The Internet abounds with incorrect interpretations of the rules around vehicle tax deductions. Saving on taxes by using your car for business sounds convenient and appealing, but understanding the actual guidelines is key for this strategy to be effective.
What steps do you need to take to gain tax savings for your business vehicle? The two main ways to claim a benefit are through Section 179 or bonus depreciation:
Section 179: This part of the tax code allows business owners to immediately deduct the cost of depreciable business expenses—equipment used by the business that wears out over time and will ultimately need to be upgraded or replaced. Typically, business assets are depreciated over time so that each year the business gets a small tax deduction that roughly corresponds to the gradual wear-and-tear on that asset. However, vehicles that are eligible under Section 179 can be written off in the year the vehicle is put into service.
For Section 179, the IRS does place a cap on the amount that a taxpayer can deduct. Starting in 2022, the maximum deduction for all assets combined is $1,080,000. If you have more than $2.7 million worth of assets placed in service, your available deduction amount will begin to decrease for every dollar beyond that. The deduction amount available for a vehicle will also depend on the type of vehicle.
So what might this deduction look like in practice? Let’s say you run a dog grooming business, and you pick up on the new trend of using a converted trailer to make house calls. If the trailer is worth $20,000, you have two options: 1) you could write that off over five years at $4,000 per year, or 2) you could write it off all upfront. Your decision will depend on whether the value of the deduction will be more in this tax year than if you were to defer it. Since Section 179 rules can change year by year, you will want to consider the maximum deduction allowed for your vehicle type (in this case, a trailer) and how that deduction would affect your overall tax strategy.
Bonus Depreciation: Bonus depreciation is similar to Section 179 in that it allows a business owner to immediately deduct the cost of a business asset—but only a percentage of the total cost. In 2022, taxpayers can potentially deduct up to 100% of an asset’s cost in the year of purchase, though not all assets will be eligible.
What Are the Main Differences?
First, Section 179 is an election that you make, and it is not guaranteed that you will qualify just because you have a depreciable asset. Taxpayers sometimes make the Section 179 election on their tax returns and don’t even realize the deduction has been suspended—that they didn’t receive the benefit that tax year. This can unfortunately affect tax planning down the road.
Bonus depreciation, on the other hand, is automatic. You actually have to elect out of bonus depreciation if you don’t want to use it—if, for instance, the write-off is likely to be larger if you “saved” it for future years. This is an area that is ripe for mistakes. Many taxpayers will fail to attach an election to opt out of the bonus, and unfortunately, once your return has been filed, you cannot go back and opt out of it. Your only option then is to file an amended return and at least claim that bonus depreciation deduction.
Another difference is that Section 179 cannot be used to create or enhance a business loss. In other words, if your business is at or below zero in terms of a net loss, you are not eligible to deduct a business expense using Section 179. However, with bonus depreciation, you can create or enhance a business loss if that is advantageous for your tax strategy.
So remember—to leverage Section 179, you have to opt in, but with bonus depreciation, you have to opt out.
How Do I Know Which Deduction to Use?
As with all tax planning, thinking through a strategy in advance is the key. As we teeter on the edge of a recession, many businesses are seeing a temporary decline in revenue. Sometimes this is because of the after-effects of COVID-19, or it may be that revenue was higher during COVID-19 if the business provided essential services or was able to meet unique demands during the pandemic. This is something we want to look out for because the value of deducting depreciation varies depending on when you take it. The deduction will be worth less when you are in a lower tax bracket than it would be in a year when you are in a higher tax bracket.
For example, if this year you are looking to create a bigger loss because of a large capital gain that came in, then the bonus depreciation will allow you to do that rather than Section 179. However, Section 179 can be useful when you are looking to shift income. Even though Section 179 cannot be used to make a loss greater, that election will cause the deduction money to become suspended and carried over to a year when it can actually be used.
So let’s say that in 2022 your business bought a vehicle for $80,000, but your business already has a net loss. However, in 2023, the business is expecting income levels to rise due to changing circumstances. In this case, you might benefit from opting out of the bonus depreciation deduction and instead electing into Section 179. Then in 2023, that deduction amount would be available to reduce taxes during that higher income year. Since the vehicle was put into service in 2022, the only way to use that $80,000 for a future year is to make that Section 179 election.
A final important detail to know about these tax strategies is that 2022 was the last year to claim a 100% bonus depreciation deduction. Under the Tax Cuts and Jobs Act, this benefit begins to phase out starting in 2023—down to 80% this year and dropping all the way to 40% in 2025. This means that business owners may need to rely more on Section 179 when planning out their future tax strategy unless new legislation appears to give bonus depreciation a boost.
For guidance in selecting the right tax strategy for your business vehicle, reach out to a Certified Tax Planner today.