Cars are something we depend on for everything - errands, school drop-offs, vet appointments, and the commute to work. Some of us even give them nicknames and gently pat the dashboard when they make loud noises. In addition to adding value to our daily lives, vehicles can also help us save on taxes! Believe it or not, your vehicle can be depreciated on your tax return to reduce your taxable income.
What is Vehicle Depreciation?
In its simplest form, depreciation is the process of decreasing the value of an asset. We intuitively understand this concept: A Ford Focus bought in 2014 has less value than one bought in 2018. (That's what I know from my experience with CarMax.)
A car's wear and tear are also evident when it is used a lot. That's why finding a used car with low mileage is always a bargain. Another contributing factor is the fact that humans continue to innovate. In other words, the car you bought five years ago can't compete with the car you buy today. New models of cars are released every year with improved functionality and features.
How Auto Depreciation Affects Your Taxes
Car depreciation for taxes is generally designed to spread the costs out over a car's "useful life" rather than writing off its entire purchase price right away.
It is the amount of time it takes for your vehicle to lose 100% of its original value. For tax purposes, the IRS considers five years as the standard for most vehicles (in other words, it has the life expectancy of a guinea pig).
There are two basic methods to depreciate your vehicle for taxes: mileage and actual expenses.
In the Case of Standard Mileage Deductions
- Almost everyone is familiar with the term “business mileage.” If you aren’t, it’s what it sounds like: the miles you drive for work. This is a great option for people who drive a lot for work, such as truckers or Uber and Lyft drivers. It could also make sense for, say, Turo hosts whose cars are often rented out.
- The IRS publishes a standard mileage rate every year to reflect all the costs associated with owning a vehicle: gas, repairs, oil, insurance, registration, and depreciation, of course.
- During January through June, that rate is $0.585, and from July through December, it's $0.625 (the IRS increased it due to high gas prices).
Calculating Your Standard Mileage Deduction
Let's say you drive 12,000 miles a year, 5,000 of which are for work. Let's say you drive 2,500 miles during the first half and 2,500 miles during the second half of the year to calculate your tax deduction.
This would give you a mileage write-off of $3,025. (2,500 x $0.585 = $1,462.50, and 2,500 x $0.625 = $1,562.50. Adding them together gives you $3,025).
Actual Expense Depreciation
Your business-related vehicle expenses can be deducted using this method of depreciation. Keeping track of these expenses is crucial if you plan on using this method. You should save receipts or use expense tracking software to catalog them digitally. It includes things like gas, maintenance, and other direct expenses. Hold onto these records for at least three years, as that's how long the IRS can open an audit. As always, stick to the facts and don't exaggerate your vehicle costs.
The only rule is that you can't alternate methods on a single vehicle. This is on a per-auto basis, so in theory, you could have two vehicles using different methods.
What is the Maximum Amount of Depreciation you can write off for your car?
When you use the mileage method, you cannot deduct depreciation separately because it's already included in the standard mileage rate. But when you use the actual expense method, you can deduct depreciation as your "basis" in the vehicle.
The basis of a vehicle is essentially the sunk cost. If you purchase a used car for $18,000, and after all fees, taxes, and registration, the overall cost is $20,000, then you have a basis of $20,000 in the car (even if you do not need financing).
It is important to know that only the portion of your basis that is associated with your business can be depreciated on your tax return.
Since most of us do not have vehicles that are strictly business-related, we must treat them as "listed" assets, which means we have to separate out what is personal from what is business-related. In the same way that mileage above is calculated: business miles / annual mileage = business use, we calculate the business portion.
In the example shown above, our $20,000 vehicle's depreciable basis would be $11,400 when multiplied by our business-use percentage.
Are you able to get a larger write-off up front?
In response to the IRS's development of ways to accelerate depreciation, many people are surprised to learn they can't deduct the entire cost of their car when they purchase it.
Currently, there are two methods for accelerating depreciation.
Accelerating depreciation with Section 179
- Section 179 deductions were introduced to encourage business owners to purchase machinery and equipment. Rather than depreciating the equipment over its useful life, you can write off the entire cost in the first year.
- A 179 deduction is also available for automobiles, but the maximum write-off for 2021 is $18,200.
- Vehicles used for less than 50% of business are not eligible for the 179 deduction.
- By claiming 100% of the cost of any machinery and equipment purchased, bonus depreciation is allowed under the Tax Cuts and Jobs Act.
- As with Section 179, there are limits on bonus depreciation - the maximum deduction is $18,200 in the first year. Furthermore, vehicles used less than half for business cannot claim bonus depreciation.
Accelerating depreciation with bonus depreciation
What is the difference between Section 179 and bonus depreciation?
Automobiles are treated similarly under Section 179 and bonus depreciation. The only difference is that bonus depreciation is automatic, so you don't need to choose anything special to claim it.
As a result, many people find this method more convenient.
Heavy vehicles, SUVs, and trucks depreciate
As of now, we have discussed depreciation in terms of "passenger vehicles." Passenger vehicles are typically not designed to seat more than nine people and usually weigh less than 6,000 pounds.
However, freelancers and self-employed individuals often work jobs that require heavy-duty vehicles. SUVs, pickup trucks, and other heavy-weight vehicles fall under the category of “transportation equipment,” so you can claim 100% of their cost under bonus depreciation and Section 179 deductions. If you purchase a truck for $80,000 and it meets transportation requirements, you can claim the full $80,000 in the first year.
Your vehicle must have a Gross Vehicle Weight Rating (GVWR) of at least 6,000 pounds in order to meet transportation requirements. Most manufacturers list this information on their labels. In the same way as with passenger vehicles, if its business use falls below 50%, you'll have to depreciate it over its useful life, which is usually six years in the case of heavy vehicles.
No one wants to spend a Saturday afternoon calculating car depreciation, but it's well worth the effort!
Here are some final tips
When calculating vehicle depreciation, consider the fact that many carsharing users purchase or lease cars specifically for use on carsharing websites. Furthermore, car-sharing platforms often have mileage and model year restrictions.
Business owners can save significant amounts of money by depreciating their cars. In order to avoid IRS penalties, you should hire a tax advisor if these depreciation guidelines seem complicated. We specialize in independent contractor taxes at Shared Economy Tax. Since we've been helping carshare owners maximize their depreciation write-offs for years, we can help you decide which depreciation method is best for you. Use the form below to receive free tax tips or sign up for a free one-on-one strategy session today.