Choosing Between the Actual Expense Method and the Standard Mileage Allowance

Read over the rules on the actual expense method and the standard mileage allowance. For the most part, the choice of method is yours. The choice applies whether you own or lease the car. In some cases, however, you may not be able to use the standard mileage rate. Where you are not barred from using the standard mileage rate and can choose between the methods, which is better? Obviously, it is the one that produces the greater deduction. However, there is no easy way to determine which method will produce the greater deduction. Many factors will affect your decision, including the number of miles you drive each year and the extent of your actual expenses. See the example's comparison.

In making your decision, bear in mind that the standard mileage allowance simplifies recordkeeping for business use of the car.

You should make the decision in the first year you own the car. This is because a choice of the actual expense method for the first year will forever bar the use of the standard mileage allowance in subsequent years. If you use the standard mileage rate, you can still use the actual expense method in later years. However, if the car has not yet been fully depreciated (using the deemed depreciation rates discussed later), then, for depreciation purposes, you must use the straight-line method over what you estimate to be the car's remaining useful life.

Depreciation

If you own your car and use it for business, you may recoup part of the cost of the car through a deduction called depreciation. The amount of depreciation depends on a great many factors. First, it depends on whether you use the depreciation allowance or claim a Section 179 deduction (discussed later in the chapter). It also varies according to the year in which you begin to use your car for business, the cost of the car, and the amount of business mileage for the year as compared with the total mileage for the year. Depreciation is covered in Chapter 14 as well.

Business Use versus Personal or Investment Use

Whether you claim a depreciation allowance or a Section 179 deduction, you can do so only with respect to the portion of the car used for business. For example, if you use your car 75% for business and 25% for personal purposes, you must allocate the cost of the car for purposes of calculating depreciation. The allocation is based on the number of miles driven for business compared to the total number of miles driven for the year.

If you use a car for investment purposes, you can add the miles driven for investment purposes when making an allocation for depreciation.

Depreciation Allowance

A depreciation allowance is simply a deduction calculated by applying a percentage to the basis of the car. Cars are treated as 5-year property under the Modified Accelerated Cost Recovery System (MACRS), the depreciation system currently in effect, as discussed in Chapter 14. As such, you would think that the cost of the car could be recovered through depreciation deductions over a period of 5 years. However, this is generally not the case because of a number of different rules that exist. These rules all operate to limit the amount of depreciation that can be claimed in any one year and to extend the number of years for claiming depreciation.

Depreciation can take several forms. There is accelerated depreciation under MACRS, which results in greater deductions in the early years of ownership and smaller deductions in the later years. There is straight-line depreciation, which spreads depreciation deductions evenly over the years the car is expected to last (the fixed number of years may, in fact, have no relation to the actual number of years the car is in operation). Tables 9.1 and 9.2 provide the percentage for depreciation under both methods. There is the first-year expense deduction, discussed later in this chapter, which is in lieu of depreciation. It takes the place of depreciation for the first year. Any part of the car not recovered through the first-year expense deduction can then be recovered through depreciation deductions in subsequent years.

Business Use

In order for you to claim an accelerated depreciation deduction or a first-year expense, the car must be used more than 50% for business. Compare the miles driven during the year for business with the total miles driven. If more than 50% of the mileage represents business use, accelerated depreciation (or the first-year expense deduction below) can be claimed.

If you satisfy the 50% test, you may also add to business mileage any miles driven for investment purposes when calculating the depreciation deduction. You may not add investment mileage in order to determine whether you meet the 50% test. If you fail the 50% test (you use the car 50% or less for business), you can deduct depreciation using only the straight-line method. Your deduction is limited to the rates listed in the section on “Conventions.”

What if the percentage of business use changes from year to year? You may use your car 75% for business in 1 year but only 40% the next. Where business use in the year the car is placed in service is more than 50% but drops below 50% in a subsequent year, you must also change depreciation rates. Once business use drops to 50% or below, you can use only the straight-line method thereafter. The depreciation rate is taken from the table for the straight-line method (Table 9.1) as if the car had not qualified for accelerated depreciation in a prior year.

