Small business owners, including real estate agents, have two methods available for deducting their auto use: The Standard Mileage Rate and the Actual Cost Method. Those who use the actual cost method are required to depreciate their vehicles. We cover the Standard Mileage Rate and The Actual Cost Method in other articles on OvernightAccountant.com. We also discuss the auto deduction in detail in our Real Estate Agent Tax-Cut Library. This article will share the basics of auto depreciation. A separate article will highlight Bonus Depreciation and the 179 Expense as they pertain to vehicles.
Why Just the Basics? There are three reasons why we limit the depth to which we delve into auto depreciation:
- The first reason is the complexity of the topic as it relates to our purpose. The intent of this article and the Real Estate Agent Tax Cut Library is to provide real estate agents practical, hands-on information to help them cut their most significant expense: TAXES. As you will learn in this article, depreciation is a convoluted and confusing topic, especially when it comes to vehicles. It is difficult to explain in a manner that will benefit those who lack a technical background in taxation. A primary challenge in writing this article is sharing enough information to help the reader grasp the general concept without drifting into a technical treatise requiring a flow chart.
- The second reason is limits on vehicle depreciation that intertwine depreciation, bonus depreciation, and the 179 expense. The vehicle’s weight and function directly impact these limits. Even tax professionals do not memorize them – we look them up in when we need them.
- The third reason these articles cover only the basics is the frequency with which Congress changes depreciation rules. Unlike many areas of the tax code, the regulations regarding Depreciation, Bonus Depreciation, and the Section 179 Expense change frequently. As a result, tax pros have to relearn the deductions every few years as all previously written guidance, articles, and books are made incorrect.
For the reasons listed above, I generally recommend that an agent claiming actual auto expenses have a tax professional prepare their return. When it comes to vehicle depreciation, even the most intuitive DIY tax software requires an expert to navigate correctly.
Auto Depreciation – Overview: Generally, there are two ways to depreciate your business-use vehicle; the Straight-Line Method and the 200% Declining Balance Method. Both are part of MACRS, which stands for the Modified Alternative Depreciation System. Both require a five year depreciated period for vehicles. This mandate, however, is in itself confusing because cars with a five-year depreciable life are depreciated over six tax years!
Another confusing element of depreciation (as if there were not enough) involves what is called the Mid-Year (also called Half-Year) and Mid-Quarter conventions. Delving into the details of these conventions is beyond the scope of this article except to say that: 1) each can impact the depreciation calculation, and 2) generally speaking, the Mid-Quarter convention only applies when more than 40% of total assets purchased during the year are placed in service during the last three months of the year. Examples in this article will utilize the Mid-Year convention.
Straight-Line Depreciation: The easiest way to depreciate a vehicle is to use Straight Line Depreciation. Under the Straight-Line Depreciation Method, a portion of the cost of the vehicle is expensed each year equally, except for the first and last year. Straight-line depreciation on vehicles works like this. Let’s say you purchase a vehicle for $20,000 on July 1st and immediately start to use it exclusively in your real estate business - meaning that 100% of the miles put on the vehicle are business miles. Your depreciation deduction each year will be $4,000 ($20,000 / 5 years or 20% each year) except that half of this depreciation is claimed in the 1st and 6th year, when half of the full-year amount is deducted (10% each year). Below is a breakdown of the vehicle’s depreciation deduction for each year:
- 1st year: 10% = $ 2,000
- 2nd year: 20% = $ 4,000
- 3rd year: 20% = $ 4,000
- 4th year: 20% = $ 4,000
- 5th Year: 20% = $ 4,000
- 6th Year: 10% = $ 2,000
Auto Depreciation – 200% Declining-Balance Method: A second method for depreciating an auto is the 200% Declining Balance Method. This method generally yields a larger deduction in the early years of owning a vehicle. The accounting theory behind the 200% declining-balance method is that some assets lose most of their value in the first few years of use. Therefore, the 200% declining-balance method depreciates assets faster - at twice the straight-line rate. If a five-year asset is depreciated at 20% per year using the straight-line method, the 200% declining-balance method rate will depreciate it at 40% per year. Unlike the straight-line method, however, each subsequent year, depreciation is based the remaining “basis” (a tax term meaning investment or cost) of the asset. For example, our $20,000 vehicle is depreciated at 40% the first year. The result: $8,000 ($20,000 * 40% = $8,000) of depreciation in year one. The second year, the depreciation claimed in year one is subtracted from the original asset basis, making it $12,000 ($20,000 minus $8,000). Depreciation for the second year will be 40% of the new basis or $4,800 (12,000 * 40%). In year three, the basis for the 40% depreciation will be $7,200, and so forth each remaining year.
