Actual Expense Method for Deducting Car and Truck Expenses

2019-05-30Deductions for car and truck expenses are the 2^nd largest category of deductions for business owners. There are 2 methods for deducting these expenses: standard mileage allowance and actual expense method. The actual expense method is, as the name implies, the deduction of actual expenses, including: depreciation, licenses, tires, garage rent, gas, oil, towing, insurance, vehicle registration fees, lease payments and fees, and repairs. Generally, the standard mileage allowance yields greater deductions for smaller, more fuel-efficient cars, while deductions for luxury cars, trucks and vans will usually be larger under the actual expense method.

Parking fees and tolls can be deducted under either method. Interest on an auto loan can be deducted by the self-employed and by businesses, both under the standard mileage allowance and the actual expense method. Vehicles can also be depreciated using the standard §179 deduction, first-year expensing, and other depreciation methods for depreciating property. However, there is an annual dollar limit for depreciation deductions for passenger cars, light trucks and vans.

If the actual expense method is chosen for the 1^st year, then the standard mileage allowance cannot be used in later years; on the other hand, if the standard mileage allowance is used in the 1^st year, then the actual expense method can be used in later years, if desired. The only drawback to switching to the actual expense method later is that if the vehicle has not been fully depreciated, then the straight-line method must be used to depreciate the vehicle over its remaining life.

The actual expense method must be used if the business operates more than 4 vehicles, such as in a fleet operation. However, if the vehicles are not used simultaneously, then expenses can be deducted by using the standard mileage allowance. The actual expense method must also be used if MACRS depreciation or the 1^st year expense deduction is claimed.

The primary focus of this article is using the actual expense method for vehicles weighing less than 6000 pounds — passenger cars, and light trucks and vans. Although common and ordinary expenses for other types of vehicles used in business are also deductible, some rules may differ or there may be additional rules for heavier vehicles, fleets, ambulances, hearses, taxis, and limousines.

If the vehicle is only partly used for business, then only the business-use percentage — equal to the number of miles driven for business or managing investments divided by the total number of miles driven for the tax year — of any expenses, including depreciation, can be deducted. Any miles driven for investment purposes can also be added.

Tax tip: if you have a corporation, then it may be advantageous to have the corporation own any motor vehicles used in its business. The corporation can fully deduct all expenses, although it will still be limited by the dollar limit on depreciation. If you own the vehicle, then being an employee of the corporation will limit most actual expense deductions to 2% of your adjusted gross income (AGI), which can only be claimed as an itemized deduction. Furthermore, if you are involved in an accident, your insurance rates will be affected and you could be sued, where your assets will be subject to any judgment. On the other hand, if the corporation owns a vehicle, its own insurance rates will not be affected and any judgments will be limited to the assets of the corporation. The only drawback is that insurance rates may be higher because a vehicle is used for business.

Deductions for Employees

If the car is provided by an employer, then the employer will include the value of that use on Form W-2, Wage and Tax Statement. Unreimbursed expenses can be deducted up to the amount that was included as income for the use of the car. Expenses paid by an accountable plan set up by the employer are free of all taxes, including payroll taxes. Therefore, no expenses are deductible unless they are unreimbursed. An accountable plan is one in which the employee must report all expenses to the employer and any excess reimbursements must be returned to the employer within a reasonable time. If the reimbursement plan does not satisfy the tax rules for an accountable plan, then it is considered a nonaccountable plan and all reimbursements are reported as income on Form W-2. Actual expenses can be deducted under the nonaccountable plan.

Special Situations

There is a tax credit of up to $7500 for plug-in highway ready electric vehicles bought and placed in service after February 17, 2009. However, for some major manufacturers, the full credit applies only to the 1^st 200,000 cars sold by the manufacturer; thereafter, there is only a partial credit for up to 1 year afterwards. The credit is calculated and claimed on Form 8834, Qualified Plug-In Electric and Electric Vehicle Credit. For business vehicles, the credit is claimed on Form 3800, General Business Credit.

If a vehicle is damaged, destroyed, or stolen, then the business-use percentage of any loss not reimbursed by insurance is deductible.