Where business use drops to 50% or less, you may have to include in income an amount called excess depreciation. This is the amount of depreciation (including the first-year expense deduction) claimed when the car was used more than 50% for business over the amount of depreciation that would have been allowable had the car not been used more than 50% in the year it was placed in service. In addition to including excess depreciation in income, you must increase the basis of your car by the same amount.

Conventions

There are special rules that operate to limit write-offs for depreciation, called conventions. Two conventions apply to depreciation for cars: the half-year convention and the mid-quarter convention.

The half-year convention, in effect, assumes that the car was placed in service in the second half of the year. Thus, in the first year you are allowed to claim only one-half the normal rate of depreciation, regardless of when in the year the car was placed in service. Thus, even if the car was placed in service on January 1, the half-year convention must still be used.

You can see in Table 9.1 how the half-year convention operates to limit depreciation in the first year. By the same token, the amount of depreciation denied in the first year will ultimately be allowed in the sixth year. Still, the half-year convention means that even though the car is classified as 5-year property, its cost will be recovered only over a period of 6 years. If the half-year convention applies to property used 50% or less for business, the depreciation rate is in Table 9.1. If the half-year convention applies to property used more than 50% for business, the depreciation rate is in Table 9.2.

The other convention, the mid-quarter convention, applies if more than 40% of all the depreciable property you place in service during the year is placed in service in the last quarter of the year.

If the mid-quarter convention applies to property used 50% or less for business, the rate is in Table 9.3.

If the mid-quarter convention applies to property used more than 50% for business, the rate is in Table 9.4.

Section 179 Deduction

The Section 179 deduction, also called the first-year expense allowance, is a one-time write-off for the cost of the car. The maximum amount of the Section 179 deduction in 2016 is $500,000. However, this may not be the limit that applies to the deduction for the purchase of a vehicle, because there are other limits that supercede this cap:

• Dollar limits (discussed later) for the purchase of passenger vehicles, light trucks, and vans

• A special limit of $25,000 for the purchase of heavy SUVs

Dollar Limit on Depreciation Deduction

The law sets a dollar limit on the amount of depreciation that can be claimed on a car used for business (see Table 9.5). The dollar limit is intended to limit depreciation that could be claimed on a nonluxury car. In essence, the government does not want to underwrite the cost of buying high-priced cars. However, in reality the dollar limits do not really correlate with luxury cars, since the average cost of a new American car was more than $33,781 as of March 2016, according to Kelley Blue Book. Still, the dollar limits are a factor you must reckon with in calculating your deduction limit.

The dollar limits in Table 9.5 do not apply to light trucks and vans (those weighing less than 6,000 pounds). Special (higher) limits apply as explained later in this chapter.

The dollar limit applies only to cars with a gross vehicle weight (the manufacturer's maximum weight rating when loaded to capacity) of 6,000 pounds or less. Most cars fall into this category.

Increase Your Dollar Limit

The dollar limit applies on a per-car basis. If you own 2 cars and use each for business, you may be able to increase your total dollar limit. Be sure to apply the percentage of business use for each car to the applicable dollar limit.

Dispositions of a Car

When you sell your car, trade it in for a new one, or lose it as the result of a casualty or theft, you have to calculate your tax consequences.

Standard Mileage Rate Barred

You cannot use the standard mileage rate when:

• You operate more than 4 cars at the same time (such as in a fleet operation). This limit does not apply to the use of more than 4 cars on an alternate basis. For example, if you own cars and vans and alternate the use of these vehicles for business use, then you are not barred from using the standard mileage rate to account for the expenses of the business use for the vehicles.

• You have already claimed MACRS or the first-year expense deduction on the car.

Standard Mileage Rate or Actual Expense Method?

As discussed earlier in this chapter, which method is preferable for you depends on a number of variables. The most important is the number of business miles you drive each year. As a rule of thumb, those who drive a great number of miles each year frequently find the standard mileage rate offers the greater deduction. However, the rate may not adequately reflect your actual driving costs. It is also important to note that the standard mileage rate is not dependent on the price of the car. Less expensive cars can claim the same deduction as more expensive cars, assuming each is driven the same number of business miles. Certainly, those with heavy SUVs can claim a greater deduction with the actual expense method.

