by Bob Rywick
If your client is planning to buy a new business automobile, she must decide whether to trade in the old business auto or to sell it and use the sale proceeds to pay part of the price of the new auto.
While you would expect that making this decision should depend solely on factors such as the amount you can get on a sale versus a trade-in, and the time and trouble involved in selling the old auto, there are also complex tax factors to take into account. The purpose of this article is to review the complex tax rules that apply to what appears to be a simple transaction, and to discuss how to achieve the best tax results.
In general, the sale of a business asset yields a gain or loss depending on the net amount you receive from the sale and your basis in the sold asset. Basis is your cost for tax purposes and, if you bought the asset, this usually equals your cost less the depreciation deductions you claim for the asset over the years.
Under the like-kind exchange rules, trading in an old business asset for a new like-kind asset doesn’t result in a current gain or loss, and the new asset’s basis will equal the old asset’s remaining basis plus any cash you paid to trade up. The rules generally are the same for business autos. However, there are a couple of special points that need to be considered.
All work and no play
As a general rule, a business auto should be traded in, not sold, if it has been used exclusively for business driving, and its basis has been depreciated below the amount that would be received if it were sold. This is especially so if the value of the trade-in is equal to or more than the amount that would be received on the sale. Trading in the old auto avoids a current tax.
In addition, if sales tax is payable on the purchase of the new auto, many states provide that the sales tax is paid on the purchase price less the value of the trade in. If the old auto were sold and the proceeds of the sale used to pay part of the purchase price, then the sales tax would be paid on the full purchase price.
Example 1: Your client, who is in a tax bracket over 15 percent, and who lives in a state with an 8 percent sales tax, plans to buy a new business auto for $40,000 in 2004. He can sell the business auto that he currently owns for $15,000, or get $15,000 against the purchase price of the new auto if he trades it in. The auto has been used exclusively for business purposes. His basis in the auto after depreciation is only $10,000. If he sells the auto, he will have a taxable gain of $5,000 on the sale, on which he will pay federal income tax of $750 (at a capital gains tax rate of 15 percent, the rate for individual taxpayers in a tax bracket over 15 percent).
In addition, he will save $1,200 in sales taxes on the purchase of the new auto (8 percent of $15,000) since he will be paying the sales tax on $25,000 ($40,000 less $15,000 for the trade-in). Thus, he would save a total of $1,950 ($750 plus $1,200) in taxes by trading the old auto in.
While your client’s basis in the new auto will be $5,000 lower than it would be if he had bought it without a trade-in ($15,000 for trade-in less $10,000 remaining basis on the old auto), that doesn’t necessarily mean lower depreciation deductions on the new auto.
Because of the luxury auto annual depreciation dollar caps, your client’s annual depreciation deductions on the new auto may be the same whether he sold the old auto or traded it in.
Caution: The owner of a used auto can often get more on a private sale of that auto than she can receive on a trade-in. If the amount received on such a sale is substantially more than the amount received on a trade-in, then the tax benefits of the trade-in may not equal the extra amount received on the sale.
Example 2: The same facts apply as in Example 1, except that your client would receive only $12,000 on the trade-in. While he would still save $1,500 in income taxes by trading in the old auto, his sales tax savings would be reduced from $1,200 to $960 (8 percent of $12,000). His total tax savings would be $1,710 ($750 plus $960), or $1,290 less than the excess of the amount he would receive on the sale ($15,000) over the amount of the trade-in ($12,000).
If your client used the old business auto exclusively for business driving, he should usually sell it for cash instead of trading it in if depreciation on the old auto was limited by the annual depreciation dollar caps. This is because the basis of the old auto will probably exceed its value. Thus, your client will be able to recognize a loss for tax purposes. However, if your client trades it in, he will not recognize the loss.
Example 3: Your client bought an auto in 1998 for $35,000 that she used exclusively for business driving. Because of the annual depreciation dollar caps, she still has an $18,565 basis in the auto, which has a current value of $13,000. Now, she wants to buy a new auto for $50,000. If the old auto is sold, she will recognize a $5,565 loss ($18,565 basis less $13,000 sale price). If the old auto is traded in for a new one, there will be no current loss.
