Our lesson this week examines the topic of car expenses. The Executive Summary provides a concise review of the key points. Before we get started, test your knowledge by completing the following quiz.
Pastor B drives his car several thousand miles each year for business purposes. He has been using the standard mileage rate to compute his car expenses (multiplying his substantiated business miles times the IRS standard mileage rate). However, he has heard that he can also compute his car expenses using the "actual expense" method. Under this method, Pastor B calculates the actual expenses he incurs in operating his car for business, instead of claiming the standard mileage rate. How does Pastor B compute the actual expenses of using his car for business, assuming that he uses his car for both business and personal purposes? This is the subject of this week's lesson. While some studies have suggested that business expenses will be higher using the actual expense method instead of the standard mileage rate, for most pastors the work that is required to keep track of actual expenses is not worth a possibly higher deduction.
Instructions Click on the correct answer for each of the following questions.
You can use the "actual cost method" to compute transportation expenses associated with the business use of your car. However, as this week's lesson demonstrates, doing so is too complicated for most taxpayers. Most prefer the simplicity of using the standard business mileage rate to compute their car expenses.
You may be able to compute the business use of your car using the actual cost method instead of the standard mileage rate. Very few pastors do so because this method is simply too complex and time-consuming. Using the standard mileage rate is much easier. While using the actual cost method takes discipline and perseverance, some studies suggest you will have a higher deduction using this method than the standard mileage rate method, especially if your car is relatively new. The question is whether you consider the potential savings in taxes worth the extra inconvenience.
Actual transportation costs include the cost of local business travel by air, rail, bus, taxi, and the cost of driving and maintaining your car, but not the cost of meals or lodging. You may not deduct the costs of commuting (e.g., by bus, subway, taxi, train, or car) between your home and your main or regular place of work. These costs are nondeductible personal expenses. The most important element of transportation expense is your car. If you are required to use your car in your work, you can deduct the expenses associated with business use of the car. Deductible items include the cost of gas, oil, tires, repairs, tune-ups, batteries, car washes, insurance, depreciation, taxes, licenses, garage rent, parking fees, and tolls.
If you use your car both for business and personal purposes, you must divide your expenses between business and personal use. For example, if you drive your car 20,000 miles during the year (12,000 miles for business and 8,000 miles for personal use) you can claim only 60% (12,000/20,000) of the cost of operating the car as a business expense.
Depreciation and "section 179 deductions"
Generally, the cost of a car is a capital expense. Because the benefits last longer than one year, you generally cannot deduct a capital expense. Instead, you "recover" this cost by claiming a section 179 deduction (the deduction allowed by section 179 of the tax code) and a depreciation deduction. By using depreciation, you recover the cost over more than one year by deducting part of it each year. The section 179 deduction and the depreciation deduction are discussed later. Generally, there are limits on both of these deductions. Special rules apply if you use your car 50% or less in your work or business. You can claim a section 179 deduction and use a depreciation method other than straight line only if you do not use the standard mileage rate to figure your business-related car expenses in the year you first place a car in service. If you claim either a section 179 deduction or depreciation using a method other than straight line for its estimated useful life in the year you first place a car in service, you cannot use the standard mileage rate on that car in any future year.
Section 179 deduction
The section 179 deduction allows you to treat part or all of the business cost of a car as a current expense rather than taking depreciation deductions over a number of years. The limit on total section 179 and depreciation deductions (discussed later) may reduce or eliminate any benefit from claiming the section 179 deduction. You can claim the section 179 deduction only in the year you place the car in service. For this purpose, a car must be placed in service. A car first used for personal purposes cannot qualify for the deduction in a later year when its use changes to business.
There are limits on: (1) The total cost of qualifying property you can choose to treat as a section 179 deduction, and (2) The total amount of the section 179 deduction plus the depreciation deduction (discussed later) you can claim for a qualifying property. Generally, you can choose to treat up to $25,000 of the cost of qualifying property as a section 179 deduction in 2003. The limit depends on the percentage of business use. You must use the property more than 50% for business to claim any section 179 deduction. If you used the property more than 50% for business, multiply the cost of the property by the percentage of business use. The result is the cost of the property that qualifies for the section 179 deduction.
In addition, the total amount of section 179 and depreciation deductions that you can claim for a car that you place in service in 2003 cannot be more than $3,060. The limit is reduced if your business use of the car is less than 100%.
The amount of the section 179 deduction reduces your basis in your car. If you choose the section 179 deduction, you must subtract the amount of the deduction from the cost of your car. The resulting amount is the basis in your car that you use to figure your depreciation deduction. Choosing a section 179 deduction can give you a larger total deduction (depreciation plus section 179 deduction) in the first year. Not choosing it can give you a larger depreciation deduction in later years.
If you want to take the section 179 deduction, you must make the choice in the tax year you both purchase the car and place it in service for business or work. Employees use Form 2106 to make this choice and report the section 179 deduction. All others use Form 4562. Make your choice by taking the deduction on the appropriate form and file it with your original tax return.
