A federal income tax return is based on an annual tax year and income and expenses are reported according to the accounting method used. According to the IRS, most individuals and many small businesses use the cash method. Under this method, income is reported in the year it is actually or constructively received. Expenses are reported in the year they are paid. So under this general rule the expenses you pay one year could not be deducted the following year.
The other method is the accrual method. Under this method, income is reported in the year it is earned, regardless of when it is received. Expenses are deducted in the year they are incurred, regardless of when they are paid. But under this method, the expenses you incur one year could not be deducted the following year even if they are paid in that year.
But if you start a business or other income producing activity, you may have costs in your first year and don’t start earning or receiving income until a later year. There are some tax provisions you can use so that you do not lose the tax benefit of those costs.
According to the IRS, business start-up and organizational costs are generally considered capital expenditures. You could elect to deduct a portion of these costs in your first year of business (up to $5,000 for 2011) and amortize the balance over a period of 180 months, starting with the month you begin operating your trade or business. This way, your initial costs are spread over later tax years when you start generating revenue.
The equipment, machinery, vehicles and other assets you purchase for use in your business would be capitalized as assets and depreciated for tax purposes. You would recover the cost through depreciation deductions each year.
You could claim a section 179 deduction to write off the cost of certain qualifying assets for tax purposes in the year you purchase them, if you choose to. If you cannot claim the full benefit of the section 179 deduction in the current year because the deduction is more than your business income, you can carry over the unused balance and apply it against income in subsequent years. According to the IRS, you can carry over the unused portion of the section 179 deduction for an unlimited number of years.
You could also claim a special depreciation allowance the year you purchase assets for use in your business. The IRS indicates that this special allowance can be 50% or 100% of the cost, depending on the asset. You can take this special depreciation allowance after any section 179 deduction you claim and before you figure regular depreciation.
If you have a net operating loss for tax purposes; that is, your expenses exceed your income, you can carry forward the loss and apply it against net income the following year. According to the IRS, you can carry forward a net operating loss and apply it against operating income in future years until the loss is used up, or up to a maximum of 20 years.
Sources:
Publication 535, Business Expenses, IRS
Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts, IRS
Publication 538, Accounting Periods and Methods, IRS
Publication 946, How to Depreciate Property, IRS