The rules for claiming software expenses are complex because there are so many different ways software can be acquired or used. You can buy, lease or develop software to use, or develop it to sell to others, and each of those methods comes with its own set of rules.
If you buy software, the general rule is that you are allowed to claim that expense by amortizing the cost over three years, but if the software is not customized for you, then it can also qualify for Section 179 expense and bonus depreciation. Software is not considered to be customized if it is (1) readily available for purchase by the public, (2) subject to a nonexclusive license and (3) hasn’t been substantially modified. In that case, you could claim some or all of the software expense in the year it was placed in service.
There are some additional exceptions to the three year amortization rule with the most common one being that if you purchase software as part of a hardware purchase and the cost of the software is not separately stated, then the software is depreciated along with the hardware.
If you lease software you will claim the expenses like any other lease expense. You will deduct the amounts you pay to rent the software in the tax year in which paid, if you are a cash-method taxpayer, or the tax year for which the rentals are accrued, if you are an accrual-method taxpayer.
If you develop your own software, the rules get even more complex. You can used a number of different methods including (1) amortizing the costs over a three-year period beginning with the month that the software was placed in service; (2) deducting the costs in the tax year in which the costs are paid, but only if all of your costs of developing the software are deducted this way; (3) amortizing the costs over a five-year period beginning with the completion of the development, but only if all of your costs of developing software are amortized this way; or, (4) amortizing the costs over a period longer than five years, but only if the costs are Code Sec. 174 “research or experimental expenditures”.
The manner in which you acquire software can have a big impact on how you are allowed to claim the expenses associated with it. The best way to deal with that complexity is to consult your tax professional to make sure you are getting the best benefit possible.
By Michael Anderson