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 or sells or leases software to others. In any of these situations, you should be aware of the complex rules for a computer software tax deduction. Determining the tax treatment for the expenses of buying, leasing or developing computer software varies.

Software You Buy

Some 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.
• Acquired from a contractor who is at economic risk should the software not perform.

The entire cost of purchased software can be deducted in the year that it’s placed 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 Section 179 expensing.

In those cases, the costs are amortized over the three-year period. The amortization begins with the month in which the software is placed in service. Note that the bonus depreciation rate will begin to be phased down for property placed in service after calendar year 2022.

Let’s say you buy the software as part of a hardware purchase in which the price of the software isn’t separately stated. As such, 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. Additionally, if you buy the software as part of your purchase of all or a substantial part of a business, the software must generally be amortized over 15 years.

Leasing Software

If you’re a cash-method taxpayer: You must deduct amounts you pay to rent leased software in the tax year they’re paid. If you’re an accrual-method tax payer: You’ll need to deduct the tax year for which the rentals are accrued. 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 Development

For a computer software tax deduction, some software is deemed to be “developed.” This means that it’s 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 either:

• Deduct the 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, generally the only allowable treatment is to amortize the costs over the five-year period. This will begin with the midpoint of the tax year in which the expenditures are paid or incurred.

If following any of the above rules requires you to change your treatment of software costs, it will usually be necessary for you to obtain IRS consent to the change.

We Can Help

We are here to assist you with all your accounting solution needs. Contact us with questions or for assistance in applying the computer software tax deduction in the way that is most advantageous for you.