Lenders v. CPAs war: automobile depreciation

[Michael Plaks]

How you write off your auto expenses does matter for taxes. It also does matter for loan underwriting. Notoriously, lenders and CPAs do not understand each others' rules and are often locked in needless conflicts. Fresh out of another such conflict, I want to illustrate how it works.

The easiest way to do so is with an example.

• 20,000 miles driven during the year
• 15,000 of those miles (75%) was for business
• $10,000 annual expenses for gas, insurance, maintenance etc.

PART 1 - TAX DEDUCTION

If you use the standard IRS mileage allowance of 58 cents/mile (2019), you have a $8,700 deduction, and your Schedule C looks like this:

If you use the actual expenses method, you claim 75% of the $10,000 operating expenses, or $7,500 plus 75% of the depreciation. The depreciation number varies based on multiple factors, but in my example it is $2,288. The total deductions are $9,788, and here is the corresponding Schedule C:

PART 2 - QUALIFIED INCOME FOR UNDERWRITING

Now, how does it work when your lender determines your income for underwriting purposes?

In the actual expenses scenario, they add back depreciation and only count $7,500 as your expenses. Your qualified income gets a $2,288 boost. You still get the full $9,788 deduction for taxes.

In the mileage scenario, it gets more interesting. The 58 cents mileage rate includes a depreciation component: 26 cents for 2019. Per Fannie guidelines https://singlefamily.fanniemae... , lenders are supposed to add back the depreciation component, using this calculation:

     15,000 business miles x 26 cents = $3,900

If they do it right, your qualified income will get a $3,900 boost, and only $4,800 of your total $8,700 auto deduction will be counted as your business expense. You still get the full $8,700 deduction for taxes.

PART 3 - WHICH IS BETTER?

Raise your hand if you expected my answer to be - it depends. Well, it does.

First, not all lenders follow the Fannie guidelines, either because their loans are not backed by Fannie or because they use their own underwriting guidelines or (quite often) because the field underwriters are not well trained. Usually, such nonconforming underwriting would work against you when you use mileage deduction, because the lender will leave your mileage deduction as is and will not add back anything. 

Occasionally, it can work in your favor: when the underwriter adds back the entire mileage deduction ($8,700) instead of only its depreciation component ($3,900).

Does it mean that you should choose the actual expenses method over mileage? After all, adding back an explicitly stated depreciation seems to be a no-brainer, plus my example shows that the actual expense deduction was a bigger tax deduction anyway. 

Again, it depends. If your automobile depreciation is large, especially when you use first-year bonus depreciation or Section 179 - you may indeed reap a substantial double benefit: major tax deduction for the IRS, and no reduction of your business income for underwriting. 

However, claiming this first-year big write-off may be prohibited by the tax rules, depending on your overall situation, and even when available it could be a bad move from your long-term tax planning perspective. 

How so? Many reasons. One of them if the fact that if you write off your entire $50,000 business truck in its first year and then trade it in or sell for $30,000 3 years later, you will have $30,000 of taxable income in year 3. Subject to income tax, state tax, and self-employment tax. Several other factors can make 1st year super-depreciation undesirable. 

The other side of the argument is the fact that your mileage deduction can be better for you, both short-term and long-term. Yes, in my example the mileage deduction was less than the actual expenses deduction, but it's only because of my sample numbers. Change the number of miles or the business use % or the actual costs - and you can easily get a mileage deduction higher than the corresponding actual expenses calculation.

Notice that in my example the boost from the lender adjustment was higher in the mileage scenario, even though the tax deduction for mileage was lower. Also, if you keep your vehicle until it falls apart, the multi-year tax benefit of the mileage deduction can significantly exceed your actual expense deductions, even with depreciation.

But wait, there is more! You cannot freely go back and forth between the two methods. Once you started actual expenses, you are not allowed to switch to mileage for the same vehicle. Stuck with the actual expenses, even if the mileage becomes more beneficial.

Bottom line: it depends. If you DIY your taxes, stick with the mileage. It is simpler to keep track of, and there's less chance of an error on your taxes. If you hire a good tax professional - we will guide you through making this complex decision. And many other decisions.