The Potential Tax Benefits of Car Leasing vs. Buying
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Summary:
If you are self-employed or a business owner, there are several ways you can deduct your leased or owned vehicle expenses from your federal taxes. However, you can only deduct the portion of the vehicle expenses that relate to your business. That means if the vehicle is also used for personal purposes, you won’t be able to deduct the total cost of the car. If the vehicle is only for personal use, you can still potentially deduct any applicable sales tax. You need to itemize your tax return to deduct vehicle costs, and some restrictions may apply.
If you are planning your next vehicle lease or purchase, you’re probably wondering how this vehicle will impact your tax situation. Even if the vehicle is used for personal reasons when you are not working, you can still deduct a portion of the car expenses that are proportionate to how much the vehicle is used for your business.
When you are self-employed or a business owner, there is quite a bit of leeway in how the costs associated with your new or leased vehicle can be deducted when you file your taxes. But since tax rules vary, the right decision for you will depend on your specific situation.
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What is considered personal vs. business use
You must be self-employed or a business owner for a vehicle to qualify as a business expense. That being said, what constitutes business use is essentially any driving done in the scope of operating the business.
Whether it be driving across town to have a business lunch with a client or picking up important documents from your lawyer’s office, if the driving is done to support the survival or further the success of your business, it will probably qualify as business use.
Keep in mind that your commute is not deductible
Your normal commute is not deductible. A commute is generally defined as traveling between your home and your main place of work. So, you cannot count the mileage you travel from home to your office as business miles.
If you drive to a work site or a meeting not at your regular office, that travel should count towards the total for your mileage deduction. But until the rules change, your typical commute is unfortunately not deductible.
Pro Tip
If your business operates five or more vehicles at once, the IRS considers it a fleet operation. This means you should probably seek tax advice from a professional since fleet operations have their own unique rules.
Tax benefits on vehicles
There are a few differences in the tax deductions available for vehicles you own compared to leased vehicles. Although one isn’t necessarily better than the other, it’s important to understand the different tax and fringe benefits between the two options.
- Leased car. Choosing to lease a vehicle will entitle you to the majority of available tax deductions, with one notable exception. If you are purchasing a vehicle, you can deduct the vehicle’s depreciation since the car would be considered an asset you own. Since a leased car is just being borrowed, you won’t be able to deduct the depreciation.
- Owned or financed car. Although leasing a vehicle will entitle you to many of the same tax benefits, owning your car outright will allow you to also deduct the depreciation of the car when you itemize your taxes. In addition to all of the other rights and obligations you’re entitled to when you own your vehicle outright.
These tax benefits will differ significantly if you choose to purchase your leased vehicle. In this case, visit a tax professional to determine what tax deductions your business vehicle may qualify for. If you need some help purchasing a car you currently lease, take a look at some of the auto loans below.
How to deduct business vehicles
There are two main ways you can deduct the business portion of the vehicle’s expenses if you itemize your taxes:
- Standard mileage rate
- Actual expenses
The two methods will result in different calculations, but you need to itemize your return to take advantage of either.
It’s important to note that if you wish to take the standard mileage rate deduction, you must do so the first year you operate the vehicle for business purposes. In the following years, you can switch to the actual costs method without penalty, but the first year of the vehicle’s business use must be deducted using the standard mileage method if you ever wish to take advantage of it.
If you’re leasing a car, you can still choose either deduction method. However, you must use that method for the entire duration of your lease term, including any potential renewals.
Standard mileage rate deduction
If you want to file your taxes using the standard mileage deduction, you must keep track of the exact number of business miles driven. Business miles are the distance traveled while running your business or working. Doing your weekly grocery shopping won’t count. But, if you’re meeting a client at their favorite restaurant across town, those miles should count as business miles.
The IRS periodically updates the standard mileage rate. In 2022, the IRS set two different standard mileage rates. From January 1st to June 30th, the rate was $0.585 per mile; from July 1st until December 31st, the rate was $0.625 per mile. If you drove 2,000 miles for work from January through June, and then drove another 2,000 miles from July until the end of the year, the calculation would be as follows.
The IRS updates the standard mileage rate as the cost of owning and operating a vehicle changes. They take into account gas prices, maintenance, and most aspects of car ownership. This way, the rate keeps pace with the cost of living associated with owning a car.
