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The Software Depreciation Deduction

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The Software Depreciation Deduction

Many freelancers and small business owners rely heavily on software to effectively and efficiently carry out their work. Imagine managing your workflow and clients without trusty apps – it'd be quite the challenge! Self-employed individuals can claim software expenses as a 1099 tax deduction, but it can get pretty complicated. The IRS classifies software as an asset, so it might need to be depreciated, depending on its cost and how often you use it for work. We’ll break down everything you need to know about the tax treatment of software development costs in 2023, what type of expense a software subscription is and claiming the software depreciation.

Table of contents

Key takeaways...Read more

Software as a business deduction...Read more

How to claim software expenses...Read more

The straight-line depreciation method...Read more

Section 179 method...Read more

Software as a business expense...Read more

Software amortization...Read more

Key takeaways

  • The tax treatment of software development costs depends on whether it is classified as a tangible or intangible asset.
  • Tangible software should be claimed with the software depreciation deduction using either the straight-line method or Section 179, while intangible software should be amortized.
  • Software expenses less than $2,500 should be written off on Schedule C.

Software as a business deduction

When it comes to the IRS and software, things can get a bit unconventional. Most computer software is labeled as "tangible" despite its non-physical nature. So, what makes software tangible in the eyes of the IRS? First, it should be designed to make your computer do something specific. Next, it should be something you can buy off the shelf, accessible to pretty much anyone. This is often called "off-the-shelf software." Third, it shouldn't be exclusively licensed to you. And last but not least, the software should be used in its original form, just the way you bought it. Most of the software self-employed individuals use is generally tangible. But what if your software doesn't tick all these boxes? Well, then, it's likely considered "intangible" by the IRS. And if that's the case, you might have to amortize the cost to claim the software depreciation deduction. So, what type of expense is a software subscription? Say you’re a graphic designer who pays a monthly subscription fee to use Photoshop. The software is a tangible asset and is ordinary and necessary to your business, so you can claim it as a deduction on Schedule C. Companies use software in different ways, and it's crucial to figure out if it's for the company itself or not. If the software is meant to be marketed, sold or leased, it's considered external-use software. In this case, it should typically be treated as an amortizable intangible asset, whether the company acquires or develops it internally. For internal-use software, it's software used within the company for various purposes:
  • For employees to provide services to customers.
  • For internal use, like in accounting, finance, or payroll, to store information or handle internal communications.
  • As part of the company's manufacturing process, running machinery to produce goods or control operations in a manufacturing plant or distribution center.
Infographic entitled What Makes Software A Tangible Asset listing four conditions that classify software expenses as a tangible asset.
Remember, not all software can be depreciated. If you buy software specifically for research and development (R&D), you can't claim depreciation on it.

How to claim software expenses

If you’re thinking, “What is the tax treatment of software development costs in 2023?” There are four ways 1099 individuals can lower their self-employment taxes by using software:
  • Software depreciation using the straight-line method
  • Software depreciation using Section 179
  • Writing off software as a regular business expense
  • Software amortization
If you’re using depreciation, you’ll first need to know the useful life of your software. The IRS recommends using three years for software depreciation. At this point, you might be wondering, “Is software amortized or depreciated?” The answer lies in whether your software is considered a tangible or intangible asset. Essentially, tangible assets are depreciated, while intangible assets are amortized. So, if your software is classified as “tangible” per the conditions we mentioned earlier, you can depreciate it. If not, amortization is the way to go.

