October 31, 2017
Many business owners routinely trade in their vehicles after using them for several years. While this practice may seem routine and uncomplicated, the decision may be more nuanced from a tax standpoint.
Under Internal Revenue Code Section 1031, an exchange of “like-kind” property held for use in a business or for investment requires the deferral of any gain or losses on the transaction. In general, the trade-in of a business vehicle (car, SUV, light truck) for another vehicle causes the deferral of any gain or loss on the trade in. In general, this rule is favorable if you are trading in a vehicle with a gain (i.e. depreciated cost is less than value), but is unfavorable if you have a loss on the vehicle.
Working in tandem with this rule are the so-called “luxury automobile” depreciation limitations. The name is a bit of a misnomer, since these depreciation limitations apply to most business vehicles. These rules put strict limits on the maximum annual depreciation that may be claimed by a business on a vehicle. As a result, it is normal and expected to have a business vehicle that has a net tax cost (after depreciation) well in excess of its value.
For example, let’s say you have a 2014 Cadillac CTS that was purchased new in 2014 for $60,000, and you’re trading it in at the end of 2017 with a value of $20,000. As you can see below, the calculated loss on this trade-in is $18,815.
If you are subject to 25% federal income tax, 5% state income tax, and 15.3% self-employment tax, the tax value of this loss is approximately $8,500. Trading in the vehicle causes you to defer this loss, and essentially roll it over into the next vehicle. Until you sell the vehicle outright, this process can continue indefinitely, with an increasing loss deferral with each trade-in.
If you are facing this scenario, you should consider as an alternative selling the vehicle outright to the dealer (or to a private party), and purchasing the replacement vehicle in a separate transaction. This allows you to recognize any losses on the vehicle, without the deferral that comes from a trade-in.
However, please note that there can be significant sales tax savings in a trade-in transaction. Under the laws of many states, the value of a trade-in can be subtracted from the taxable amount for the purchase transaction. With the example above and with a 7% state sales tax rate, this could represent a $1,400 permanent benefit to the trade-in transaction.
Overall, it is normal for a vehicle transaction to compare a permanent sales tax savings for a trade-in, with a larger deferral of loss value on the income tax side if you sell the vehicle outright. This comparison does not have one size fits all solution - each transaction should be evaluated separately, and each business should make a decision based on their particular tax situation.
This article is intended to serve as general guidance, and should not be construed as specific tax advice for your situation. Please consult your tax advisor for any specifics on these matters.
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