The tax treatment of software development costs changed on July 4, 2025, when the One Big Beautiful Bill Act restored full, immediate deduction for domestic development work. For tax years beginning after December 31, 2024, you deduct U.S.-based software development costs in the year you pay or incur them under the new Section 174A of the Internal Revenue Code. Foreign development costs still have to be amortized over 15 years. And unamortized balances from the 2022 through 2024 mandatory-capitalization years can be recovered on an accelerated schedule. The result is three different regimes a company may need to run at the same time.
What Counts as a Software Development Cost
Any amount you pay or incur to develop software is treated as a research or experimental expenditure for tax purposes.1Office of the Law Revision Counsel. 26 U.S. Code 174 – Amortization of Research and Experimental Expenditures That classification sweeps in a broader range of costs than most companies expect. IRS Notice 2023-63 sets out the categories:
- Wages and all compensation elements for employees and contractors who perform, supervise, or directly support development work, including base pay, overtime, stock-based compensation, vacation and sick leave pay, payroll taxes, pension costs, and employee benefits.2Internal Revenue Service. Notice 2023-63 – Guidance on Amortization of Specified Research or Experimental Expenditures under Section 174
- Materials, supplies, and tools consumed during development, plus equipment not depreciable under Section 168.
- A proportional share of rent, utilities, insurance, repairs, maintenance, and security for the spaces where development happens.
- Depreciation on equipment used in development.
- Attorney fees and filing costs to obtain a patent on the resulting software.
- Travel tied directly to performing or supporting development work.
The stock-based compensation piece catches many companies off guard. If you grant restricted stock units or options to developers, the compensation expense attributable to their development work has to be treated as a Section 174 cost, not simply booked as general compensation. For startups paying heavily in equity, this can meaningfully increase the dollar amount running through these rules.
General and administrative overhead unrelated to development, marketing and sales expenses for the finished product, and end-user training stay outside Section 174. Those remain ordinary deductions under their own code sections.
Domestic Costs: Full Expensing Starting in 2025
For tax years beginning after December 31, 2024, Section 174A allows you to deduct the full cost of domestic software development in the year the expense is paid or incurred. If your team is in the United States and you spend $2 million on a new product this year, you deduct $2 million this year. No capitalization schedule, no mid-year convention, no waiting.
The provision is permanent, not a temporary incentive with a sunset. Long-range R&D budgeting can assume the deduction will still be there. The IRS released Rev. Proc. 2025-28 in August 2025 with procedural guidance for implementing the new expensing rules and making related elections; companies that had been capitalizing under the prior version of Section 174 follow those procedures when switching to immediate expensing.
Foreign Development Costs: Still 15 Years
The mandatory amortization framework from the Tax Cuts and Jobs Act still applies to foreign software development. If you pay an overseas contractor to build software or run a development team outside the United States, those costs are capitalized and amortized over 15 years.3GovInfo. 26 U.S. Code 174 – Amortization of Research and Experimental Expenditures
Amortization starts at the midpoint of the tax year in which the expenditure is paid or incurred, regardless of when the software is placed in service or whether the project is even finished.3GovInfo. 26 U.S. Code 174 – Amortization of Research and Experimental Expenditures Because of this mid-year convention, a 15-year amortization actually stretches across 16 tax returns. For a $1.5 million foreign expenditure:
- Annual amortization: $1,500,000 รท 15 = $100,000
- Year 1: $50,000
- Years 2 through 15: $100,000 each
- Year 16: $50,000
A team split between U.S. and offshore offices creates a cost allocation problem. You need contemporaneous records showing where the work was actually performed, because the tax treatment turns on that split.
Cleaning Up Unamortized 2022 Through 2024 Balances
Companies that capitalized domestic development costs during the three years of mandatory amortization still have unamortized amounts on their books. The One Big Beautiful Bill Act gives three ways to handle those leftover domestic balances:
- Keep amortizing the remainder on the original five-year schedule.
- Deduct the entire remaining unamortized balance in the first tax year beginning after December 31, 2024.
- Deduct the balance ratably across two tax years, starting with the first tax year beginning after December 31, 2024.
The right choice depends on your income profile. A big taxable-income year points toward the lump-sum deduction. A company trying to smooth its tax liability may prefer the two-year spread. These transition options apply only to domestic costs. Foreign development costs incurred during 2022 through 2024 stay on their original 15-year schedule.
Software You Buy Rather Than Build
Purchased software follows different recovery rules depending on how you acquire it.