The straight-line depreciation method

This is the easiest way to claim software depreciation. All you need to do is subtract the “salvage value” of the product from the original cost and divide the amount by the useful life of the software. The salvage value is just how much your software will be worth when it no longer works. This number can be zero, too. Taxpayers can report depreciation on Form 4562. You can also only depreciate your software if it costs less than $2,500 and is used for your work less than 50% of the time. Say you run a freelance construction business and heavily rely on engineering software for your work. You recently purchased a premium software package for $2,600, which you plan to use for your projects. You estimate that this software will be relevant and effective for your work for the next three years before upgrading it. As this software is considered a tangible asset, you decide to deduct the cost using the straight-line depreciation method. You divide the purchase price ($2,600) by the estimated useful life of the software (3 years), as you estimate that that salvage value will be $0. This results in a depreciation deduction of $866.67 ($2,600/3 years) each year, and reduces your taxable income to help save on estimated taxes.
Infographic entitled Software Depreciation Example 1 showing how to calculate depreciation with the straight-line method.
This was a simple example but what if you have software for both business and personal usage? You can still write it off, but you’ll just need to calculate the business use percentage. Let’s use the same example from before. Say you also use the engineering software in your spare time for some personal projects. You estimate that you use the software 25 hours a week for work and 4 hours for personal use. Your business use percentage will be calculated based on yearly use, so you find that 86.2% of your software is used for work. This means you can claim $747.06 as a software depreciation on your tax return.
Infographic entitled Software Depreciation Example 2 showing how to calculate depreciation when software is also used for personal reasons.
If you purchased software in the middle of the year, you can still write it off the cost. But you’ll have to prorate the deduction amount. You can take the full amount as a deduction from next year. If we use the previous example and assume that you only started using the software 4 months into the year. Your deduction calculation would look like this:
  • (8/12) x $747.06 = $498.04

Section 179 method

If you’re eligible to claim a Section 179 deduction, you can write off all your software costs all at once. This method is simply an accelerated way to depreciate your asset. You can only claim it for software that you bought specifically for your business. It also has to have a business use percentage of at least 50% and considered tangible. You can also only claim the depreciation deduction with this method in the year you use the software. So, if you purchased software in 2023 but only started using it the next year, you can only claim it when you file your 2024 returns.

Software as a business expense

If your software expenses are less than $2,500, you can write them off as a regular business deduction on Schedule C under “Other Expenses.” This can be either software subscriptions or one-off purchases. Some examples include:
  • Project management software (Trello, Asana)
  • Communication software (Zoom, Slack)
  • Tax preparation software
  • Accounting software
  • Storage software (Google Drive, Dropbox)
  • Microsoft Office
  • Design software (Adobe Creative Cloud, Canva Pro)
  • Social media management software (Hootsuite, Buffer)
  • Payroll software
  • VPN software
Knowing what tax treatment to give software development costs can be challenging, even for the most experienced self-employed individuals. With FlyFin, you can get unlimited CPA support along with an A.I. that finds all your business deductions. You can also use the built-in calculators to find your self-employment taxes, estimated tax payments and tax penalties. And best of all, you can claim it as a deduction on your taxes!

Software amortization

We mentioned earlier that software considered intangible assets have to be amortized. According to the IRS, if you've got software developed or acquired on or after December 31, 2003, you can amortize the expense over a 15-year period using the straight-line method. This rule was set because it can be challenging for taxpayers to estimate the useful life of software correctly. You should also assume that there's no salvage value in the software amortization process, making this calculation much simpler.
Infographic entitled Where Should I Report Software showing where to report the different types of business software tax deductions.
Keeping good records is important for any business deduction, especially when claiming depreciation. Hold on to purchase receipts and any documents related to:
  • Your software’s useful life
  • Business use percentage calculation
  • Reason for choosing a particular depreciation method
  • Amortization schedule
  • Business income
Software depreciation can be complicated at the best of times, so don’t be afraid to get professional tax advice if needed.

Office Supplies Tax Deduction

Office supplies are tax deductible for self-employed individuals and can be reported under the office expenses category on Schedule C.

Phone Tax Deduction

Cell phones can be a business tax deduction for self-employed individuals if it is an ordinary and necessary expense. A separate business cell phone can be fully written off.

Advertising Tax Deduction

Ordinary and necessary promotion expenses and marketing expenses are tax-deductible for self-employed individuals. They should be claimed on Schedule C when filing 1099 tax.