Depreciation

A depreciation deduction is equal to a certain percentage of the taxpayer's basis in the motor vehicle. The tax basis for claiming depreciation is equal to the cost the vehicle multiplied by the number of miles driven for either business or investment divided by the total number of miles driven for the tax year. So if you pay $20,000 for your vehicle, and 75% of the driven miles were for business or investments, then 75% × $20,000 = $15,000 is the basis used for calculating the depreciation deduction.

Luxury and sales taxes are added to the cost basis of the vehicle — they are not deductible as separate items. So these taxes can only be depreciated or, as part of the cost basis, they will reduce any gain or increase any loss on the disposition of the vehicle.

Vehicle Cost = Cash Payment + Adjusted Tax Basis of Trade-In Vehicle

New Vehicle Tax Basis = Vehicle Cost, Including Luxury or Sales Taxes, Destination Charges, Dealer Preparation Fees – First-Year Expense Deduction – Qualified Electric Vehicle Tax Credit

The depreciation amount allowable for each year decreases the taxpayer's basis in the vehicle by that amount. Depreciation is based on the class life of the motor vehicle, which is 5 years. However, because of other tax rules, there is a limit to how much can be depreciated in each year. Thus, the number of years that depreciation is allowed may be greater than the class life. In any case, the depreciation duration is extended by 1 year because of the half-year convention, which only allows ½ or some other reduced percentage of depreciation that can be claimed in the 1^st and last year.

There are 2 major methods for depreciating cars and trucks over an extended period: straight-line depreciation and Modified Accelerated Cost Recovery System (MACRS). Depreciation under the straight-line half-year convention equalizes the amount that can be depreciated for each year, so 20% of the basis can be deducted for the 2^nd through the 5^th year, and 10% can be deducted in the 1^st and 6^th years. Under the MACRS half-year convention, the following percentages can be deducted:

Depreciation Deduction = Original Tax Basis × Relevant Depreciation Percentage × Business and Investment Use Percentage

However, the depreciation allowance under either method cannot be greater than the business use percentage of certain dollar amounts. So if the business use percentage of your vehicle is 75% for the 1^st year, then the 1^st year dollar limit of $3160 is reduced to 75% × $3160 = $2370. The dollar limit applies to each vehicle.

To claim accelerated depreciation or first-year expensing, the vehicle must be used more than 50% for business in the 1^st year. If the 50% test is satisfied, then miles driven for investment purposes can also be added, but the investment miles cannot be used to calculate the 50% test. Hence, more than ½ of the total miles driven must have been for business — not for investment or personal use. If business use drops below 50% after the 1^st year, then the straight-line depreciation method must be used. Additionally, excess depreciation must be added back to income, equal to the amount of depreciation claimed minus the amount of depreciation that would have been allowable had the straight-line method been chosen to begin with:

Excess Depreciation = Amount of Depreciation Claimed – Amount of Depreciation Allowable under the Straight-Line Method

Section 179 Deduction is Limited by the Dollar Limit on Depreciation

Section 179 deduction is a first-year expensing allowance where up to $500,000 can be deducted rather than depreciated. However, because there is a dollar limit on depreciation on passenger cars, light trucks and vans (i.e., vehicles whose gross vehicle weight rating (GVWR) does not exceed 6000 pounds), the limit is much lower than the §179 allowance. For instance, in 2015, the maximum that can be deducted for a passenger car is $3160 and $3460 for light trucks and vans (2016 limits: $3160 and $3560). Because a much larger deduction can be taken using the special depreciation allowance for qualified vehicles, it makes little sense to use a §179 deduction unless the vehicle does not qualify for the special depreciation allowance. (The GVWR can usually be found on the label on the inside edge, near the hinges of the driver’s door.)

However, there are no dollar limits on the depreciation of trucks or vans that weigh more than 6000 pounds, so the full §179 deduction can be taken.

However, any §179 deduction can only be taken on the net cost of the vehicle, after subtracting any trade-in value of another vehicle. So if you buy a truck for $50,000 and your payment is reduced by $10,000 for a traded-in vehicle, then the §179 deduction will be limited to the $40,000 net cost.