Your client also may be better off selling her old business auto for cash rather than trading it in, if she used the standard mileage allowance to deduct auto-related expenses. For 2004, the allowance is 37.5 cents for each business mile traveled. The standard mileage allowance has a built-in allowance for depreciation, which must be reflected in the basis of the auto.
The deemed depreciation is:
- 16 cents for every business mile traveled during 2003-2004;
- 15 cents for every business mile traveled during 2001-2002;
- 14 cents for every business mile traveled during 2000; and,
- 12 cents for every business mile traveled during 1996-1999.
When it’s time to dispose of an auto, the depreciation allowance may leave your client with a higher remaining basis than the auto’s value. Under these circumstances, the auto should be sold to recognize the loss.A little of both
The rules are more complicated when an auto is used partially for business and partially for personal purposes. This often happens when your client is self-employed, or is an employee required to supply an auto for business use.
If such an auto is sold, cost and depreciation must be allocated between the business and personal parts. Gain or loss on the business part is recognized; gain, but no loss, is recognized on the personal part.
Observation: If property used for both personal and business purposes is sold, gain or loss is computed as if there were two separate transactions. Part of the cost, selling price, depreciation and selling expenses must be properly attributed to each.
Accordingly, it’s possible on the sale of an auto used partly for business and partly for personal purposes to have a taxable gain on the sale of the business part, and a nondeductible loss on the sale of the business part. This is because the depreciation taken on the business part has reduced the basis of that part, but the basis of the part used for personal purposes has not been reduced.
Example 4: Your client used his auto 60 percent for business and 40 percent for personal purposes. The auto cost $30,000 when it was bought in 2000. Of the total cost, $18,000 was allocated to the business use and $12,000 to personal use. Depreciation of $7,611 was taken on the business part, leaving the adjusted basis of the business part as $10,389. Since no depreciation can be taken on the personal part, the basis of that part remained at $12,000.
In 2004, your client sells the auto for $20,000, with $12,000 of the sales price allocated to the business part, and $8,000 to the personal part. As a result, your client has a taxable gain of $1,611 on the sale of the business part ($12,000 less $10,389) and a non-deductible loss of $4,000 on the sale of the personal part ($12,000 basis less $8,000).
If your client trades in the part-business, part-personal-use auto, a special basis rule applies for depreciation purposes only: The basis of the new auto as computed under the normal trade-in rules is reduced by any difference between the depreciation that would have been allowable had the old auto been used 100 percent for business driving, and the depreciation claimed for its actual business use.
Example 5: The same facts apply as in Example 4, except that your client trades in his old auto in connection with his purchase of a new auto. The new auto costs $40,000, with $20,000 of the price being paid in cash and the $20,000 balance by trading in the old auto. Your client’s adjusted basis in the old auto is $22,389 (original price of $30,000 less $7,611 of depreciation deducted for business use).
However, in determining your client’s basis in the new auto, that basis must be reduced by the excess of the depreciation that would have been taken if the old auto had been used 100 percent for business purposes ($12,685) over the amount of depreciation actually taken ($7,611). This excess is $5,074. Accordingly, your client’s basis in the new auto is $37,315 (cash of $20,000, plus adjusted basis of old auto of $22,389, less $5,074).
Why not lease?
The complex rules that apply to purchased business autos are one reason why many businesses are leasing autos instead of buying them. You simply deduct the business/investment use portion of annual lease costs, and, if the auto is a luxury model (for example, if the lease began during 2004 and the auto’s fair market value exceeds $17,500), you add back to income during each lease year an income inclusion amount derived from an IRS table. You should, however, also be aware of the following:
- If you trade in an auto in exchange for a lower lease price on a new auto, the transaction won’t be a tax-free like-kind swap. This means that any realized gain or loss will be recognized under the rules that apply to a sale.
- If you pay an additional sum up-front, it should be amortized over the life of the lease.
- Any refundable deposit required as part of the lease deal can’t be deducted at all.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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