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As a freelancer, you may use your car frequently for business related trips. Luckily, car expenses can be one of your largest potential tax deductions, so it’s a good idea to take full advantage of it.
How do you calculate car expenses?
Calculating car expenses can be more complicated than calculating something like office supplies because there are more factors that go into it. Typically, there are two methods to calculate the expense:
Method 1: The Standard Mileage Rate
This is by far the simplest method. You track your business mileage, and then multiply the total number by the IRS set rate that year ($0.56/mile for 2014). This $0.56/mile includes:
Maintenance and repairs (oil, tires, etc.)
This means the rate includes these expenses and you cannot separately deduct them.
If you’ve used the Actual Costs Method for this car in a prior year (see below), you are not allowed to switch back to the Standard Mileage Rate. There are also a few other cases where you cannot use it:
If you aren’t the owner or lessee of the car
If you use five or more cars at the same time, or
If you have claimed a Section 179 deduction (discussed later).
Method 2: The Actual Costs Method
In this method, you keep track of every cost you have related to your car (gasoline, insurance, etc.). This often means a lot of receipts to track.
One thing you’ll also have to track is depreciation. Depreciation is when you “smooth out” an expense over a period of time. For example, say you buy a $10,000 car. It doesn’t provide all its value in the first year – it provides you value for the entire time you have it.
The easiest way to calculate your depreciation for the year is “straight-line”. This is the total cost divided by the number of years. So if you depreciate a $10,000 car over 5 years (the number of years the IRS has set for car depreciation), that’s $10,000 / 5 = $2,000 per year depreciation expense. There are also other methods like the 200% declining balance or 150% declining balance.
Sound confusing? It can be.That’s why most people decide to use the Standard Mileage Rate.
How do I keep track of mileage?
The IRS’s specified method is a paper log with the starting/ending odometer balance and what the business purpose was. (The IRS provides you with an electronic version of this.)
How do I differentiate between business and personal use?
Most people use their car for both business and personal use. You are only allowed to expense business related expenses. As we discussed, you can calculate your business expenses with these two methods:
Standard Mileage Rate: multiply only your business mileage by the IRS standard rate.
Actual Costs Method: if your gas/insurance/etc expenses for 2014 are $1,000 and you use the car 60% business / 40% personal, then you can deduct $1,000 * 60% = $600.
What is a Section 179 Deduction?
A Section 179 deduction allows you to write off the full cost of a new car in the year you purchased it for business. There are certain restrictions related to this deduction:
You must own the car and have purchased it; you cannot have received it as a gift or inheritance. You also cannot have purchased it from a “related party” (typically, a family member).
You must use the car more than 50% of the time for business. Your total deduction cannot exceed the percentage of the time you use it for business (e.g. for a $10,000 car used 80% of the time for business, you can only write off up to $8,000).
Your deduction cannot cause you to go from a business profit to a business loss. If it does, you have to “carry over” the remaining amount to future years. (For example, if you made $5,000, had no other expenses, and put a $10,000 car into use claiming the Section 179 deduction, you can only write off up to $5,000 this year.)
For SUVs, you can only write off up to $25,000.
The car itself doesn’t have to be new—it just has to be new to you. However, you must take the deduction the year the car is “ready and available” for use. So if this is the first year you are using it for business, you can’t take the deduction if you purchased it last year.
Also of note: if you take a Section 179 deduction, you are effectively recognizing all of the depreciation on the car in the first year. Thus, you cannot use the Standard Mileage Rate that year or in any future years, since the rate includes depreciation (you would effectively be double counting depreciation—which the IRS doesn’t like).
Most importantly, if you stop using the car for business (or use it less than 50% of the time for business) or sell the car before 5 years pass, then you are subject to a “Section 179 recapture”. This means that the expense you previously wrote off could become income in the year you sell the car – meaning your tax bill will be artificially high that year.
Due to all of the restrictions, plus the additional calculations and tracking required, it’s often a lot easier to skip the Section 179 deduction and just use the Standard Mileage Rate. The deduction primarily makes sense for business owners who have a large fleet of cars (at which point you should be having an accountant do all this for you).
What are other expenses I should be aware of?
Let’s take a look at four common expenses that many aren’t aware can be taken as deductions:
Parking and Tolls: In addition to either of the two methods above, you can expense parking fees and tolls that relate to business driving. For example, if you’re cleaning a client’s house and have to pay for parking, you can expense the parking. But if you’re taking a break for lunch, you cannot expense the parking (since it is not business related).
Cell Phone: If you pay for a phone and data plan, you can write off the business portion of this cost. The IRS allows you to use a bit of judgment when calculating this number. Let’s say you pay $50 per month for your personal cell phone use. After joining a ridesharing company, you decide to upgrade to a $100 per month data plan since you’ll be using their app and GPS often. You have a good case for writing off the extra $50 per month, because you wouldn’t have purchased it if you hadn’t started this new business.
Food for Passengers: You cannot expense meals for yourself. You can, however, write off 50% of snacks or drinks provided to passengers.
Car Interest Payments: You can write off interest on your car loan payments. However, like all expenses, you can only write off the business portion (e.g. 60% of the interest if you use the car 60% business / 40% personal).
What about subscription radio, air freshener, or [other]?
The IRS allows you to use some judgment on determining if an expense is business related. An expense must be ordinary and necessary for your line of business in order for it to qualify as an expense. Ordinary means common and accepted in your business; necessary means helpful and appropriate.
For example, a Sirius XM subscription might not meet this test. It’s semi-ordinary to give passengers music options, but not really necessary (since you could just use free radio). But air freshener for the car is both ordinary and necessary, since many drivers use it and it helps keep your passengers happy.
Disclaimer: Sorry, our lawyers require this: keep in mind that this content is meant only as a guide, and not as professional tax/legal advice. Please hire a tax or legal professional if you are in need of professional advice.