Should you depreciate your vehicle or take a mileage deduction?

If you drive for work, you know that the related expenses add up quickly. Fortunately, the Internal Revenue Service (IRS) recognizes this and allows deductions from your income taxes. However, you must choose between one of two options.

You can use the standard mileage rate method or the actual expense method. If you qualify for both, you may want to calculate each method to determine which gives you the largest deduction. If you chose a method and then want to switch, you will need to seek advice because, under certain circumstances, you are not allowed to switch methods.

Picking the proper method

The standard mileage rate deduction is the easier of the two methods, particularly if you use your car for both business and pleasure. To take the standard mileage deduction, you simply track the actual miles you drive for business and multiply by the allowed mileage deduction, which is modified periodically. For 2007, the IRS-approved rate is 48.5 cents per mile.

If you decide to use the actual expense method, you’ll need to keep more detailed records and do some additional calculations to determine if you qualify. Your goal is to document the actual cost of operating you car for business purposes. This includes the cost of gas; oil; repairs; tires; insurance; registration fees; licenses; and depreciation, if you own your car, or monthly payment, if you are leasing.

With few exceptions, you will use the Modified Accelerated Cost Recovery System (MACRS) to determine your depreciation rates. The percentages for each year are very precise, 20 percent for the first year, 32 percent for the second year, 19.2 percent the third year, 11.52 percent for years four and five, and 5.76 percent for the sixth year.

The IRS has also established yearly depreciation maximums. For cars first used for business in 2007, the maximum first-year depreciation is $3,060. The maximum for second-year depreciation is $4,900; for the third year, it is $2,850; and for all other years, it is $1,775. This means higher priced luxury cars may not be fully depreciated for several years, well past when you might want another vehicle. The maximum depreciation amounts vary for some types of vehicles, as well, such as some trucks, vans, and electric vehicles, so you’ll want double check the IRS regulations for your specific vehicle depreciation limits.

If you use your car for personal use, as well as business, the depreciation limits are reduced by the percentage of non-business use. For example, if your car is used for business 80 percent of the time, your maximum depreciation for each year is reduced by 20 percent.

If you are an employee and your vehicle expenses are fully reimbursed by your company, you are not eligible for a deduction, unless those reimbursements are included as part of your wages. Then, your vehicle expenses are subject to the 2% of adjusted gross income limit, so you may need some assistance in determining your eligibility.

Because of the depreciation limitations on more expensive cares, you may to consult a tax professional if your are considering buying or leasing a new vehicle. A pre-purchase consultation can help you determine the true after-tax cost for the type of vehicle you are considering.

David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.