Depreciation Deduction

If you use a car you own in your business, you can claim a depreciation deduction: that is, you can deduct a certain amount each year as a recovery of your cost or other basis in the car. You cannot use the standard mileage rate if you decide to take a depreciation deduction in the year you first place the car in service.

You generally need to know the following three things about the car you intend to depreciate.

1. Your basis in the car.
2. The date you place the car in service.
3. The method of depreciation, recovery period, and convention you will use.

Basis.   Your basis in the car for figuring depreciation is generally its cost. This includes any amount you borrow or pay in cash, in other property, or in services. Additional rules concerning basis are discussed later in this chapter under Unadjusted basis.

Placed in service.   You generally place a car in service when it is available for use in your work or business, in the production of income, or in a personal activity. Depreciation begins when the car is ready for use in your work or business or for the production of income.

For purposes of computing depreciation, if you first start using the car only for personal use and later convert it to business use, you place the car in service on the date of conversion. Your basis is the lesser of the fair market value or your adjusted basis in the car on the date of conversion.

Car placed in service and disposed of in the same year.   If you place a car in service and dispose of it in the same tax year, you cannot claim any depreciation deduction for that car.

Methods of depreciation.   Generally, one depreciation system is available for cars: the Modified Accelerated Cost Recovery System (MACRS). MACRS rules for cars are discussed later in this chapter.

Exception.   If you used the standard mileage rate in the first year of business use and change to the actual expenses method in a later year, you cannot depreciate your car under the MACRS rules. You must use straight line depreciation over the estimated remaining useful life of the car.

To figure depreciation under the straight line method, you must reduce your basis in the car (but not below zero) by a set rate per mile for all miles for which you used the standard mileage rate. The rate per mile varies depending on the year(s) you used the standard mileage rate. For the rate(s) to use, see Depreciation adjustment when you used the standard mileage rate under Disposition of a Car, later.

This reduction of basis is in addition to those basis adjustments described later under Unadjusted basis. You must use your adjusted basis in your car to figure your depreciation deduction. For additional information on the straight line method of depreciation, see Publication 534, Depreciating Property Placed in Service Before 1987.

Percentage of business use.    Generally, you must use your car more than 50% for qualified business use (defined next) to qualify for the section 179 deduction and MACRS deduction. If your business use is 50% or less, you must use the straight line method to depreciate your car. This is explained later under Car Used 50% or Less for Business.

Qualified business use.   A qualified business use is any use in your trade or business. It does not include use for the production of income (investment use). However, you do combine your business and investment use to compute your depreciation deduction for the tax year.

Use of your car by another person.   Do not treat any use of your car by another person as use in your trade or business unless that use meets one of the following three conditions.

1. It is directly connected with your business.
2. It is properly reported by you as income to the other person (and, if you have to, you withhold tax on the income).
3. It results in a payment of fair market rent. This includes any payment to you for the use of your car.

Business use changes.   If you used your car more than 50% in qualified business use in the year you placed it in service, but 50% or less in a later year (including the year of disposition), you have to change to the straight line method of depreciation. See Business use drops to 50% or less in a later year under Car Used 50% or Less for Business, later.

More-than-50%-use test.   You meet this test for any tax year if you use your car more than 50% in qualified business use. You must meet this test each year of the recovery period (6 years under MACRS) for your car.

If you use your car for more than one purpose during the tax year, you must allocate the use to the various purposes. You do this on the basis of mileage. Figure the percentage of qualified business use by dividing the number of miles you drive your car for business purposes during the year by the total number of miles you drive the car during the year for any purpose.

Property does not cease to be used more than 50% in qualified business use by reason of a transfer at death.

Change from personal to business use.    If you change the use of a car from 100% personal use to business use during the tax year, you may not have mileage records for the time before the change to business use. In this case, you figure the percentage of business use for the year as follows.

1. Determine the percentage of business use for the period following the change. Do this by dividing business miles by total miles driven during that period.
2. Multiply the percentage in (1) by a fraction. The numerator (top number) is the number of months the car is used for business and the denominator (bottom number) is 12.

Example.   You use a car only for personal purposes during the first 6 months of the year. During the last 6 months of the year, you drive the car a total of 15,000 miles of which 12,000 miles are for business. This gives you a business use percentage of 80% (12,000 ÷ 15,000) for that period. Your business use for the year is 40% (80% × 6/).

