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Tax Newsletter
May 2001

Acquiring an auto - should you buy or lease?

The decision to buy or lease an auto can be complex, involving the evaluation of a variety of financing options and a number of tax considerations. Ultimately, the best alternative is that which leaves you with the most cash at the end of the day, after taking into account availability of cash and all of the costs, taxes and otherwise, associated with the acquisition.

Tax considerations

Acquisition through a business (corporation or sole proprietorship). Taxpayers may deduct actual expenses of operating a vehicle, such as gasoline, tires, repairs, insurance, etc. However, deductions are not permitted to the extent an auto is used for personal purposes. An allocation based on the ratio of business miles to total miles may be required to arrive at the business portion of operating costs. Corporations generally deduct all of the operating costs associated with a vehicle; personal use is accounted for through reimbursement by the employee of costs associated with personal use, or by reporting additional compensation income to the employee.

Taxpayers who acquire an automobile through a business are not permitted to deduct the full cost of such vehicle in the year of purchase. Instead, the cost is recovered through depreciation. The depreciation is limited for “luxury” autos—autos weighing 6,000 pounds or less and costing more than $15,400. Additional limitations apply if business use is less than 50% of total use.

As an alternative to depreciation, taxpayers may elect to use the standard mileage deduction (34.5 cents per mile for 2001). The mileage rate is applied to all business miles. The standard mileage rate is deemed to cover the costs of operation; thus, additional deductions for gasoline, repairs, etc. are not permitted.

Taxpayers who lease a vehicle are often able to accelerate their initial tax deductions. A taxpayer may deduct monthly lease costs, subject to a “lease inclusion” adjustment. If the leased auto’s fair market value is greater than $15,500, the law requires an additional amount be included in income. The “lease inclusion” amount is intended to correspond to the luxury auto limitations that apply to vehicle purchases. Additional costs of operating the vehicle may also be deducted.

Business use of an employee vehicle. Employees are often reimbursed for use of their vehicles based on cents-per-mile of business use. To the extent an employee incurs auto expenses that are not reimbursed, such expenses are only deductible as miscellaneous itemized deductions, subject to the 2% of AGI limitation. However, employees who finance their purchase using home equity indebtedness are able to deduct the interest payments without being limited by the 2% rule.

An employee with a leased vehicle may benefit from lower cash outlays; however, tax savings may be limited because of the 2% limit on miscellaneous itemized deductions.

Cash flow considerations

Aside from the actual costs associated with a new car acquisition, a taxpayer’s cash flow availability and/or ability to finance will have a significant impact on the method of acquisition. A purchase often requires a major cash outlay or loan commitment. Lease contracts may offer more flexibility, both in terms of up-front cash and monthly lease payments.

We recommend that a taxpayer perform a cash flow analysis to determine which alternative provides the optimum benefits. The objective is to compare the present value of the after-tax cash outlays under each alternative. Thus, for a purchase, the analysis would take into account the present value of the initial cash payment, the after-tax cost of any financing, the tax savings associated with depreciation and after-tax proceeds of future sale, if applicable. Under the lease alternative, the cash down payment and after-tax cost of lease payments would be considered.

In performing the comparison, it is critical that the underlying assumptions be comparable (i.e., will the auto be retained for the lease period; what expenses are covered by the lease payments, etc.). Of course, the taxpayer’s ability to fund any cash requirements may ultimately be the determining factor in selection of acquisition method.

Factors favoring the buy alternative:

  • Purchaser wants to pay cash rather than finance;
  • Purchaser plans to hold auto for more than four years;
  • Auto weighs more than 6,000 pounds (i.e., not subject to luxury auto limits);
  • Purchaser plans high mileage usage (more than 18,000 miles/year);
  • Disposition of the asset at the appropriate time will not be difficult, and the seller expects to be able to realize a reasonable price at the time of sale.

Factors favoring leasing:

  • Lessee wants lower monthly payments;
  • Lessee plans frequent trade-ins;
  • Auto weighs less than 6,000 pounds and costs more than $15,300;
  • Lessee plans low mileage usage (less than 15,000 miles/year);
  • The leasing arrangement offers maintenance services or insurance coverage that would be difficult to arrange or more costly if the asset is purchased.

The decision to buy or lease is a complex one and requires you to take into account many different factors, cash flow, timeframe for holding the asset, ability to dispose of the asset, etc. Although not all of the factors are financial, performing a discounted cash flow analysis should play a key role in the decision-making process.

Please feel free to contact us should you have any questions regarding the foregoing.

The information contained in this newsletter is general in nature and does not constitute tax advice or opinion. Applicability to specific situations should be determined through consultation with your tax advisor.

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