Lease with an Option to Buy

When you have this arrangement, are you leasing or buying the car? The answer depends on:

• The intent of the parties to the transaction.

• If any equity results from the arrangement.

• If any interest is paid.

• If the fair market value of the car is less than the lease payment or option payment when the option to buy is exercised.

When the factors support a lease arrangement, the payments are deductible. If, however, the factors support a purchase agreement, the payments are not deductible.

Inclusion Amount

If the car price exceeds a certain amount and you deduct your actual costs (you do not use the standard mileage rate), you may have to include in income an inclusion amount (technically, you merely reduce the deduction for vehicle lease payments by the inclusion amount). This is because the law seeks to equate buying with leasing. Since there is a dollar limit on the amount of depreciation that can be claimed on a luxury car that is owned, the law also requires an amount to be included in income as an offset to high lease payments on a car that is leased. In essence, the inclusion amount seeks to limit your deduction for lease payments to what it would be if you owned the car and claimed depreciation. The inclusion amount, applies if a car is leased for more than 30 days and its value exceeds a certain amount. Amounts are adjusted annually for inflation. The inclusion amount is taken into account as long as you lease the car, but the amount taken into account each year is based on the year that the lease begins (i.e., you are unaffected by future inflation adjustments). If the capitalized cost of the car is specified in the lease agreement, that amount is considered to be the fair market value of the car. At the start of the lease, you can see what your inclusion amount will be for that year and for all subsequent years. The inclusion amount is based on a percentage of the fair market value of the car at the time the lease begins.

The inclusion amount applies only if the fair market value of the car when the lease began was more than $16,700 in 2010, $18,500 in 2011 and 2012, $19,000 in 2013, $18,500 in 2014, $17,500 in 2015, and $19,000 in 2016.

Inclusion amounts in Table 9.9 are taken from IRS tables, which can be found in the appendix to IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses. Those rates apply to cars first leased in 2016. The full amount in the table applies if the car is leased for the full year and used entirely for business. If the car is leased for less than the full year, or if it is used partly for personal purposes, the inclusion amount must be allocated to business use for the period of the year during which it was used. The allocation for part-year use is made on a day-by-day basis.

Remember that if you use your car for commuting or other nonbusiness purposes, you cannot deduct that allocable part of the lease; there is no inclusion amount for this portion.

There are separate inclusion amount tables for trucks and vans first leased in 2016. This information can be found in IRS Rev. Proc. 2015–19 (Table 6).

Should You Lease or Buy?

The decision to lease or buy a car used for business is not an easy one. There are many financial advantages to leasing. Most important is that you need not put forth more than a small amount of up-front cash to lease, whereas a purchase generally requires a significant down payment. So leasing can enable you to drive a more expensive car than you could afford to buy. However, as a practical matter, if a car is driven extensively (more than 15,000 miles per year), leasing may not make sense because of the annual mileage limit and the charge for excess mileage. In such cases, owning may be preferable. Take into consideration that at the end of the lease term you own nothing, whereas at the end of the same period of time with a purchased car you own an asset that can be sold or traded in for a newer model. And, if you want to get out of the lease before the end of the lease term, there may be substantial penalties and fees (although there may be ways to avoid them).

Whether there are any tax advantages is difficult to say. With leasing, you deduct the entire lease charge; with a purchase, you generally deduct depreciation, although you may be able to fully expense up to $25,000 for a car weighing more than 6,000 pounds. Given the current dollar limits on depreciation, this may not be as great as the lease charge. While the inclusion amount is designed to offset this differential, it may not be sufficient to make leasing and depreciation equate.

The only way to know whether leasing or buying is more advantageous tax-wise is to run the numbers. Project your deductible costs of leasing versus your costs of purchasing the car.

What Is Included on Your W-2?

