Friday, February 4, 2011

Vehicle Expense - Should I Take Depreciation and Actual Costs ... or Mileage?

Answer ... it depends!  What are you using the vehicle for?  How many miles are you driving for a tax deductible purpose each year?  How much will your miles driven vary from one year to the next?  How many years do you plan to keep the vehicle? What is the time value of money to you ... specifically how much more valuable is a tax deduction today than a tax deduction 1, 2, or maybe more years in the future?

Your tax software will give you an answer for this year.  If that answer will also work best for you for the remaining years you use the car, you're in good shape.  Otherwise, you will want to visit with your tax pro... one that you have picked that will take the time to explore each of these options with you.  Be sure to remember that whether you choose to take claim depreciation and actual operating costs, or you choose to use the IRS mileage rate, you are required to continue using that choice for as long as you own and operate that vehicle.
You will want to meet with your tax pro before you buy the vehicle to discuss whether you should lease or buy, what special tax credits are available for the type of vehicle you are considering to see if that will sway your final decision on which vehicle you will choose, and to get started on the questions posed in the last paragraph.

You will want to meet again at or near the time you file your next income tax return after acquiring the vehicle.  This is when many of the tax decisions become final, meaning you have to live with them for as long as you have the vehicle.  So, it's worth going through everything one more time  to make sure none of the assumptions you have made changed since you acquired the vehicle.  Remember, most tax software will only help you with the current year, so check with your tax pro to see if later years are an important consideration for you.

Let me give you an example.  You buy a delivery truck for your business for $30,000, including all taxes and other dealer fees, on December 1.  Your plan is to have one of your reps drive it on an 80 mile daily route 5 days a week.  You have another vehicle for personal use and you don't allow the rep to use it personally either.  We'll also assume that this delivery truck wouldn't be well suited for personal use, so it will truly be 100% business use, just to keep the illustration simpler.  You expect to get 12 miles per gallon of fuel at an average of $3.50 per gallon.  Insurance will be $1,200 per year.  You hate maintenance, so you plan to trade it in 3 years from now at about 60,000 miles so that all you need to do in the meantime is basic oil changes and similar routine maintenance that you think will cost $600 per year.  Similar 3 year old trade-ins right now are going for $18,000, and you don't see that changing much in the next time you own the truck.

Your question:  How should I choose to report this vehicle on my tax return?

The easy way to claim this vehicle on your taxes is to use the mileage rate, currently 51 cents per mile for business use.  You don't have to keep records of your vehicle expenses if you don't want to, just document the mileage in a daily log or similar record.  If this rate stays the same while you own the truck, you will have a tax deduction of $816 for 1,600 miles in year 1, $10,608 for 20,800 miles in each of years 2 and 3, and $9,792 for 19,200 miles in year 4.  This adds up to $31,824 in tax deductions for the life of the vehicle.

If you use the actual cost method, you will probably qualify to write the entire $30,000 cost of the truck off in year 1 since it is being used 100% for business and it likely weighs more than 6,000 pounds.  If the expenses come in even intervals (unlikely, of course, but close enough for this illustration), your tax deductions will be $30,605 in year 1, $7,862 in each of years 2 and 3, followed by net taxable income of $10,742 in year 4 (the $18,000 you will get from selling it, less $7,258 for fuel, insurance, and repairs).  This adds up to $35,587 in tax deductions for the life of the vehicle, plus you have the added benefit that most of the deductions come in the beginning. 

The difference from the mileage rate becomes larger if you replace the truck with another one and are able to write it off in the same way, thus avoiding the net taxable income possibility in the final year.  An alternative would be to trade in the truck on a new one, in that case you don't claim the value of the trade in as income on your tax return, but instead reduce the amount you claim depreciation for on the new vehicle you traded for.

What Factors Could Make The Mileage Rate The Better Choice?

In this example, depreciation works out to 19.2 cents per mile ($30,000 original cost less $18,000 residual value divided by 62,400 miles driven).  I have seen cases where depreciation was as low as 10 cents per mile and others where it was 50 cents per mile. 

Fuel use is another huge factor to consider.  In this example, it was high at 29.2 cents per mile ($3.50 per gallon divided by 12 miles per gallon).  If the vehicle in question gets 25 miles per gallon, fuel use is cut in half to 14.0 cents per mile.

Maintenance can also make a difference and can offset reductions in per mile depreciation achieved by keeping vehicles longer.  Even though the mileage rate may be best in a given situation, I still suggest keeping records of actual costs to help with your decision of how long to keep your vehicles in service.

Bottom line here:  You should estimate total cost per mile to drive your new vehicle and compare it to the IRS mileage rate as one of the key factors in choosing which method to report your business use vehicle on your tax return.  I have seen cases where actual cost, including depreciation, is as low as 30 cents and others as high as $1.00 per mile.  At even 10,000 business miles per year, that relates to a benefit of $2,100 to $4,900 per year in additional tax deductions from making the best choice for you.  If more business miles are driven, obviously the decision becomes even more important.

Should I Take Depreciation Now or Later? Generally people take the IRS up on their offer to let them deduct in full now.  If you have a start up business with little or no profit now, and especially if you have contracts coming on line that will push you into a higher tax bracket in the future, I have seen cases where taking depreciation over 5 years has been worth several thousand extra dollars.  It is worth the time to do the math both ways.

Does This Change If I Have Business Use Of A Vehicle As An Employee?

The same choices are usually available to you, including claiming depreciation in the year the vehicle is purchased.  Where it is different is that you have to file Schedule A to itemize deductions to claim this expense, you have to reduce the deduction by 2% of adjusted gross income, and the deduction is eliminated if you are subject to alternate minimum tax (AMT).  Keep these factors in mind before making a decision to buy a business vehicle that is based on tax savings you are hoping for.

Summary.  This example was designed to illustrate how various factors that play out over the full life of the vehicle can change whether the mileage or actual cost method yields the best result in a given situation, as well as which depreciation choice is best.  Clearly, all of this will vary by the specifics of each individual situation, but I hope I have shown how getting planning help is worthwhile at the time the vehicle is purchased and at least one more time when the first tax return is filed after the purchased.

Please share your questions, comments, or experiences hauling watermelons in the space provided!  I also offer a free 30-minute initial consultation and would welcome your e-mail at dougbeecher@yahoo.com to arrange that.

 
Picture credit for funny delivery vehicle:  Melon Delivery by Fran Hogan  (We now have proof that it was Colonel Mustard in the conservatory with a watermelon to the head!)

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