Limits.    The amount you can claim for section 179 and depreciation deductions may be limited. Maximum limits apply depending on the year in which you placed your car in service. You have to adjust the limits if you did not use the car exclusively for business. See Depreciation Limits, later

Unadjusted basis.    You use your unadjusted basis to figure your depreciation using the MACRS depreciation chart explained later under Modified Accelerated Cost Recovery System (MACRS). Your unadjusted basis for figuring depreciation is your original basis increased or decreased by certain amounts.

To figure your unadjusted basis, begin with your original basis in your car, which generally is its cost. Cost includes sales and luxury taxes, destination charges, and dealer preparation. Increase your basis by any substantial improvements you make to your car, such as adding air conditioning or a new engine. Decrease your basis by any deductible casualty loss, section 179 deduction, diesel fuel tax credit, gas guzzler tax, clean-fuel vehicle deduction, and qualified electric vehicle credit. See Publication 535 for more information on the clean-fuel vehicle deduction, and the qualified electric vehicle credit.

If your business use later falls to 50% or less, you may have to include in your income any excess depreciation. See Car Used 50% or Less for Business, later, for more information.

If you acquired the car by gift or inheritance, see Publication 551, Basis of Assets, for information on your basis in the car.

Improvements.   A major improvement to a car is treated as a new item of 5-year recovery property. It is treated as placed in service in the year the improvement is made. It does not matter how old the car is when the improvement is added. Follow the same steps for depreciating the improvement as you would for depreciating the original cost of the car. However, you must treat the improvement and the car as a whole when applying the limits on the depreciation deductions. Your car's depreciation deduction for the year (plus the depreciation on any improvements) cannot be more than the depreciation limit that applies for that year. See Depreciation Limits, later.

Effect of trade-in on basis.   When you trade an old car for a new one, your original basis in the new car is generally your adjusted basis in the old car plus any additional payment you make.

Traded car used only for business.   If you trade in a car that you used only in your business for another car that will be used only in your business, your original basis in the new car is your adjusted basis in the old car, plus any additional amount you pay for the new car.

Example 1. Paul trades in a car that has an adjusted basis of $3,000 for a new car. In addition, he pays cash of $17,000 for the new car. His original basis of the new car is $20,000 (his $3,000 adjusted basis in the old car plus the $17,000 cash paid). Paul’s unadjusted basis would be the same unless he claims the section 179 deduction, special depreciation allowance, or has other increases or decreases to his original basis.

Example 2.   In July 1997, Marcia purchased a car for $26,000 and placed it in service for 100% use in her business. She did not claim a section 179 deduction. Marcia's unadjusted basis for the car was $26,000. For 1997 through 1999, Marcia figured her depreciation deduction using the MACRS chart for those years.

In September 2000, Marcia traded that car in and paid $14,200 cash for a new car to be used 100% in her business. Marcia is allowed one-half of the regular depreciation amount for 2000 for her old car. (See Disposition of a Car, later.)

Marcia figures her original basis in the new car, $27,792, as follows.

Cost of old car	$26,000
Less: Total depreciation allowed  from 1997 through 2000	- 12,408
Adjusted basis of old car	$13,592
Plus: Additional cost for  new car	+ 14,200
Basis of new car	$27,792

Traded car used partly in business.   If you trade in a car that you used partly in your business for a new car that you will use in your business, you must make a trade-in adjustment for the personal use of the old car. This adjustment has the effect of reducing your basis in your old car, but not below zero, for purposes of figuring your depreciation deduction for the new car. (This adjustment is not used, however, when you determine the gain or loss on the later disposition of the new car. See Publication 544 for information on how to report the disposition of your car.)

To figure the unadjusted basis of your new car for depreciation, first add to your adjusted basis in the old car any additional amount you pay for the new car. Then subtract from that total the excess, if any, of:

1. The total of the amounts that would have been allowable as depreciation during the tax years before the trade if 100% of the use of the car had been business and investment use, over
2. The total of the amounts actually allowable as depreciation during those years.

For information about figuring depreciation, see Modified Accelerated Cost Recovery System (MACRS), which follows Example 2, later.

Example 1.   In March, Mark traded his 1996 van (placed in service in 1996) for a new 2000 model. He used the old van 75% for business and he used the new van 75% for business in 2000. Mark claimed actual expenses (including $8,494 depreciation expense) for the business use of the old van since 1996. He did not claim a section 179 deduction for the old or the new van.