Off-the-Shelf Software
Commercially available software that you buy under a nonexclusive license and don’t substantially modify is depreciated under Section 167(f)(1) over a straight-line 36-month recovery period.4Office of the Law Revision Counsel. 26 USC 167 – Depreciation It also qualifies for bonus depreciation under Section 168(k).5Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System The One Big Beautiful Bill Act restored 100-percent bonus depreciation for property acquired after January 19, 2025, and made it permanent.6Internal Revenue Service. Notice 2026-11 – Interim Guidance on Additional First Year Depreciation Off-the-shelf software bought and placed in service in 2026 can be fully written off in the year of purchase.
Software Acquired With a Business
Custom software picked up as part of buying an entire business or a substantial portion of one gets pulled into Section 197. The statute excludes off-the-shelf software and software acquired outside a business purchase, but software that doesn’t meet those exclusions becomes an amortizable intangible.7Office of the Law Revision Counsel. 26 U.S. Code 197 – Amortization of Goodwill and Certain Other Intangibles
Section 197 intangibles amortize ratably over 15 years, starting in the month of acquisition.7Office of the Law Revision Counsel. 26 U.S. Code 197 – Amortization of Goodwill and Certain Other Intangibles The clock is mandatory and can’t be shortened based on the software’s actual useful life. When you allocate a purchase price across the acquired assets, every dollar assigned to custom software locks in for 15 years.
The Research Credit Runs Alongside the Deduction
Software development costs that qualify under Section 174 may also generate the Research and Development Tax Credit under Section 41. The credit and the deduction are separate benefits, and the same expenditures can potentially produce both.
Qualified research expenses for the credit include wages paid to employees performing or directly supporting qualified research, supplies consumed in the research, and amounts paid for the right to use computers in the research. Contract research payments also count, but only 65 percent of amounts paid to outside researchers flow into the credit calculation.8Office of the Law Revision Counsel. 26 USC 41 – Credit for Increasing Research Activities
Section 41 is effectively a subset of Section 174. Not every Section 174 cost qualifies for the credit, because the four-part test for qualified research is narrower. But every dollar claimed for the credit must also be treated as a Section 174 expenditure. Handle both calculations together, not as separate exercises.
Qualifying small businesses with gross receipts below a set threshold can elect to apply the credit against payroll taxes instead of income taxes. For a pre-revenue software company that doesn’t yet owe income tax, this produces immediate cash savings rather than a carryforward.
What Happens When You Abandon or Sell a Project
Under Section 174(d), if you abandon, retire, or dispose of software for which you capitalized development costs, you do not get to deduct the remaining unamortized balance in that year. Amortization simply continues on the original schedule.3GovInfo. 26 U.S. Code 174 – Amortization of Research and Experimental Expenditures Before the TCJA, a company shelving a failed project could write off the remaining costs as an ordinary loss. That option is gone.
Two situations still trigger this rule going forward:
- Foreign development projects, because those costs remain on a 15-year amortization schedule. Abandoning the project doesn’t shorten the schedule.
- Any 2022 through 2024 domestic capitalized balances that weren’t cleared out under the OBBBA transition elections.
If you sell rather than abandon, the seller still cannot accelerate the unamortized development costs, and the buyer gets no amortization deduction for the seller’s original expenditures. Gain or loss on the sale is measured against the software’s adjusted basis, which is the original capitalized amount minus accumulated amortization. When a corporation ceases to exist in a Section 381(a) transaction, the acquiring corporation steps into the transferor’s shoes and continues amortizing.
Changing Your Accounting Method
Switching tax treatments for software development costs is a change in accounting method. The IRS generally requires Form 3115, though streamlined procedures have accompanied both the TCJA and OBBBA transitions. For the switch to Section 174A expensing in tax years beginning after December 31, 2024, follow Rev. Proc. 2025-28. Getting the paperwork wrong doesn’t change your underlying tax, but it creates audit exposure and processing delays you don’t need.
State Conformity Doesn’t Always Match
Federal and state treatment can diverge. Some states conform to Section 174A and allow immediate expensing for domestic development. Others decouple and keep their own capitalization or amortization rules. During 2022 through 2024, a handful of states allowed immediate expensing while the federal government required five-year amortization; the reverse situation may now exist in states that haven’t updated their conformity to reflect Section 174A. A company operating in multiple states may need separate development-cost calculations for the federal return and for each state. Check your state’s current conformity date and any specific decoupling provisions before assuming federal treatment flows through.