You may notice that continuing to deduct 40% year-after-year never fully depreciates the vehicle - the basis never reaches zero. To eliminate this problem, the IRS (in its ever-gracious-generosity) has supplied a table showing its version of MACRS 200% Declining Balance Method.
- 1st year: 20.00%
- 2nd year: 32.00%
- 3rd year: 19.20%
- 4th year: 11.52%
- 5th Year: 11.52%
- 6th Year: 5.76%
Below is how the vehicle purchased in the above example would be depreciated using this method:
- 1st year: 20.00% = $ 4,000
- 2nd year: 32.00% = $ 6,400
- 3rd year: 19.20% = $ 3,840
- 4th year: 11.52% = $ 2,304
- 5th Year: 11.52% = $ 2,304
- 6th Year: 5.76% = $ 1,152
Total: 100.00% = $20,000
You may also notice that the IRS version of the 200% Declining-Balance Method, is not the same as the accounting version.
Depreciation and the Business Use Percentage: Because driving is such an integral part of the real estate lifestyle, it is uncommon for an agent to drive a vehicle exclusively for business. The car is also used to run personal errands, pick up groceries, or take the kids to school and practice. When this is the case, the depreciation deduction, like all actual vehicle costs, is limited to the percentage of business miles put on the vehicle.
For example, if you drove our $20,000 vehicle 12,500 total miles in the 1st year and only 8,500 of those miles were for business, your business-use percentage would be 68% (8,500 / 12,500). Your straight-line depreciation deduction for year one would be $1,360 ($2,000 * 68%).
Each year, your depreciation deduction will change based on the percentage of miles the vehicle was used for business. If you drive the vehicle 68% for business in year one, 78% in Year two, 60% in year three, and 45%, 80%, and 70% for the following three years, your depreciation deduction each year would be as follows under the Straight-Line Depreciation method:
- 1st year: $ 2,000 * 68% = $ 1,360
- 2nd year: $ 4,000 * 78% = $ 3,120
- 3rd year: $ 4,000 * 60% = $ 2,400
- 4th year: $ 4,000 * 45% = $ 1,800
- 5th Year: $ 4,000 * 80% = $ 3,200
- 6th Year: $ 2,000 * 70% = $ 1,400
Converted Personal-Use Vehicle: What happens if you buy your vehicle on July 1st but do not start using it for business until January 1st of the following year? According to the IRS, you have taken a personal-use vehicle and converted it to business use. There is a tax-rule regarding personal-use property converted to business use. In its most basic form, it states that the depreciable value of the converted property is the LOWER of the owner’s basis (a tax term meaning investment or cost) in the property or its Fair Market Value on the date placed in service (converted to business use).
According to this rule, your value (basis) for depreciation of the vehicle will not be the $20,000 you paid in July. Instead, it will be the vehicles Fair Market Value on January 1st. If the “blue book” value of the vehicle on January 1st of the following year is $16,800, your value for depreciation purposes will be $16,800. Since the vehicle is depreciated over five years (using straight-line depreciation in this example) and assuming you drive the vehicle for business the same amount as in the previous example, your depreciation deduction is as follows:
- 1st year: $16,800 * 10% * 68% = $ 1,681
- 2nd year: $16,800 * 20% * 78% = $ 2,621
- 3rd year: $16,800 * 20% * 60% = $ 2,016
- 4th year: $16,800 * 20% * 45% = $ 1,512
- 5th year: $16,800 * 20% * 80% = $ 2,688
- 6th year: $16,800 * 10% * 70% = $ 1,176
Switching between Standard Mileage Rate & Actual Costs: If you use the standard mileage rate in the first year, you can switch between the standard mileage rate and the actual cost method in later years. However, if you use any form of depreciation other than straight-line in any of those years, you cannot go back to using the standard mileage rate.
Limits on Depreciation: Further complicating vehicle depreciation and expensing are limits governing the amount of depreciation, bonus depreciation, and Section 179 expense claimed on a vehicle each year. The type and weight of the vehicle influence these limits. We discuss these limits in a separate article, Actual Auto Expense: Bonus Depreciation & the Section 179 Expense.
Take Away: Even the basics of auto depreciation provide a labyrinth of pitfalls for the nonprofessional preparer. Our goal, however, is not to turn you into a tax professional. It is to lay a foundation for agents who desire a better understanding of how the auto deduction works and provide a basic framework for those determined to prepare their tax returns.
Summary and Invite: We hope this article has helped you understand the basics of auto depreciation. If you’d like to learn more about cutting your most significant expense, TAXES, check out our Real Estate Agent Tax Cut Library. The Real Estate Agent Tax Cut Library includes over eight hours of video broken into twenty-nine searchable volumes and covers every possible deduction a Real Estate Agent can take on their tax return. Our Broker Version will help your entire agency cut their taxes! We also invite you to browse our courses.