Tax Deduction for Software - The Guide To Writing Off Software Costs

7

Min Read

Tom Smery

Yes, you may be able to deduct taxes that are software-oriented. Treatment of software is considered as a miscellaneous deduction, and you may use the IRS Code Section 179 - Net Operating Loss Deduction. You may claim these expenses at the end of the tax year when you are filing for the other deductions of your business.

Bear in mind that for you to deduct computer software expenses, certain conditions need to apply. These conditions include:

  1. Your deductions are itemized
  2. Your deductions make up more than 2% of your AGI

As long as the conditions are met, you are eligible for a tax write-off.

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What Is Section 179?

Section 179 is part of the IRS tax code that allows business owners to deduct treatment of software and other miscellaneous qualifying equipment. The Section 179 deduction allows you to get a tax write-off for software pieces that were either purchased or leased for your company.

Section 179 has been around for a while, and the chances are high that every business owner may have deducted some costs through it.  Items within the code continue to change, as well as the requirements.

For the 2021 tax year, Section 179 has the following specifications for software equipment:

  • 100% bonus depreciation
  • $2,620,000 spending cap
  • $1,050,000 deduction limit

The purpose of this deduction is to help small businesses with average income make purchases encouraging business growth. An organization can deduct purchases in the year that they become qualified for it, helping them increase their income.

Types of Software You Can Write Off

Depending on the nature of your business, you can deduct several types of software. Categorization depends on their use and development, and once you familiarize yourself with the tax rules of Section 179 for computer software, you should be able to calculate your tax deduction.

Without further ado, here is what the IRS allows you to deduct at tax time.

Purchased Software

Some software costs fall into the category of "purchased software," meaning that they will have a specific deduction method according to the IRS. For computer software to be considered "purchased," it needs to follow at least one of the rules below:

  • It is a piece of computer software that received no customized treatment and is available to the general public and without an exclusive license to the buyer
  • It needs to be bought from a contractor who is at risk for an economic downfall, should the software fail to perform.

For software  to be considered a deductible expense, it cannot have a code that is specifically related to your business. For software to be deductible purchase, it needs to meet the following criteria:

  • Business owners use it in more than half their tasks, being an important part of income generation.
  • The life of the purchased software product, whether it includes hardware or not, should be at least half a year.
  • The software needs to be given a "determinable useful life," during which the buyer can expect to use the product without any issues.

The full cost of the computer software may be deducted through section 179, as long as it is filed in the year that it has been placed into service. In other words, you'll need to write it off immediately, by the end of the current tax year - and not after it had led a long and "useful life."

There are some cases in which you may not be immediately deductible - for example, when you do not meet the deduction requirements. You may want to keep a record of your purchases so that the IRS can determine whether you are eligible or not.

That being said, if these costs are not immediately deductible, they may be amortized over a three-year tax period. The calculations will start from the month you purchased the computer software for your business or property and put it into service.

Sometimes, software can be bought as part of a hardware purchase - in which case, you may not have a separately stated cost for the computer software. In this scenario, you'll have to treat the cost as if it is part of the hardware.

In other words, when you depreciate the costs of the hardware over the years, the same thing should apply to the cost of software. Moreover, if the software you bought is part of a substantial purchase for your business, then the costs of the software ought to be amortized over the next 15 years.

Leased Software

Even if you just lease software rather than purchase it, it still means that you'll have paid quite a lot for it. In many cases, software subscriptions are not cheap. As a result, the general public may have issues keeping up with the yearly costs.

Thankfully, the IRS allows for tax deduction when you decide to lease rather than purchase a piece of software. For example, if your company needs a subscription for a Cloud service or a paid online service, the costs for it are considered deductible.

The deduction needs to be filed for in the same year that you paid for it.  This applies if you're a cash-type taxpayer, in which case you'll have to pay by the end of the tax year.

However, if you are an accrual-type taxpayer, then it needs to be paid by the end of the tax year when the leased items are accrued. You might want to check with the IRS page about the deadlines and other aspects, as the code often goes through different changes.

Bear in mind that leased software may not be deductible in the years before the computer software being allocable. Moreover, if the leased product has rental costs that go past $250,000, the IRS may apply a series of special rules. You may want to further investigate with them for lease-related aspects if this applies.

Note: a tax software for self-employed folks that will help maximize tax deductions for the year...could also be written off. Bonsai Tax will scan your receipts from your bank/credit card statements and help you save thousands during tax time. In fact, users save on average of $5,600 by using our software. Try a 14-day free trial today.

Company-Developed Software

Even if  you do not purchase or get software on a lease, it doesn't mean that you do not suffer any costs. In many circumstances, software development costs can become an even bigger expense.

Software is categorized as "developed" when its development took place within the business. In other words, the company did not purchase it but instead created it.

If the software does not perform well on the market, then the contractor will not be at economic risk. It is their property, so the market is not that important.

For the following tax year, the bonus depreciation applies for software development costs, should it meet the condition. If the bonus depreciation is not applicable, then the tax payer can choose to deduct the development costs through other means. Amortization periods throughout multiple years are often used in order to cover related costs.

How Much Can You Deduct for Software?

While you can still deduct the costs for the computer software, keep in mind that they are part of the "MISC Deductions" category. As a result, you can only deduct what is over 2% of your AGI. That is the minimum deduction you can go for.

With that in mind, if you meet all of the requirements, you may deduct up to $1,050,000 of that purchase from the gross income of your company. If the software purchase goes past this price, then you can get the 100% bonus deduction for it instead.

Check with the IRS to see how much you can get. In most cases, it will depend on the income of the taxpayers, the costs inquired, and whether the piece receives custom treatment or not. This section will also come with more details.

Check out our full list of 1099 write-offs to see what other deductions you may qualify for as a freelancer.

The Bottom Line

Taxpayers who wish to run a business can generally have all their expenditures written off. The condition is that they meet the requirements asked in Section 179. With their taxes deducted, they can now focus on making a profit for their business.

Tom Smery
Tom Smery is a certified CPA for over a decade. In his free time, he writes articles to pass on his expert knowledge on taxes and accounting. Thomas has a wide range of deep knowledge on 1099 taxes, and finance topics. You can find him fishing when he is not preparing taxes for his clients or writing about accounting.

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