculating capital allowances accurately requires meticulous record-keeping and specific financial data. Businesses must gather details for each asset, including the exact date it was placed in service, which is when the asset is ready and available for its intended use. The original cost of the asset is also necessary, and this should include not only the purchase price but also any associated costs like sales taxes, freight charges, and installation fees.

If an asset is later disposed of, the disposal proceeds are needed to determine any gain or loss for tax purposes. Maintaining an asset register that lists all depreciable assets, their acquisition dates, costs, and depreciation claimed to date is highly beneficial. Purchase invoices, receipts, and other documentation supporting the asset’s cost and acquisition are crucial for substantiating claims during a tax audit. Understanding the type of asset is important because different assets have varying recovery periods and may qualify for different accelerated depreciation methods.

Calculating Capital Allowances

In the United States, businesses can utilize several methods to recover the cost of qualifying assets, primarily through Section 179 expensing, bonus depreciation, and the Modified Accelerated Cost Recovery System (MACRS). These methods allow businesses to deduct a portion of an asset’s cost each year, or in some cases, the full cost upfront, to reduce taxable income.

The Section 179 deduction allows businesses to expense the full cost of qualifying property, such as machinery, equipment, and off-the-shelf software, in the year it is placed in service, rather than depreciating it over multiple years. For tax year 2025, the maximum Section 179 deduction is $1,250,000. This deduction begins to phase out dollar-for-dollar once the total cost of Section 179 property placed in service during the year exceeds $3,130,000 for 2025. Businesses exceeding the phase-out threshold are not eligible for any Section 179 deduction if total equipment investments reach $4,380,000.

Bonus depreciation provides an additional first-year deduction for qualifying new and used property. For property acquired and placed in service after January 19, 2025, a new law permanently restores 100% bonus depreciation. This means businesses can deduct the entire cost of eligible assets, such as equipment, computer hardware and software, and certain vehicles, in the year of purchase. This accelerated deduction is taken after any Section 179 deduction and before regular MACRS depreciation.

The Modified Accelerated Cost Recovery System (MACRS) is the primary method for depreciating most tangible property placed in service after 1986. MACRS assigns assets to specific property classes, each with a predetermined recovery period over which the asset’s cost is depreciated. Common recovery periods include 3-year, 5-year (e.g., computers, office equipment, vehicles), and 7-year property (e.g., office furniture and fixtures). Real property, such as nonresidential buildings, generally has a 39-year recovery period.

MACRS typically uses accelerated depreciation methods, such as the 200% declining balance method for most personal property, which allows for larger deductions in the early years of an asset’s life. A half-year convention usually applies, meaning that property is considered placed in service in the middle of the year, regardless of the actual purchase date. If an asset is not fully expensed under Section 179 or bonus depreciation, the remaining basis is depreciated using MACRS.

Claiming Capital Allowances

After calculating the allowable deductions, businesses must report these amounts to the Internal Revenue Service (IRS) on their tax returns. The primary form used for this purpose is Form 4562, “Depreciation and Amortization.” This form is essential for claiming depreciation and amortization expenses, electing the Section 179 deduction, and providing information on the business use of certain property, such as vehicles.

Part I of Form 4562 is specifically for electing and calculating the Section 179 expense deduction. Businesses will enter details of the qualifying property and the elected expensing amount in this section. Part II of the form is used to claim the special depreciation allowance, or bonus depreciation, for eligible property. The total cost of eligible property placed in service and the applicable bonus depreciation percentage are reported here.

The remaining depreciation, calculated under MACRS, is reported in subsequent parts of Form 4562, depending on the type of property. This form is then filed along with the business’s annual income tax return, such as Form 1120 for corporations or Schedule C (Form 1040) for sole proprietors. Filing Form 4562 is required for each year a business claims depreciation on assets or makes a Section 179 election. Businesses should ensure all assets are placed in service by December 31 of the tax year to be eligible for deductions in that year.