Special Depreciation Allowance

For qualified vehicles placed in service during the tax year, an additional special depreciation allowance (aka bonus depreciation) deduction of 50% of the vehicle's depreciable basis, which is the basis after subtracting any §179 deduction but before any depreciation deduction under MACRS. To qualify for this allowance, the vehicle must have been used more than 50% for business, not including any miles driven for investments. However, because of the dollar limitation on depreciation of vehicles, the maximum depreciation deduction for qualified passenger cars is $11,160; for light trucks and vans, it is slightly higher: $11,460. If the special depreciation allowance is not claimed, then the maximum first-year depreciation deduction is $3160 for cars and $3460 for light trucks and vans. Qualified vehicles include cars, trucks, and vans purchased new after 2007 and placed in service in a trade or business, and was used more than 50% for qualified business use, not including miles driven for investments.

If the special depreciation allowance is not claimed for qualified property, then that election applies to all 5-year property placed in service during the tax year. The election to not claim the special depreciation allowance is made by attaching a statement indicating the class of property, which is 5 years for cars, trucks and vans, for which the election is being made.

Excess Depreciation

Claiming the §179 deduction or the special depreciation allowance requires that the vehicle be used more than 50% for business for each year of its life. If business use declines to less than 50% for any year, then the depreciation claimed by first-year expensing must be recaptured by adding the excess depreciation, which is the total claimed depreciation that exceeds what would otherwise be deductible under the straight-line method, back to income in the year in which business use declines to less than 50%. Excess depreciation is also added back to the basis in the vehicle. So if your gross income is $50,000 and the basis in your vehicle is $16,000, and you had $2000 of excess depreciation, then your gross income would increase to $52,000 and the basis in your vehicle would increase to $18,000.

Excess Depreciation = Depreciation Claimed – Depreciation Allowed by the Straight-Line Method

Excess depreciation is figured on Form 4797, Sales of Business Property.

Depreciation Deduction Is Limited by a Dollar Limit

To avoid subsidizing luxury vehicles, the government places a strict dollar limit on the amount of depreciation that can be claimed annually on passenger cars, and light trucks and vans weighing less than 6000 pounds. The dollar limits for the depreciation of light trucks and vans, those weighing less than 6000 pounds, are slightly higher than those for passenger cars.

Example: You buy a vehicle for $30,000 and use it 100% for business. The maximum that can be deducted is $3160 in the 1^st year (without the bonus depreciation), $5100 in the 2^nd year, $3050 and 3^rd year, and $1875 in the 4^th and later years, until the car is fully depreciated. If the business use percentage is only 50%, then the maximum depreciation that could be claimed will be ½ of those figures.

If the vehicle weighs more than 6000 pounds but less than 14,000 pounds, then the dollar limits do not apply. Light trucks and vans weighing less than 6000 pounds have higher limits.

SUVs, trucks, and vans that are modified primarily for business use, such as having shelving in the cargo area or having the name of the business on the side of the vehicle — so-called qualified nonpersonal use vehicles — have no dollar limits on the depreciation.

Disposition of the Vehicle

When a vehicle is disposed of — sold, traded in, or subject to a casualty, such as theft or accidental damage – any taxable gain must be calculated. If the car is sold, then the gain is equal to the sales proceeds minus the adjusted basis of the vehicle.

Adjusted Basis = Original Basis – First-Year Expensing – Claimed Depreciation

Gain or Loss = Sales Proceeds – Adjusted Basis

With the standard mileage allowance, there is a deemed depreciation, = depreciation rate per mile × business use percentage. A reduced depreciation can be claimed for the last year, equal to 50% of the full-year amount, but only if the vehicle was placed in service in January – September; otherwise, the amount of depreciation that can be claimed in the last year depends on the quarter in which it was sold, equal to the percentage of the depreciation that could have been claimed for a full year:

• January – March: 12.5%
• April – June: 37.5%
• July – September: 62.5%
• October – December: 87.5%

If the vehicle is traded in for another vehicle that will be used for business, then the adjusted basis of the old vehicle will be added to any cash paid for the new vehicle to determine the tax basis of the new vehicle. However, only the cash paid can be used as a basis for first-year expensing; the trade-in basis is not considered. Depreciation is calculated based on the amount of cash paid plus the adjusted basis of the trade-in. In the unlikelihood that the value of the trade-in exceeds the price of the new vehicle, gain will have to be recognized, equal to the difference between the value of the trade-in minus the adjusted basis in the old vehicle.

