What Is Capital Allowance and How Does It Work?

Capital allowances represent a fundamental aspect of tax planning for businesses that invest in long-term assets. These allowances provide a method for businesses to reduce their taxable profits by recovering the cost of certain investments over time or, in some cases, immediately. This tax relief encourages businesses to invest in new equipment and property, fostering economic growth and productivity.

What Capital Allowance Means

Capital allowance, often referred to as depreciation or cost recovery in the United States, is a tax provision allowing businesses to deduct the cost of certain assets from their taxable income. Unlike day-to-day operational expenses, which are fully deductible in the year they are incurred, the Internal Revenue Service (IRS) generally requires businesses to spread the deduction for significant investments over several years. This reflects the asset’s useful life.

Capital expenditures are investments in assets that provide long-term benefits, such as machinery or buildings, differing from daily operational costs. By reducing taxable profits, capital allowances lower a business’s tax liability.

Assets That Qualify

Businesses can claim capital allowances for a wide range of tangible assets used in their operations. Common examples include machinery, vehicles like cars and vans, computer equipment, and office furniture. Tools and certain types of building fixtures, such as heating, ventilation, and air conditioning (HVAC) systems, security systems, and roofs, may also qualify.

For an asset to qualify, it must be used for business purposes and its cost not fully expensed in the year of purchase. Land and structural building elements generally do not qualify, though specific improvements within a nonresidential building can be eligible.

How Capital Allowances Reduce Tax

In the United States, capital allowances primarily function through mechanisms like Section 179 expensing, bonus depreciation, and the Modified Accelerated Cost Recovery System (MACRS). These provisions allow businesses to deduct the cost of qualifying assets, thereby reducing their taxable income. The specific method and amount of deduction depend on the asset type and when it was placed in service.

Section 179 Expensing

Section 179 expensing permits businesses to deduct the full purchase price of qualifying equipment and software in the year it is placed in service. For 2025, the maximum Section 179 deduction is $1,250,000. This deduction begins to phase out when a business purchases more than $3,130,000 in equipment, fully phasing out at $4,380,000. This incentive is available for both new and used property, provided it meets IRS guidelines and is used more than 50% for business purposes. The deduction is also limited to the business’s taxable income.

Bonus Depreciation

Bonus depreciation provides an opportunity for accelerated cost recovery. The “One Big Beautiful Bill Act” (OBBBA) permanently restored 100% bonus depreciation for qualified property acquired and placed in service after January 19, 2025. This allows businesses to immediately expense the entire cost of eligible tangible property with a recovery period of 20 years or less, including new and used assets.

Modified Accelerated Cost Recovery System (MACRS)

For assets that do not qualify for Section 179 expensing or bonus depreciation, or for costs exceeding these limits, businesses use the Modified Accelerated Cost Recovery System (MACRS). MACRS is the primary tax depreciation system in the U.S., allowing businesses to recover the cost of tangible property over a specified period. Assets are assigned to various classes with predetermined recovery periods, such as 3, 5, 7, 10, 15, or 20 years for personal property, and 27.5 or 39 years for real property. MACRS generally uses accelerated methods, allowing larger deductions in the initial years of an asset’s life.

Claiming Capital Allowances

Claiming capital allowances involves specific steps through a business’s tax return. Businesses typically report these deductions on IRS Form 4562, “Depreciation and Amortization.” This form is used to claim depreciation, make the Section 179 election, and report the business use of certain property. The total depreciation deduction from Form 4562 is then carried over to the appropriate tax form for the business, such as Schedule C for sole proprietors or Form 1120 for corporations.

Accurate record-keeping is essential for capital allowance claims. Businesses must maintain detailed records for each qualifying asset, including the date of acquisition, its original cost, and any improvements made. Documentation such as invoices, receipts, and records of how the asset is used in the business are crucial. Many businesses work with tax professionals or accountants to ensure all eligible allowances are identified and claimed correctly, navigating tax regulations.