Help me gain appreciation for depreciation

February 20, 2009 6:29 PM

My friend seems to think that he is essentially getting a free SUV under the new small business stimulus package. Help me understand this so i can 'splain it to him

My buddy has a business where he basically does consulting work for a single customer. for his services this customer pays him approx $100k per year. He lives in NYC, and his customer's office is just a short train ride from his home.

for some reason I'll never understand, he has been thinking about getting a car and mentioned this to his accountant, who told him to buy a big hybrid SUV,so he can get the sales tax back, and take advantage of the added depreciation.

A vehicle this size will cost him a minimum of about $65,000 and even at the promotional 0.9% that's in the neighborhood of about $900 a month, plus $400 a month for parking and insurance.

Somehow he is convinced that with all the tax benefits, he will basically be getting the car for free.

I am clearly not an accountant, nor do I understand depreciation, but this just sounds insane to me, especially when you figure that he will literally only drive about 500 a miles a month.

Is there any of you "green visor" types out there that can explain this to me so I can understand it, and then explain it to him? I'd hate to see a friend take on such a big monthly nut at such uncertain times.

thanks

posted by Mr_Chips to work & money (6 comments total)

For a while there was a tax break on large trucks that was intended to help farmers and construction companies save money. People started taking advantage of that and buying up massive SUVs that reached the weight equivalent and claiming them as business expenses. I thought for sure that loophole was plugged by now, but maybe I am wrong.
Google stuff like "loophole, tax, suv" and you can come up with some articles. I remember seeing something about this on one of those investigative news shows years ago.
posted by idiotfactory at 6:57 PM on February 20, 2009

He might kind of have a point, with the accelerated depreciation. Here's how I'm thinking of this.

First of all, depreciation: go read about it. Instead of explaining in detail I will just summarize and say that "accelerated depreciation" essentially means that he gets to count large chunks of the car's cost as a business expense in the early years of ownership (probably years 1-3), and less each year as time goes on. I don't feel like tracking down the actual IRS depreciation schedule for a hybrid light truck (but it's probably out there somewhere), so I'll be using a "for instance" schedule that may or may not track reality. Surely this is why your friend pays an accountant.

Anyway.

So if your friend makes $100K per year in consulting fees, I'm guessing he pays about 40% between income tax and self-employment tax which, for simplicity, we will call $3500 per month. The point of buying an expensive hybrid car is that he will be calling it a business expense - and if he's in Manhattan, doing non-manual labor at another site within the burough, already indicates that his accountant is a bit aggressive.

At any rate, assume this is a valid business expense. Normally, for short-lived assets, you take an immediate deduction. E.g., $500 in office supplies in year 1 gets paid for pre-tax, saving you 40% of $500 or about $100. For longer lived assets that "depreciate" in value over a number of years, you have to spread out the tax benefit (or else there would be a huge tax benefit to buying all new equipment every year, which is something the federal government, in its wisdom, has decided not to subsidize). So with the car purchase, the $65K expense will be spread over several years, probably about 10.

Now, there are a zillion ways to spread $65K over 10 years, which you understand if you read that wikipedia article. But if the depreciation is accelerated, that means there are bigger lumps up front and the amount declines over the years. So let's just assume - and I am totally making this up - that your friend gets to depreciate 50%, 30%, and 20% in the first 3 years of owning that SUV (so it's entirely depreciated over 3 years, which is very aggressive).

So, year 1: 50% of 65K is $32,500 of car expense that's deductible in year 1. Expensing that amount saves you 40%, which is $13,000. Spread out over 12 months, that's $1083. If the payment is $900, he is coming out ahead in the first year, not counting the other expenses you mention such as parking and insurance. Depending on how you look at it, that could still seem like a "free" car, particularly if he anticipates selling it after the first year. Yes, it declines in value, but remember he was freerolling in the first year, so he doesn't care. Well... he could still care depending on whether the resale value is enough to cover the balance of the loan.

Now I don't know how many of these assumptions are realistic, but you can twiddle the variables, and the point is it's a close call that actually depends on various inputs - he might not be crazy.

