Most individuals and a large number of small businesses are cash basis tax payers. This means that money is recorded as income when it is received (not when an invoice is created) and as expenses when the payment is made (as opposed to when the bill is received). However, the expenses are considered tax deductions in they year that they are paid for.
The general IRS rule is that you cannot pay an expense for a future year and deduct it on this year's tax return. An expense you pay in advance, is recorded on your books as a "prepaid asset" and then deducted in the year that it applies to.
There is an exception to this rule knows as the 12-month rule. This exception states that you may deduct a prepaid future expense in the current year when it is paid as long as the expense is for the right or benefit for a period that extends no longer than the earlier of:
- 12 months, or
- Until the end of the tax year after the tax year in which the payment was made
Rent, insurance, interest and lease or loan costs are common prepaid expenses.