The total cost associated with the lease or purchase is generally a major factor in decision making. While lease payments include an interest factor, they will still typically be less than those to finance the purchase of a vehicle. Thus, the business owner may be able to afford a higher-end car. However, some hidden costs need to be taken into account. If the automobile will be used to travel long distances, the added miles could cost extra. Leases typically include a mileage allowance of between 10,000 and 12,000 miles per year, above which additional charges apply. At the end of a lease term, the vehicle can either be purchased or returned to the dealer. If purchase is anticipated, it is certainly more advantageous to do so upfront since the total cost of the vehicle over its life will be less.
For a purchased vehicle, the business portion of annual depreciation can be deducted on the vehicle. The established depreciable life for passenger autos is five years. It may be advantageous to lease vehicles expected to be traded in or sold before that term since it will take five years to recover the cost of the vehicle through depreciation. Automobiles can also qualify for accelerated methods of depreciation including section 179 and bonus depreciation, although there are limitations, and the rules can become complicated. Trucks and SUV's may also be eligible for section 179 of bonus, but different rules apply to those types of vehicles.
A common question we ask our clients is "how much does it weigh"? Here's why that's important. Annual depreciation limits exist for passenger automobiles, which are any vehicle with four wheels weighing less than 6,000 pounds so some SUV's and trucks may fall in this category. Passenger autos placed in service in 2020 are limited to $10,100 of depreciation in the first year, $16,100 in year two, $9,700 in year three and $5,760 for each year thereafter. If bonus depreciation is used, the first year limit increases to $18,100. 2021 limits have not been released yet so 2020 limits still apply. These auto limits do not apply to vehicles with a gross weight of over 6,000 pounds but under 14,000 pounds which includes many SUV's and trucks. The section 179 deduction for the first year on these vehicles is limited to $25,000, but you may be able to deduct the rest of the cost using bonus depreciation. Trucks weighing over 14,000 pounds typically have no limit for section 179 depreciation and therefore can be fully deducted the year in which they are placed in service. There are factors when determining whether to use section 179 versus bonus including federal limits to how much section 179 can be taken and states have different rules for section 179 limits and many still so not allow for bonus depreciation.
There are additional depreciation rules for any vehicle used less than 50% business use, the most significant being section 179 and bonus cannot be used and the method of depreciation must be changed to allow even lower amounts to be deducted each year.
For leased vehicles, the business use of monthly payments are deductible but are reduced by a lease inclusion amount. The IRS publishes a table on which to find the annual inclusion based on the fair market value of the vehicle determined at the inception of the lease. The inclusion is prorated for the number of days of the lease term in the tax year and is further reduced to the business use percentage. Due to the luxury auto limits discussed previously, the amount of deductible lease payments, even with the annual inclusion, may exceed the depreciation deduction available. Therefore, the type of car desired can also influence the decision to lease or buy.
The two methods of acquisition differ in what happens when the vehicle is disposed of. The return of a leased vehicle to the dealer at the end of the term does not generate a gain or loss. However, selling an owned vehicle could cause a taxable event. In the past, when an owned vehicle was traded in, the gain or loss on the trade in was rolled into the basis of the new vehicle; however, the tax law has changed and now any gain or loss on a traded in vehicle must now be recognized when it is traded in.
Unlike business entities which must use actual costs, self-employed individuals are allowed two methods for deducting expenses related to autos. These two methods are also available for employee business expenses and reimbursements. The methods include using a standard mileage rate or the deduction of actual expenses incurred. Owners of vehicles can switch from the standard mileage rate to actual expenses later on. For leased vehicles, the same method must be used for the life of the lease. Vehicles on which accelerated depreciation methods are taken cannot later use the standard mileage rate.
The standard mileage rate for 2021 is 56 cents per mile. The rate is published annually by the IRS based on the average annual cost of maintaining an auto and includes depreciation, maintenance and repairs, gasoline and oil, insurance, and registrations. Additional deductions for business tolls and parking are permitted even if the standard mileage rate was used. A mileage log must be maintained to substantiate mileage with the destination, distance, and purpose of business trips. Commuting miles are not deductible.
In order to deduct the actual expenses incurred for a vehicle, proper books and records with itemized receipts must be maintained. Actual expenses include the business percentage of gasoline, oil, insurance, parking, registration fees, repairs, and other maintenance. Any personal use costs should be added to the employee's W-2 as a fringe benefit. Self-employed individuals may also deduct interest paid on a loan used to purchase a vehicle. Employees, however, are not eligible to deduct such interest. The business percentage is calculated as the total business miles divided by the total number of miles driven per year. A mileage log must still be maintained under this method to substantiate the business use.
While it may be tempting to just go out and lease a fast and fancy auto, business owners should consider what works best for their company. In the end, answering the question,
“Should you buy or lease your business vehicle?” is entirely based on your individual circumstance. With all the relevant factors in mind, the overall cost of the vehicle in the long-term net of tax benefits can be maximized.
