By Daniel Rinke and George Jones, CCH Washington Staff Writers

Publication 463, Travel, Entertainment, Gift, and Car Expenses, has been recently republished by the IRS, and it adds several significant tax-savings ideas for business owners, particularly with regard to expensing and taking the 30-percent bonus depreciation for cars used in a trade or business. In addition, there are more favorable rules regarding the expensing and bonus depreciation to sport utility vehicles as well.

Maximizing Automobile Deductions

Despite recent environmental and safety campaigns to discourage the purchases of SUVs, these vehicles remain as popular as ever. Part of their popularity, at least among business owners, stems from the very generous tax savings such vehicles can generate.

As with any depreciable property, the costs can be written-off over the useful life of the property based on the class to which such property is assigned under tax law. SUVs are generally categorized as an automobile or a light general purpose truck (a distinction that can have significant consequences).

Automobiles and light trucks carry a five-year MACRS recovery period under IRS rules. Unfortunately, however, as a "listed item" of property under the depreciation rules, automobiles are limited by the "luxury" auto cap. This cap restricts the amount of depreciation that may be taken each year by assuming that the vehicle costs no more than $15,300 (far from the common "luxury" class automobile, but nevertheless designated as such under the tax rules). This assumption restricts regular depreciation, first-year expensing, and the first-year bonus depreciation. For tax years 2002 and 2003, the maximum combined first-year regular depreciation and expensing limit is $3,060; the limit when bonus depreciation (see below) is factored in rises to $7,660. These maximum amounts are adjusted for inflation each year.

In addition, Pub. 463 highlights the creation of a special bonus depreciation deduction. The Job Creation and Worker Assistance Act of 2002 added new rules, which, as a result of the incidents of September 11, 2001, allow a special depreciation deduction equal to 30 percent of the adjusted basis of the car or truck. To be eligible, the car or truck must be qualified property (any property with a recovery period under 20 years is allowed), must be new, and must have been acquired after September 10, 2001 but before September 11, 2004, and placed in service before January 1, 2005.

Though not discussed in Pub. 463, it should also be mentioned that taxpayers purchasing SUVs that weigh in excess of 6,000 lbs. may be rewarded with an another additional tax windfall because such vehicles are considered to be light duty trucks. Sec. 179 allows taxpayers to annually expense $25,000 of the cost of qualifying business property. Though the Sec. 179 deduction (plus any depreciation) is limited for cars to $3,060 in the year of purchase, it is not limited for equipment such as light duty trucks. A taxpayer could apply the entire Sec. 179 deduction toward the purchase of an SUV weighing in excess of 6,000 lbs. Likewise, the 30 percent bonus first-year depreciation is not limited for light duty trucks.

Example #1. To illustrate the impact of these rules on taxpayers, consider a business person buying an SUV on January 1, 2003, that weighs 6,500 lbs. and which costs $50,000. The taxpayer could depreciate (in the first year) $25,000 under Sec. 179 and 30 percent of the remaining adjusted basis under the bonus depreciation deduction, and then also take a standard MACRS depreciation deduction, which is 20 percent of the remaining adjusted basis. Thus, the taxpayer could recover $36,000 of tax dollars in year one: [($50,000-$25,000 = $25,000 - (30% x $25,000) = $17,500 - (20% x $17,500) = $14,000] with $50,000 - $14,000 = $36,000. Note that the order to determine depreciation begins with Sec. 179 expensing, then special 30 percent bonus depreciation, and finally the MACRS depreciation.

This lies in stark contrast to what would happen to a business owner who buys an SUV that weighs 6000 lbs or less, which doesn't qualify as a light duty truck. Pub. 463 provides that the total of all deductions allowable under regular MACRS and bonus depreciation and/or Sec. 179 expensing are limited to $7,660 in year one. The allowable deduction is further reduced to the extent that the business owner uses the car for non-business purposes.

Example #2. Returning to the earlier example, but changing the figures, if the taxpayer buys an SUV on January 1, 2003, for $50,000 that weighs 4,000 lbs., that taxpayer can take either the standard MACRS deduction or the Sec. 179 expensing deduction, but in either case it is limited to $3,060. This deduction would reduce the tax basis in the SUV to $46,940 ($50,000 - $3,060 = $46,940). The taxpayer may then take the special bonus deduction of 30 percent. Ordinarily, the 30 percent bonus depreciation would reduce the basis of the business asset to $32,858 [$46,940 - (30% x $46,940) = $32,858]. However, since the total of these deductions is $17,142 ($14,082 + $3,060 = $17,142), the deduction must be reduced to the maximum allowable first-year deduction of $7,660, raising the adjusted basis to $42,340. Revised Pub. 463 also provides several examples to illustrate this point.

Remember that the special bonus depreciation deduction is subject to recapture in the same manner as traditional expensing and MACRS deductions. Therefore, any gain recognized upon selling of the asset is included in income to the extent of the previously allowed depreciation deductions.

Example #3. Returning to the above example, if the taxpayer sold his SUV for $45,000 in January of 2004, the taxpayer would be forced to recapture $2,660 ($45,000 - $42,340 = $2,660) of the depreciation deductions and treat the recaptured amount as ordinary income.

Trading-In

Taxpayers are also free to trade vehicles used for business purposes without having to recognize gain because such trades are treated as like-kind exchanges.

Example #4. Again using our example, let's assume the taxpayer wants to trade his SUV with an adjusted basis of $42,340 for an SUV that costs $55,000. If the dealer allows the taxpayer $44,000 on the trade-in (the taxpayer will still have to pay the $11,000 price difference), the taxpayer will have no income, but his basis in the new vehicle will be reduced by the difference between his adjusted basis and the trade-in value allowed. Thus, the taxpayer's basis in the new vehicle will be $53,340 [($44,000 - $42,340 = $1,660) so ($44,000 + $11,000 - $1,660 = $53,340)]. If taxpayer sold old the SUV in an independent transaction, and there was gain, the taxpayer would be forced to recognize that gain.

Standard Mileage Deduction

One last change worth noting that is highlighted in Pub. 463 is the standard mileage rate, which had been increased to 36.5 cents-per-mile for 2002 and then decreased to 36 cents-per-mile in 2003 (primarily due to lower gasoline prices during the annual test period). Remember that using the standard mileage rate precludes the taxpayer from using any of the depreciation deductions referenced above and also precludes the taxpayer from deducting actual car expenses such as lease payments, oil, gas, tolls, insurance or repairs.

This is because a portion of the standard mileage rate reflects a per-mile depreciation rate. For the tax year 2002, the depreciation rate is 15 cents-per-mile. Thus, if the taxpayer bought an SUV with a basis of $25,000 in January of 2002 and drove it 15,000 miles, all business use, the business standard mileage rate would yield a deduction of $5,475 and a reduction of basis by $2,250 to $22,750 ($0.365 x 15,000 = $5,475) and ($0.15 x 15,000 = $2,250).

For more information, check out the discussion of methods for determining vehicle expense deductions in the Small Business Guide.

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