Pro Tip
Suppose your vehicle has a low cost to operate, such as a hybrid or electric car, or you travel excessively for work, such as an Uber or Lyft driver. In that case, the standard mileage rate will probably entitle you to the larger deduction. However, exceptions always apply. If you are unsure, be sure to consult with a professional.
Actual expense method
The actual expense method is just that. You will need to calculate the total of all of your vehicle expenses, such as the lease payments, auto insurance, gasoline, and maintenance. Then, multiply the sum by the portion of the vehicle used for business.
Let’s assume 40% of the miles put on your car were for business purposes while the other 60% were for personal use, and your total expenses were $12,000. You would then multiply $12,000 by 40%. This would give you a total deductible amount of $4,800.
Deducting actual expenses on a leased car
You can deduct your car lease payments when you file your taxes, but you will likely be unable to deduct your full lease payment. You can still only deduct the portion of the vehicle used in the scope of operating your business. If the vehicle is strictly a business vehicle, then you can deduct the whole lease payment.
Just as if you were deducting using the standard mileage method, you’ll need to calculate how much of the vehicle’s use was business related and not personal. So if you drive the car 50% of the time for work and 50% for personal reasons, you would multiply the business use percentage by the cost of your car lease payments.
Let’s assume you pay the average cost of a lease for your car. That means your monthly payment is around $467 for an annual average of about $5,604.
This means that the average taxpayer who drives a leased car 50% of the time for business and 50% for personal use will be able to deduct roughly $2,802 from their car lease payments every tax year.
Pro Tip
Even if you have a leased vehicle, your monthly lease payment will still just be a portion of your total deduction if you deduct actual expenses. Other eligible expenses may include gasoline, toll roads, parking expenses, oil changes, and other similar costs.
Deducting actual expenses on a car you own
If you buy the vehicle and don’t have a car lease payment, your total deductible car expenses can include a depreciation deduction. It doesn’t matter if you pay cash upfront or if you have a monthly car payment on a financed vehicle — the car’s depreciation is tax deductible if you use the actual expenses method when calculating your deduction.
Most new cars and anything placed into service after 1986 can generally only be depreciated using the Modified Accelerated Cost Recovery System (MACRS) method. There are limits to how much a vehicle can depreciate, so consult with an expert if you are unsure of how to calculate the appropriate amount.
Which method is right for you?
Remember, if you have a leased car, you must use the same method for your entire lease period. Choosing whether to use the standard mileage rate or the actual expenses method is up to you, but you have to use one method until the end of the lease.
The best choice will depend on your financial situation. So if you’re unsure which is right for you, it’s probably time to consult with a tax professional.
Are there any tax deductions for personal vehicles?
Unfortunately, if you lease a vehicle and are not self-employed, there aren’t any tax benefits. But if you purchased a vehicle (even if it’s financed), there may be some tax advantages. You can choose to deduct some of the state and local taxes when you itemize your tax return. If you pay sales tax in your state or your state levies a property tax on vehicles, you can usually deduct those when filing your federal return.
The Internal Revenue Service (IRS) refers to a state and local tax deduction as a SALT deduction. However, the IRS only allows taxpayers to make a SALT deduction on property and sales taxes or income taxes, not on both. So you may be better off not deducting sales tax on your next personal vehicle purchase, depending on how much you may have to pay in state income taxes.
IMPORTANT! No matter which type of SALT deduction you elect to use, the IRS limits SALT deductions to a combined total of $10,000 for individuals and $5,000 for couples who are married but filing separately.
Key Takeaways
- If the vehicle is used for business purposes, there are different deductions you can take during tax season. The two most common methods are the standard mileage deduction or the actual costs.
- If you lease your car, you can use whichever method you prefer. However, you must use that method for the duration of your entire lease, including any possible renewals.
- If you buy (or finance) your vehicle outright and want to use the standard mileage rate deduction, you must use that method the first year the car is operated in the scope of your business. In the following years, you can file using whichever deduction method you prefer.
- If your vehicle is just a personal vehicle, you can potentially deduct the sales taxes and the property taxes associated with the car. However, deducting the sales and property taxes will likely prevent you from claiming other deductions, namely state and local income tax deductions.
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