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 determining the tax treatment of the expenses of buying, leasing, or developing computer software.
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, or
- 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 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 beginning with the month in which the software is placed in service. Note that the bonus depreciation rate will start to be phased down for property placed in service after the calendar year 2022.
If you buy the software as part of a hardware purchase in which the software price 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. 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.
Software that is leased
You must deduct amounts you pay to rent leased software in the tax year they’re paid 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 that is developed
Some software is deemed “developed” (designed in-house or by a contractor who isn’t at risk if the software doesn’t perform). For tax years beginning before the 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. Generally, for tax years beginning after the calendar year 2021, the only allowable treatment is to amortize the costs over the five-year period beginning with the midpoint of the tax year in which the expenditures are paid or incurred.