- Learn how to deduct the costs of computer software you buy.
- Find information about the tax treatment of leased software.
- Learn how to deduct the costs of software your business developed.
These days, most businesses buy or lease computer software to use in their operations. Or perhaps your business develops computer software to use in your products or services. What if you sell or lease software to others? In any of these situations, you should be aware of the complex rules that determine the tax treatment of the costs of buying, leasing, or developing computer software.
Deducting the costs of computer software you buy
Some computer software costs are deemed to be costs of “purchased” software, meaning it’s either:
- Non-customized software available to the general public under a nonexclusive license, or
- Acquired from a contractor who is at economic risk should the software not perform.
You may deduct the entire cost of purchased software in the year that you place it into service. The cases in which the computer software costs are ineligible for this immediate write-off are the few instances in which 100% bonus depreciation or Section 179 small business expensing isn’t allowed. Or when a taxpayer has elected out of 100% bonus depreciation and hasn’t made the election to apply Sec. 179 expensing. In those cases, you must amortize the costs over the three-year period. This begins with the month in which you place the software in service. Also note: The bonus depreciation rate begins to phase down for property placed in service after calendar year 2022.
What if you buy the software as part of a hardware purchase in which the price of the software isn’t separately stated? Then, you must treat the computer software costs as part of the hardware costs. Therefore, you must depreciate the software under the same method and over the same period of years that you depreciate the hardware. What if you buy the software as part of your purchase of all or a substantial part of a business? Then, the software must generally be amortized over 15 years.
What about leased software?
Are you a cash-method taxpayer? Then, you must deduct the amount you pay to rent leased software in the tax year in which you pay for them. Accrual-method taxpayer? You deduct the amounts paid in the tax year for which you accrue the rentals. However, the IRS generally doesn’t permit deductions before the years to which the rentals are allocable. Also, if a lease involves total rentals of more than $250,000, special rules may apply.
How do I deduct the costs of computer software my business developed?
We refer to some software as “developed” (designed in-house or by a contractor not at risk if the software doesn’t perform). For tax years beginning before calendar year 2022, bonus depreciation applies to developed software to the extent described above. If bonus depreciation doesn’t apply, the taxpayer can either deduct the computer software development costs in the year paid or incurred or choose one of several alternative amortization periods over which to deduct the costs. For tax years beginning after calendar year 2021, you must generally amortize computer software costs over the 5-year period beginning with the mid-point of the tax year in which you pay or incur the expenditures.
If following any of the above rules requires you to change your treatment of computer software costs, it will usually be necessary for you to obtain IRS consent to the change by filing Form 3115.
We can help
Have questions or need assistance in applying the tax rules for treating computer software costs in the way that is most advantageous for you? Then call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.