Tax Rules for Deducting the Computer Software Costs of Your Business

• Learn about the rules that determine the tax treatment of the expenses of buying, leasing, or developing software.
• Discover the definition of “purchased software” and how to treat it tax-wise.
• Find out more about the tax rules around leased software.
• What are the rules regarding software developed by your business?

Do you buy or lease computer software to use in your business? Do you develop computer software for use in your business, or for sale or lease to others? Fiducial has the scoop on the complex rules that apply to determining the tax treatment of computer software costs, whether buying, leasing, or developing.

Purchased software costs

The IRS deems some software costs to be the costs of “purchased” software, meaning software that’s either:

• Non-customized software available to the general public under a non-exclusive license or
• Acquired from a contractor at economic risk should the software not perform.

You may deduct the entire cost of purchased software in the year you place it into service. The cases in which the 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 period begins with the month in which you place the software in service. Note that the bonus depreciation rate will begin to be phased down for property placed in service after calendar year 2022.

If you buy the software as part of a hardware purchase in which the price of the software isn’t separately stated, you must treat the software cost as part of the hardware cost. Therefore, you must depreciate the software under the same method and over the same period of years that you depreciate the hardware. Also, if you buy the software as part of your purchase of all or a substantial part of a business, generally, you must amortize the software over 15 years.

Leased software costs

You must deduct amounts you pay to rent leased software in the tax year you pay them, if you’re a cash-method taxpayer, or the tax year for which the rentals are accrued, if you’re an accrual-method taxpayer. However, deductions aren’t generally permitted 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.

Software developed by your business

Some software is deemed to be “developed” (designed in-house or by a contractor who isn’t 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 do one of two things. They can deduct the development costs in the year paid or incurred; or alternatively, they can choose one of several other amortization periods over which to deduct the costs. For tax years beginning after calendar year 2021, generally, you may only amortize the costs over the five-year period. This period begins with the midpoint 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 software costs, you will need to get IRS consent to the change.

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