Last week, the IRS made an unusual announcement that it will increase the standard mileage deduction rate to 62.5 cents per mile starting July 1, 2022. This was in response to the rapid increase in gas prices from the start. of the year. The IRS made a similar hike mid-year in 2008, when gas prices underwent a similar hike.
With auto and gas prices steadily rising, it would be prudent to have a general understanding of the tax rules relating to the deductibility of automotive 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 you to deduct a percentage of a car’s operating expenses such as gas, insurance, maintenance costs. If a car is hired, the rents are also proportionally deductible. So, if a car incurs $ 5,000 in operating expenses for the year and is used 80% of the time for business purposes, $ 4,000 of the cost is tax deductible.
There are some drawbacks to using the actual spend method. If you use this method in the first year that the car is used for business purposes, it is not possible to switch to the standard mileage method the following year.
Furthermore, the purchase price of a car is generally not deductible whether it is paid in full or by repaying the loan. Conversely, the cost of a car is amortized over a number of years. But the exception to the depreciation rule is for some heavy vehicles, commonly SUVs that weigh 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 commercial purposes.
Note FOMO: This is the last year you can purchase a heavy vehicle and claim a full 100% deduction. In 2023, the bonus amortization amount will be reduced to 80% of the purchase price with a phasing out in future years.
The standard mileage method allows you to deduct the standard mileage rate for each mile traveled for business purposes. The rules are very liberal for commercial purposes as long as it is reasonable. For example, driving 100 miles to the bank to deposit a $ 50 check would be considered unreasonable.
The only work-related deduction that is not deductible is travel from home to the office and back. However, you can get around this rule if you can dedicate a part of your home as a home office. This can be achieved if you dedicate a part of the house solely for business purposes and carry out the necessary business activities there, such as virtually meeting customers, research work and administrative duties to name a few.
Also, the standard mileage rule cannot be used if you have requested the accelerated depreciation rules mentioned above.
So based on the above, which method would provide the most tax savings? It depends on how you intend to get and use the car.
Leasing. If you are renting a car, it is generally best to use the actual spend method. This is because most leases limit the number of miles you can travel without incurring a penalty. Therefore, using the standard mileage rate may not be convenient.
To give a simple example, let’s say you are renting a car and plan to use it 80% of the time for business. The lease requires payment of $ 800 per month with an annual mileage limit of 12,000. Plus, insurance, gas, and maintenance cost an average of $ 600 per month. So your total monthly operating expenses amount to $ 1,400 per month. In addition, the standard kilometer rate is 60 cents per mile.
Using the actual expenses method, $ 1,120 of operating expenses are tax deductible as they represent 80% of total monthly operating expenses. On the other hand, if you use the standard mileage method, if you only drive 80% of the annual business limit (9,600 miles), the mileage deduction will be limited to $ 5,760 per year or $ 480 per month. Using the actual spend method, you will receive a greater deduction of $ 640 each month.
Purchase. If you bought your car, which method to use will depend on several factors. The first is if you are purchasing a heavy vehicle that is eligible for bonus depreciation. If you take bonus amortization, you can make significant tax savings if you fall into a high tax bracket. But you can’t use the standard mileage deduction while you own the car.
If you own a regular passenger car, you will need to consider the purchase price, depreciation, operating and maintenance costs, and the number of miles you plan to travel. Typically, if you buy an expensive car with high maintenance costs and don’t plan to drive it often, you should use the actual spend method as 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 that you can switch to the actual spending method later.
But if you buy a cheap car with high gas mileage and low maintenance and plan to drive it extensively, it has traditionally been advised to use the standard mileage method. This was due to the fact that the standard mileage deduction would generally be higher than the actual spending method. However, in 2018, annual depreciation limits increased significantly, which could make using the actual spend method more attractive.
Buying or leasing a car is an important 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 tax per year, and over time, the tax savings can pay off the car itself.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolves tax disputes. He is also in tune with people with large student loans. He can be reached by email at [email protected]. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.