One of the major expenses of any new or established sole proprietor is operating an automobile. There are several issues to consider which have tax ramifications:
- Should I buy or lease an automobile?
- Do I use standard mileage rates or actual expenses?
- If I use actual expenses, what effect will the business use percentage have on depreciation?
Since your decisions have consequences for several years thereafter, it is important to know the details behind some of these decisions. Today, we will focus on the lease vs. buy decision in acquiring an automobile for a sole proprietor.
Below are some items to consider when making the decision to lease or buy an automobile.
Standard Mileage Rates vs. Actual Expenses
An important decision must be made at the time of acquisition of the automobile whether to use the standard mileage rate or the actual costs. This is important because not only does it affect your tax treatment in future years, but also the amount of paperwork to substantiate your automobile deduction.
The IRS’s decision to allow taxpayers with leased vehicles to use the standard mileage deduction has reduced much of the income tax impact. However, there are still several factors to be considered. If the vehicle is leased, then the election is permanent for the entire lease term (including renewals). If you own the car and elect to use the standard mileage rate the first year, you have the option of changing to actual costs in future years. The only limitation is that you must calculate the vehicle’s depreciation using the straight-line method.
Effect of Actual Cost on Depreciation
Financing a purchase of an automobile will give you an interest deduction from your business income equal to the percentage of business use of the automobile times the yearly interest paid. If electing to use actual costs, this could result in a substantial deduction from your business income. The downside is that you may be required to make a large down payment and have a large monthly payment. The lease payment has an implicit interest payment, but may not require as much of a down payment and may have smaller monthly payments.
You do not claim depreciation on a leased car and there is no depreciation recapture when you exchange one leased vehicle for another. Additionally, no basis calculation is necessary to determine gain or loss since you do not own the car and there will not be a gain or loss on the leased vehicle. This is not the case with a purchased automobile. You must take into consideration the depreciation limitations placed on automobiles. When exchanging one car for another new car, the basis calculation of the new car could become very complicated if you switched from standard mileage to actual costs at any time during the life of the vehicle.
Cash Flow Implications
Other important aspects of the lease vs. buy decision include the cash flow issue and long-term goals of the owner of the car. If you need the lowest monthly payment possible, there are attractive lease payments available on new cars. If you plan to keep the car for more than a couple of years, a purchased vehicle may be less expensive in the long run than a leased vehicle after taking all costs into consideration. Leased vehicles frequently have mileage limitations and high end-of-lease buyout amounts.
The decision to lease or purchase a vehicle for business has many influencing factors which all need to be taken into consideration before signing the deal on a vehicle. If you would like assistance in making this important business decision, contact the experts at Henssler Financial: 770-429-9166 or [email protected].