Business Insurance Tax Deduction

Self-employed individuals can deduct business insurance expenses from their 1099 taxes. Sole proprietors and single-member LLCs can claim it on Schedule C.

Meals Tax Deduction

The meals and entertainment deduction in 2024 allows 1099 workers to deduct 50% of business meal costs. Certain meal and entertainment expenses are still fully deductible.

Business Travel Tax Deduction

Expenses related to traveling are deductible for business purposes. A per diem rate is set for deductible travel expenses.

Charitable Contribution Tax Deduction

If you make a charitable donation to an organization, it might count as a tax deduction. Not all charitable donations count as a write-off.

Clothing And Accessories Tax Deduction

Self-employed individuals can take the clothing tax deduction if their clothes cannot be worn outside the work environment.

Commission And Fees Tax Deduction

Self-employed individuals can claim certain commissions and fees as tax deductions if they are related to their business and are ordinary and necessary.

Contract Labor Tax Deduction

If you do any contract labor, you will have to pay contract labor taxes, also known as SE tax. Estimated payments quarterly need to be made for tax liabilities over $1,000.

Internet and WiFi Tax Deduction

Self-employed individuals can deduct some of their internet bills if they work from home as part of the home office deduction. Internet costs can also be reported on Schedule C.

Medical and Dental Tax Deduction

Certain dental and medical costs can be claimed as a medical tax deduction if itemized when paying income taxes. Expenses have to be more than 7.5% of AGI.

Rent Tax Deduction

Rent is tax deductible for self-employed individuals who work from home or have a separate office space. Some states offer renters tax credits to lower state taxes.

Repair and Maintenance Tax Deduction

Capital improvements can be claimed as a tax deduction through depreciation. Repairs to rental properties can be claimed as a business expense.

Professional and Legal Services Tax Deduction

Legal fees are tax deductible from 1099 taxes under the legal and professional fees category on Schedule C. The category also includes consultant and tax prep fees.

Shipping Tax Deduction

Business-related shipping expenses are tax-deductible. Shipping supplies and the cost of shipping are included as write-offs.

Student Loan Payment Tax Deduction

Student loan interest paid is tax-deductible, and every type of education loan qualifies for the deduction.

Taxes and Licenses Tax Deduction

Self-employed individuals can take the license fee tax deduction on taxes and licenses that are ordinary and necessary business expenses.

Training and Education Tax Deduction

The educator expenses tax deduction allows eligible educators to deduct $300 of unreimbursed expenses from their taxes. Use education tax credits to lower tax liability.

Utilities Tax Deduction

Utilities are tax deductible when they are an ordinary and necessary business expense. They can be claimed with the home office deduction or as a rental property deduction.

Vehicle Insurance Tax Deduction

Interest on a car loan is tax deductible if it is used for business. Choose between the standard and actual method when claiming the vehicle deduction.

Vehicle Purchase Tax Deduction

You can claim the vehicle tax write-off if you’re self-employed and use your vehicle for business. It can also be taken if you lease your vehicle.

Mortgage Interest Tax Deduction

The mortgage interest deduction can be claimed by homeowners who itemize their expenses. You could claim the mortgage interest tax credit if you’re in a lower tax bracket.

Office Supplies Tax Deduction

Office supplies are tax deductible for self-employed individuals and can be reported under the office expenses category on Schedule C.

Phone Tax Deduction

Cell phones can be a business tax deduction for self-employed individuals if it is an ordinary and necessary expense. A separate business cell phone can be fully written off.

Advertising Tax Deduction

Ordinary and necessary promotion expenses and marketing expenses are tax-deductible for self-employed individuals. They should be claimed on Schedule C when filing 1099 tax.

Business Insurance Tax Deduction

Self-employed individuals can deduct business insurance expenses from their 1099 taxes. Sole proprietors and single-member LLCs can claim it on Schedule C.

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