The employer has a choice of what to report. The employer can either report the actual value of your personal use or assume that you used the car entirely for personal purposes and include 100% of the benefit in your income. This 100% amount is based on the annual lease value for the car (explained in Chapter 7). The full amount reported on your W-2 is income to you. Your W-2 will note whether the 100% annual lease value or actual personal use was reported. Even though you must include the full amount reported on your W-2, whatever it might be, you may be able to reduce your income tax. You can offset this income to the extent that what was reported as personal use was actually business use and you deduct your business expenses. Where to claim these business deductions is detailed at the end of this chapter.

If your employer reported 100% of personal use even though you used the car in part for business, you can deduct your actual expenses for business use that were not reimbursed by your employer. If your employer included only a portion of the use of the car designed to reflect your personal use, then you can deduct any actual expenses for business use that were not reimbursed by your employer.

4-Wheel Vehicles

There is a credit for a new plug-in highway-ready electric vehicle purchased and placed in service in 2016. The credit is up to $7,500, regardless of the weight of the vehicle.

The full $7,500 credit for such vehicles as the Chevy Volt, Ford Focus Electric, Tesla Model S, and Nissan Leaf applies only to 200,000 cars per manufacturer; there is a partial credit for up to a year after this limit is reached. The IRS has approved about 30 vehicles for the credit, although not all qualify for the full $7,500 amount.

If the vehicle is purchased for business, it is part of the general business credit (see Chapter 23).

The credit can be claimed for both regular tax and alternative minimum tax purposes (see Chapter 28).

2-Wheel Vehicles

There is also a credit for a 2-wheel electric vehicle (electric motorcycle). The credit is 10% of the cost of the motorcycle, for a maximum credit of $2,500. The motorcycle must have a battery capacity of at least 2.5 kilowatt-hours, be manufactured primarily for use on public streets, roads, and highways, and be capable of achieving speeds of at least 45 miles per hour. (There had been a credit for a 3-wheel vehicle acquired before 2014, but this credit expired and was not extended.)

Note: The credit expires at the end of 2016 unless Congress extends it. See the Supplement for any update.

Accountable Plan

If your employer maintains an arrangement that reimburses you for business-related use of the car, requires you to adequately account to the employer for these expenses, and also requires you to return within a reasonable time any advances or reimbursements in excess of these expenses, then the plan is treated as an accountable plan. (For details on adequate accounting under accountable plans and returning excess amounts within a reasonable time, see Chapter 8.) If your employer maintains an accountable plan for reimbursement of business expenses and the amount of reimbursement does not exceed the standard mileage allowance, the reimbursements are not reported on your W-2, and you do not deduct any expenses. If the reimbursements exceed the standard mileage allowance, only the excess over the standard mileage allowance is included on your W-2. You may then deduct your actual expenses that exceed the standard mileage rate.

Nonaccountable Plan

Your employer must include on your W-2 form all reimbursements made under a nonaccountable plan.

Proving Expenses with a Mileage Allowance

Generally, required recordkeeping includes tracking the odometer at the start and end of each business trip (as well as the date, destination, and purpose of the trip). However, the IRS permits “sampling” in some situations. You are treated as having adequate substantiation if you keep records for a representative portion of the year and can demonstrate that the period for which records are kept is representative of use for the entire year.

Sampling may not be used if you cannot show a consistent pattern of car use. Also, not all substantiation shortcuts are acceptable. For instance, 1 taxpayer used mileage figured by a computer atlas to substantiate his car expenses. Unfortunately, the Tax Court rejected this method, observing that he failed to keep track of his odometer readings at the time the expenses were incurred.

If your employer pays for car expenses with a mileage allowance, it generally is considered to be proof of the amount of expenses. The amount of expenses that can be proven by use of this allowance is limited to the standard mileage allowance or the amount of a fixed and variable rate (FAVR) allowance that is not included on your W-2. The FAVR allowance includes a combination of fixed and variable costs, such as a cents-per-mile rate to cover variable operating costs (e.g., gas, oil, routine maintenance, and repairs) and a flat amount to cover fixed costs (e.g., depreciation, insurance, registration and license fees, and personal property taxes). The FAVR allowance applies only if the car is used for certain employees. Thus, use of this allowance is the employer's choice, not the employee's.