Realizing Tax Benefits of a Loss Deduction
February 4th, 2014 at 5:54 PM
You are going to replace your old business vehicle with a new vehicle before the end of the year.
But you have this nagging fear that the old business vehicle has some tax benefits that you need to know about before doing anything with it.
Your first question on the old vehicle: Where do I start?
Where Do You Start?
The first thing you need to know is this: If you sold the old business vehicle today, would you have a taxable gain or a deductible loss? (Note: Every business vehicle, including mileage-rate vehicles, has a gain or loss that you need to consider.)
To find your gain or loss, you will need to compute the tax basis of the vehicle.
Once you know the amount of your gain or loss, you can plan. I will examine a loss on sale and the possible paths that you could follow to dispose of your vehicle.
Let’s look at your loss deduction. You want the best tax benefits today, and today is the day you are deciding what to do with the old business car. You are considering the five choices below:
- Sell the old business vehicle to a third party.
- Sell the old business vehicle to your 18-year-old child.
- Give the vehicle to charity.
- Trade in the vehicle on the new vehicle.
- Convert the old business vehicle to personal use.
One answer gives you the best benefit today. Make your selection.
The correct answer is #1. By selling the old business vehicle to a third party, you deduct the tax loss this year.
Why B Is Wrong
You may not deduct a loss on a sale of a business asset to a related party. If you sell your old business vehicle to a related party, you essentially toss the tax-benefit money in the trash.
The difference with the vehicle compared with shares of a stock is that the vehicle is not likely going up in value after the sale. This means that neither you nor your 18-year-old child is going to receive a penny of tax benefit from the sale.
Why C Is Wrong
The donation of a business vehicle triggers the capital asset rules for donations and not the “qualified vehicle rules.” In plain English, this means that tax law limits your donation of the business vehicle to the lower of your adjusted basis or fair market value. This “lower of basis or market value rule” makes the loss deduction disappear.
Again, you’re looking at the trash bucket. If you donate your loss-deduction business vehicle to charity, the loss gets lost.
If you sell the vehicle outright and give the cash to charity, you
- Realize the benefits of your loss deduction, and
- Give the charity the full cash value of the vehicle.
Why D Is Wrong
The trade-in of your old business vehicle on the new business vehicle produces no immediate gain or loss. On a typical vehicle trade-in, Section 1031 defers any gain or loss.
The good news on the trade-in is that the tax law did not make you toss tax-benefit money in the trash. The bad news is that tax law does not allow you to realize the loss immediately.
Instead, the loss adds to your basis and you realize the tax benefits of the loss in the depreciation of the new vehicle. But this realization could be problematic.
For example, the luxury auto limits could further defer your realization of any tax-loss benefits to many years in the future or until you replace the new car with another car.
If after the trade-in you are a mileage-rate user, you don’t see any tax benefits of the loss carryover while you use the mileage rates, because the IRS embeds a per-mile fixed rate of depreciation in the mileage rate. Therefore, with the mileage rate, you realize the benefits of your loss deduction only when you sell your mileage-rate vehicle to a third party.
Why E Is Wrong
Three bad things happen you convert a loss-deduction vehicle to personal use:
- You don’t get an immediate loss deduction.
- Your personal use of the vehicle erodes the value of the vehicle and that reduces the tax benefits you receive from your tax loss deduction when you finally sell to a third party.
- You need to sell that now personal-use vehicle to a third party to realize the loss deduction. Question: Will you remember this now diluted but still valuable business-loss tax deduction some years later when you sell the old business vehicle?
I will explore how to best treat the gain on the sale of your business vehicle in a future article.