Mark paid $12,800 for the 1996 van in June 1996. He paid an additional $9,800 when he acquired the 2000 van. Mark was allowed ½ of the depreciation deduction amount (which is included in the $8,494 depreciation expense total) for his old van for 2000, the year of disposition, as explained later under Disposition of a Car.

Mark figures the unadjusted basis for depreciating his new van as shown next.

Cost of old van		$12,800
Less: Total depreciation allowed on the  business cost of old van, $9,600  ($12,800 × 75%), from 1996-2000		- 8,494
Adjusted basis of old van		$ 4,306
Plus: Add'l cost for new van		+ 9,800
Basis of new van before trade-in  adjustment		$14,106
Trade-in adjustment:
Depreciation at 100% business use:
2000-($12,800 × .1152) × 1/ yr	$ 737
(Limit: $1,775)
1999-12,800 × .1152	1,475
(Limit: $1,775)
1998-12,800 × .192	2,458
(Limit: $2,950)
1997-12,800 × .32	4,096
(Limit: $4,900)
1996-12,800 × .20	2,560
(Limit: $3,060)
Total	$11,326
Less: Actual depreciation allowed	- 8,494
Excess of 100% over actual	$2,832
Less: Lesser of Excess amount ($2,832)
or Adjusted basis of old van ($4,306)		- 2,832
Unadjusted basis of new van   for depreciation		$11,274

Example 2.   Rob paid $15,000 for a new car that he placed in service in 1997. He used it partly for business in 1997 (9,000 business miles of 15,000 total miles), 1998 (12,000 business miles of 16,000 total miles), and 1999 (14,400 miles of 18,000 total miles). He used the standard mileage rate in those years to claim the business use of his car. (See Depreciation adjustment when you used the standard mileage rate under Disposition of a Car, later.)

On January 2, 2000, Rob traded in this car and paid an additional $6,000 for his new car. Rob figures the unadjusted basis for his new car as shown next.

Cost of old car		$15,000
Less: Total depreciation allowed:
1999-14,400 mi. × .12	$1,728
1998-12,000 mi. × .12	1,440
1997- 9,000 mi. × .12	1,080	- 4,248
Adjusted basis of old car		$10,752
Plus: Additional cost for new car		+ 6,000
Basis of new car before trade-in  adjustment		$16,752
Trade-in adjustment:
Depreciation at 100% business use:
1999 - 18,000 mi. × .12	$2,160
1998 - 16,000 mi. × .12	1,920
1997 - 15,000 mi. × .12	1,800
Total	$5,880
Less: Actual depreciation allowed	4,248
Excess of 100% over actual	$1,632
Less: Lesser of Excess amount ($1,632)
or Adjusted basis of old car ($10,752)		- 1,632
Unadjusted basis of new car  for depreciation		$15,120

Modified Accelerated Cost Recovery System (MACRS).    The Modified Accelerated Cost Recovery System (MACRS) is the name given to the tax rules for getting back (recovering) through depreciation deductions the cost of property used in a trade or business or to produce income.

The maximum amount you can deduct is limited, depending on the year you placed your car in service. See Depreciation Limits, later.

Recovery period.   Under MACRS, cars are classified as 5-year property. You actually depreciate the cost of a car, truck, or van over a period of 6 calendar years. This is because your car is generally treated as placed in service in the middle of the year and you claim depreciation for one-half of both the first year and the sixth year.

Depreciation deduction for certain Indian reservation property.   Shorter recovery periods are provided under MACRS for qualified Indian reservation property placed in service on Indian reservations after 1993 and before 2004. The recovery period that applies for a business-use car is 3 years instead of 5 years. However, the depreciation limits, discussed later, will still apply.

For more information on the qualifications for this shorter recovery period and the percentages to use in figuring the depreciation deduction, see chapter 3 of Publication 946.

Depreciation methods.   You can use one of the following three methods to depreciate your car.

1. The 200% declining balance method (200% DB) over a 5-year recovery period that switches to the straight line method when that method provides a greater deduction.
2. The 150% declining balance method (150% DB) over a 5-year recovery period that switches to the straight line method when that method provides a greater deduction.
3. The straight line method (SL) over a 5-year recovery period.