Most individuals and many small businesses use the cash basis method of accounting. With this method, you record income when money is received and you record expenses when money is paid out. Tax deductions are taken in the year they're paid. The general rule is that you can’t prepay business expenses for a future year and deduct them from the current year’s taxes. An expense you pay in advance can be deducted only in the year or years to which it applies. Such an expense must be prorated over time, rather than deducted in full in the tax year in which it is paid. This makes these expenses more like capital expenditures than current expenses.
However, there’s an important exception called the "12-month rule." It lets you deduct a prepaid future expense in the current year if the expense is for a right or benefit that extends no longer than the earlier of:
- 12 months, or
- until the end of the tax year after the tax year in which you made the payment.
Common prepaid expenses include rent, insurance, interest, and the cost of obtaining a lease or loan.
Prepaid Rent
Unless the 12-month rule applies, rent payments for the use of property after the taxable year are only partially deductible in the year you make the payment.
Prepaid Insurance
Prepaid insurance premiums are deductible when paid as long as they don't apply to a period extending more than 12 months after the end of the taxable year when the payments were made. If the insurance contract runs for a longer period, you need to take the deduction over time.
Loan Expenses
Expenses of obtaining a loan include commissions, escrow expenses, legal fees, and commitment fees. These expenses are deductible if the loan is related to the production of business or investment income. However, prepaid loan expenses for a personal loan generally aren't deductible at all. If deductible, loan expenses must be deducted over the life of the loan. The 12-month rule can't be used to deduct such expenses in a single year.
Prepaid Interest
Prepaid interest is interest that you pay in advance for a period that goes beyond the end of the tax year. You can’t fully deduct such prepayments in a single year. Rather, you must deduct them over the life of the loan. This is, prepaid interest must be deducted in the year it is due, not the year it is paid.
Points paid to obtain a loan are generally treated as additional interest charges, so they're treated as paid over the term of the loan. However, special rules apply to points paid to obtain a home mortgage. Homeowner-taxpayers can deduct the points in full in the tax year they're actually paid if:
- the loan is secured by the taxpayer's principal residence
- paying points is an established business practice in the area where the loan was made, and
- the points paid were not more than the points generally charged in that area.
Qualifying to Use the 12-Month Rule
To use the 12-month rule, you must apply it when you first start your business or first file taxes as an individual. You must get IRS approval if you haven’t been using the rule and want to start doing so. IRS approval is granted automatically. You must file IRS Form 3115, Application for Change in Accounting Method, with your tax return for the year you want to make the change. When you do this, you apply the 12-month rule to your prior years’ taxes, which may result in additional deductions and tax refunds for prior years. Filing Form 3115 is a complex process best done by a tax professional.
Talk to an Attorney
If you're thinking about prepaying some of your expenses, make sure you know the tax consequences. Don't assume you'll be able to get the full tax benefits of the payment in the year it's made. If you have any questions, talk to a professional tax preparer or a tax lawyer before you file.