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Last week, the IRS made an unusual announcement that it will raise the standard mileage deduction rate to 62.5 cents per mile starting in July 1, 2022. This was in response to rapidly rising gas prices since the beginning of the year. The IRS did a similar midyear increase back in 2008 when gas prices underwent a similar increase.
With car and gas prices steadily increasing, it would be prudent to have a general understanding of the tax rules regarding the deductibility of automobile expenses. The IRS allows the use of a car to be tax deductible in two ways — the actual expense method and the standard mileage method. Today’s column will compare these two methods and help you decide which method to choose.
The actual expense method allows the deduction of a percentage of a car’s operating expenses such as gas, insurance, maintenance costs. If a car is leased, the lease payments are also proportionally deductible. So if a car incurs $5,000 of operating expenses for the year and is used 80% of the time for business purposes, then $4,000 of the cost is tax deductible.
There are a few drawbacks to using the actual expense method. If you use this method in the first year the car is used for business purposes, you cannot switch to the standard mileage method in the next year.
Also, the purchase price of a car is generally not deductible whether it is paid in full or through loan repayments. Instead, the cost of a car is depreciated over a certain number of years. But the exception to the depreciation rule is for certain heavy vehicles, commonly SUVs weighing more than 6,000 pounds. The cost can be 100% tax deductible as a bonus depreciation if the car is used more than 50% for business purposes.
FOMO note: This is the final year when you can purchase a heavy vehicle and claim a full 100% deduction. In 2023, the bonus depreciation amount will be reduced to 80% of the purchase price with higher phase-outs in future years.
The standard mileage method allows you to deduct the standard mileage rate for every mile driven for business purposes. The rules are very liberal on business purposes so long as it is reasonable. For example, driving 100 miles to go to a bank to deposit a $50 check would be considered unreasonable.
The only business-related deduction that is not deductible is the drive from home to the office and back. However, you can get around this rule if you can dedicate a portion of your home as a home office. This can be accomplished if you dedicate a portion of the home strictly for business purposes and perform necessary business tasks there, such as virtually meeting clients, research work, and administrative duties to name a few.
Also, the standard mileage rule cannot be used if you claimed the accelerated depreciation rules mentioned above.
So based on the above, which method would provide the most tax savings? It depends on how you plan to obtain and use the car.
Leasing. If you are leasing a car, it is generally better to use the actual expense method. This is because most lease agreements limit the number of miles you can drive without incurring a penalty. Thus, using the standard mileage rate might not be cost effective.
To give a simple example, suppose you are leasing a car and plan to use it 80% of the time for business. The lease agreement requires you to pay $800 per month with a 12,000 annual mileage limit. Also, your insurance, gas, and maintenance costs $600 per month on average. So your total monthly operating expenses comes to $1,400 per month. Also, the standard mileage rate is 60 cents per mile.
Using the actual expense method, $1,120 of the operating expenses are tax deductible since it is 80% of the total monthly operating expenses. On the other hand, if you use the standard mileage method, if you only drive 80% of the annual limit for business purposes (9,600 miles), your mileage deduction will be limited to $5,760 annually or $480 per month. By using the actual expense method, you will get a $640 greater deduction every month.
Buying. If you purchased your car, which method to use will depend on several factors. The first is whether you are buying a heavy vehicle that is eligible for bonus depreciation. If you take the bonus depreciation, you can realize substantial tax savings if you are in a high tax bracket. But you cannot use the standard mileage deduction while you own the car.
If you own a regular passenger car, you will have to consider the purchase price, depreciation, operating and maintenance costs, and the number of miles you plan to drive. Generally, if you purchase an expensive car with high maintenance costs and don’t plan to drive it often, you should use the actual expense method since the standard mileage rules will likely result in a lower tax deduction. However, it is recommended that you use the standard deduction in the first year so you can switch to the actual expense method later.
But if you buy an inexpensive car with high gas mileage and low maintenance, and you plan to drive it extensively, it was traditionally recommended to use the standard mileage method. This was because the standard mileage deduction would usually be higher than the actual expense method. However, in 2018, the annual depreciation limits increased substantially which might make using the actual expense method more attractive.
Buying or leasing a car is a major decision that requires a lot of thought. And trying to maximize the tax benefits only makes it more complex. But with careful planning and some degree of luck, you can save thousands of dollars in taxes per year and over time, the tax savings can pay for the car itself.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.
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