If you use actual car expenses to figure your deduction for a car you own and use in your business, you can claim a depreciation deduction. That is, you can deduct a certain amount each year as a recovery of your cost or other basis in the car. You cannot use the standard mileage rate if you decide to take a depreciation deduction in the year you first place the car in service.
You generally need to know the following things about the car you intend to depreciate: (1) your basis in the car, (2) the date you place the car in service, (3) the method of depreciation and recovery period you will use. Your basis in a car for figuring depreciation is generally its cost. This includes any amount you borrow or pay in cash, other property, or services. You generally place a car in service when it is available for use in your work or business, in an income-producing activity, or in a personal activity. Depreciation begins when the car is placed in service for use in your work or business or for the production of income. For purposes of computing depreciation, if you first start using the car only for personal use and later convert it to business use, you place the car in service on the date of conversion. If you place a car in service and dispose of it in the same tax year, you cannot claim any depreciation deduction for that car.
Generally, you figure depreciation on cars using the Modified Accelerated Cost Recovery System (MACRS). MACRS rules for cars are discussed later in this chapter. If you used the standard mileage rate in the first year of business use and change to the actual expenses method in a later year, you cannot depreciate your car under the MACRS rules. You must use straight-line depreciation over the estimated remaining useful life of the car.
Generally, you must use your car more than 50% for qualified business use during the year to qualify for the section 179 deduction and MACRS deduction. You must meet this more-than-50%-use test each year of the recovery period (6 years under MACRS) for your car. If your business use is 50% or less, you must use the straight-line method to depreciate your car. A qualified business use is any use in your trade or business. Do not treat any use of your car by another person as use in your trade or business unless that use meets one of the following three conditions: (1) It is directly connected with your business. (2) It is properly reported by you as income to the other person (and, if you have to, you withhold tax on the income). (3) It results in a payment of fair market rent. This includes any payment to you for the use of your car.
If you use your car for more than one purpose during the tax year, you must allocate the use to the various purposes. You do this on the basis of mileage. Figure the percentage of qualified business use by dividing the number of miles you drive your car for business purposes during the year by the total number of miles you drive the car during the year for any purpose.
The amount you can claim for section 179 and depreciation deductions may be limited. The maximum amount you can claim depends on the year in which you placed your car in service. You have to reduce the maximum amount if you did not use the car exclusively for business.
You use your unadjusted basis to figure your depreciation using the MACRS depreciation chart (published in IRS Publication 463). Your unadjusted basis for figuring depreciation is your original basis increased or decreased by certain amounts. To figure your unadjusted basis, begin with your car's original basis, which generally is its cost. Cost includes sales and luxury taxes, destination charges, and dealer preparation. Increase your basis by any substantial improvements you make to your car, such as adding air conditioning or a new engine. Decrease your basis by certain amounts including any deductible casualty loss, section 179 deduction, gas guzzler tax, and qualified electric vehicle credit. When you trade an old car for a new one, your original basis in the new car is generally your adjusted basis in the old car plus any additional payment you make.
The Modified Accelerated Cost Recovery System (MACRS) is the name given to the tax rules for getting back (recovering) through depreciation deductions the cost of property used in a trade or business or to produce income. The maximum amount you can deduct is limited, depending on the year you placed your car in service. Under MACRS, cars are classified as 5-year property. You actually depreciate the cost of a car, truck, or van over a period of 6 calendar years. This is because your car is generally treated as placed in service in the middle of the year and you claim depreciation for one-half of both the first year and the sixth year.
You can use one of the following three methods to depreciate your car: (1) The 200% declining balance method (200% DB) over a 5-year recovery period that switches to the straight-line method when that method provides an equal or greater deduction. (2) The 150% declining balance method (150% DB) over a 5-year recovery period that switches to the straight-line method when that method provides an equal or greater deduction. (3) The straight-line method (SL) over a 5-year recovery period. Before choosing a method, you may wish to consider the following facts. (1) Using the straight-line method provides equal yearly deductions throughout the recovery period. (2) Using the declining balance methods provides greater deductions during the earlier recovery years with the deductions generally getting smaller each year.
MACRS depreciation charts are set forth in IRS Publication 463 each year, along with instructions for their use and helpful examples. Using this material will make it easy for you to figure the depreciation deduction for your car.
There are limits on the amount you can deduct for depreciation of your car. (The section 179 deduction is treated as depreciation for purposes of the limits.) The maximum amount you can deduct each year depends on the year you place the car in service. These limits are shown in a table each year in IRS Publication 463.
The depreciation limits are reduced based on your percentage of personal use. If you use a car less than 100% in your business or work, you must determine the depreciation deduction limit by multiplying the limit amount by the percentage of business use during the tax year.
If you use your car 50% or less for qualified business use either in the year the car is placed in service or in a later year, special rules apply. See IRS Publication 463.
As this week's lesson shows, calculating the business use of a car using the actual expense method is a very complex task. It is because of this complexity that Congress and the IRS created a far simpler method for calculating car expenses—the standard mileage rate. This is the method used by most pastors. Note, however, that if you want to use the standard mileage rate for a car you own, you must choose to use it in the first year the car is available for use in your business. Then in later years, you can choose to use either the standard mileage rate or actual expenses.