Example: A new car cost $20,000. You pay $12,000 in cash plus $8000 for a trade-in. Your basis on the trade-in is $5000. Therefore, the basis for the depreciation of the new vehicle will equal $12,000 + $5000 = $17,000. For first-year expensing, only the $12,000 matters. To calculate the depreciation for each year, multiply $17,000 by the business usage percentage multiplied by the depreciation percentage for that year.

Unadjusted Basis of New Car = Adjusted Basis of Old Car + Additional Amount Paid for New Car – (Total Allowable Depreciation if Business Use Percentage was 100% for Old Car – Total Allowed Depreciation for Old Car)

For any vehicle damaged or stolen, any insurance reimbursement that exceeds the adjusted basis of the vehicle will be recognized as a gain, unless the reimbursement is used to purchase another vehicle for business or to repair the old vehicle within 2 years after the year of the casualty or theft, in which case, no gain is recognized. However, the adjusted basis of the new vehicle will be equal to its cost minus any unrecognized gain.

Motor Vehicle Leasing

The payments for leasing a car are deductible, but no depreciation can be claimed, since only owned property can be depreciated. If the lease includes an option to buy, then what is deductible depends on whether it is a lease or a purchase agreement. The difference will depend on whether:

• it was intended to be a lease or purchase
• any interest was paid
• the taxpayer received any equity from the payments
• the fair market value of the car is less than the lease payment or option payment when the option is exercised

If the circumstances support a purchase agreement, then the taxable consequences will be the same as if the car was bought outright.

Motor vehicle rentals for less than 30 days are immediately deductible. Lease terms exceeding 30 days are deductible if the motor vehicle was used entirely for business. If there was any personal use, then only the portion of business use over total use can be deducted. Advance payments can only be deducted for the period in which they apply.

Inclusion Amount

The tax code seeks to equalize leasing with buying. Because there are dollar limits on depreciating owned vehicles, the deduction for leasing payments is reduced by an additional amount, called the inclusion amount, listed in IRS tables by the fair market value of the vehicle and the year of the lease. However, the inclusion amount is not subtracted from the calculated deduction but is added to income, thereby offsetting the full deduction by the inclusion amount. The inclusion amount only applies to cars with a fair market value exceeding $19,000 or trucks and vans exceeding $19,500 in 2015 on the 1^st day of the lease.

The inclusion amount only applies to leases longer than 30 days and only on the portion of the lease allocable to business use. The portion of the lease allocated to personal use, including commuting, is not deductible. The allocation for time is based on the number of days of business use. Inclusion amounts, based on IRS tables, must be added to income if the lease exceeds the following amounts:

The inclusion amount that must be added to income is equal to the inclusion amount listed in the IRS table multiplied by the number of days of the lease within the tax year.

Inclusion Amount Added to Income = Inclusion Amount Listed in IRS Table × Business Use Percentage × Number of Days in the Lease during the Tax Year/365 (366 for leap year)

Example: If, according to the IRS table, the inclusion amount is $19,000 for the year and the car was leased for 90 days and used exclusively for business, then the inclusion amount that must be added to income = 90 ÷ 365 × $19,000 ≈ $4685.

Recordkeeping

Records must be maintained for all business mileage that includes the following information:

• date
• destination
• business purpose
• type and amount of expenses
• beginning and ending odometer readings that would show the actual miles driven for business

Obviously, the actual expense method also requires recording all actual expenses such as the cost of fuel and oil, licenses and taxes, insurance, and repairs and maintenance.

Expenses by employees are reported on Form 2106, Employee Business Expenses. Expenses are generally miscellaneous itemized deductions and only the amount that exceeds 2% of AGI is deductible. However, employees with a physical or mental disability can deduct expenses as an itemized deduction related to their disability in operating the vehicle, but the 2% floor does not apply.

The self-employed reports actual car expenses on Schedule C, Profit and Loss from Business. The self-employed must record the date when the vehicles were placed in service, and the number of miles driven for business, personal, and commuting. Vehicles that are placed in service during the tax year must be reported on Form 4562, Depreciation and Amortization. Expenses and depreciation in later years can be reported on Schedule C.