Tax law lesson over. Phew.
posted by rkent at 7:23 PM on February 20, 2009 [6 favorites]

Let's assume that his federal tax rate is 25%, his self-employment tax is 15% and his NYC tax is 10% for a total of 50%. Assuming that he can charge all of his auto costs to his business, it means that the tax deductions end up paying for about half. The actual numbers are little more complicated but this is good enough for a quick and dirty approximation. This 50% discount is a far cry from getting it for free, but better than a poke in the eye with a sharp stick. On the other hand, he's still paying half the cost out of his pocket for something that may be of questionable value to him. In other words, would you buy a gallon jar of maraschino cherries at Costco just because it was on sale at half price. In his case we're talking at least $32,500 that he could spend on something else he enjoys or invest for retirement.

This is how it should be looked at in the total scheme of things. The example rkent gave is how it looks from a cash flow basis, which is good for the first year. But the problem comes in the second and subsequent years. You rapidly use up your deduction and still have several years to pay off the car with no deduction. So when all is done, you really pay about the same amount, 50%, as in my first scenario at the top.

Further, if you think you can get away by selling the car after the first year, there is a catch called depreciation recapture. In rkent's example, you subtract the depreciation, $32,500 in the first year from the cost of the car. This means your new cost basis for the care is the remaining $32,500. Let's say you get really lucky and can sell the car for $60,000 to get out from under your loan. The difference between the $60,000 sale price and the $32,500 cost basis is considered profit that you must recapture. So you have $27,500 added to your income in the second year on which you have to pay taxes. There is no free lunch. It looks good in the first year but eventually you end up paying in subsequent years.

Have your friend ask his accountant about depreciation recapture.
posted by JackFlash at 7:51 PM on February 20, 2009

Sec 179 deductions let you take $25k in the first year provided the truck is ginormous (GVW > 3 tons; shockingly this is actually pretty common these days [BMW X5, Land Rover, a big Nissan; probably not a coincidence that lots of luxury SUVs hover right over the IRS threshold]).

Given the discounts that are already available for the 8 people currently shopping for cars in New York, screwy IRS regulations that net an additional 40% off retail makes for a pretty good deal. I don't think it makes the car free under any manipulation of the variables, especially when you look at insurance and parking and such, but it does encourage one to buy a fancy ANWR-draining SUV instead of a perfectly sufficient fuel-sipping station wagon. If you go under 6000 lb. you can only take something like $5k in the first year. So even if gas spiked back up to $4 per gallon you'd have a hard time driving enough to make a Jetta competitive with an X5 in terms of cost of ownership.

I am not an accountant, I am certainly not your friend's accountant, etc.
posted by genug at 7:56 PM on February 20, 2009

If he has a business where he can spend that kind of cheese, he should have an accountant who can 'splain this to him.
posted by Lesser Shrew at 9:49 PM on February 21, 2009

This isn't the heavy truck loophole (which still exists). This is the stimulus bill's "bonus depreciation" for equipment purchases that allows up to 57% of a purchase price to be deducted as a business expense in the first year. Under certain circumstances, as much as 100% of purchases under $250,000 could be written off.

I don't think "free" is that far off the mark here -- these are tremendously good terms even by the already generous business expense and depreciation standards in place.

But your friend has to keep in mind, too, that this just means that his write-off makes his income untaxable. I ran some quickie figures that suggest (if single, no dependents) his taxes would be around $30,000. So if he buys the $60,000 truck, he gets it for about 50% off in terms of taxes saved (not counting state taxes).

Generally, then, it's an excellent deal, but it's hardly "free". He'll also be able to deduct some/most of his expenses (actual expenses, or via mileage), as long as he uses it in business. So it isn't even built into the code to get a gas-sipper, other than specific tax bonuses targeting hybrids or whatever.

Both rkent and JackFlash make some good points, especially the opportunity cost of getting this vehicle versus, say, saving for retirement. That $30K or whatever is a big chunk of change. Sticking it in a Roth IRA or something else tax-deferred would be a great nest egg.
posted by dhartung at 11:30 PM on February 21, 2009 [1 favorite]