Swing a smart tax deal on business car trade-ins

A subscriber to Small Business Tax Strategies has asked us about a common situation: What happens tax-wise when I trade in one business car for another? Do I have to pay the IRS any tax on the value negotiated with the dealer?

Answer: Usually, you won’t owe any current tax on the trade-in of a business car, although you’ll still have to make certain adjustments in the new car’s basis. Depending on the situation, you might even jigger the trade-in value to lock in a better tax result.

As a practical matter, however, you will probably keep writing off depreciation costs each year without ever recovering the full cost of any one of your cars, especially if you’re buying high-priced vehicles (see chart below).

Here’s the whole story: If you trade in a vehicle you use for business driving for another business-use vehicle, the transaction qualifies as a “like-kind exchange” under Section 1031 of the tax code. In other words, you don’t pay any tax if you complete the deal within the two tax law deadlines:

1. The new vehicle must be identified within 45 days of the trade-in.
2. You must receive the new vehicle within 180 days or your tax return due date (plus) extensions, if that’s earlier.

If you don’t receive a business car in ex­­change, you have either a taxable gain or a loss upon disposition.

Assuming you are negotiating a trade-in, your adjusted basis of the new vehicle for depreciation equals the adjusted basis of your old vehicle plus any additional amount you have to pay for the new vehicle, minus the extra depreciation you could have claimed if the traded-in vehicle was used 100% for business (see box below).

Don’t cross the line on luxury cars

Another tax law provision limits the annual amount you can deduct for a business car. The limits are adjusted for inflation, but the thresholds have moved imperceptibly, or not at all, in recent years.

The IRS hasn’t announced the new limits for 2013 yet, but here are the limits for vehicles placed in service in 2012, based on 100% business use. (IRS Revenue Procedure 2012-23)

Note that the Section 179 deduction allows you to currently deduct up to $139,000 of the cost of business property placed in service in 2012. But you can’t use the Section 179 deduction to override the luxury car limits.

Tip: It probably doesn’t make sense to waste the Section 179 deduction on luxury cars. Use it for other business property.

Example: How to figure out your basis

Let’s say you purchased a business car for $30,000 in 2009, but you upgraded to a more expensive model last year costing $50,000. We will assume that your adjusted basis in the old car is $20,000 and that you’ve already claimed $9,908 in depreciation deductions on the car based on 80% business use. If you had claimed 100% business use, your deduction would have been $12,385. (For simplicity, this example will not take into account any bonus depreciation or Section 179 deductions.)

To figure out the basis of your new car, start with the adjusted basis of your old car of $20,092 ($30,000 cost – $9,908 in depreciation). Then you add the additional $20,000 in cost for the replacement vehicle ($50,000 – $30,000) to arrive at a subtotal of $40,092. Finally, you subtract the excess depreciation of $2,477 based on 100% business use ($12,385 in allowable depreciation – $9,908 actually claimed). Result: Your new adjusted basis is $37,615.

Here’s how it breaks down:

Although your basis is being adjusted upward, your depreciation deduction is still limited by the luxury car rules. For instance, if you used your new car 80% for business in 2012, your first-year deduction equals $2,528 (80% of $3,160), or $8,928 (80% of $11,160) if you claim bonus depreciation.

Tip: Try to negotiate a higher trade-in value to reduce the sales tax due on a new vehicle.

Depreciation costs