The Tax Cuts and Jobs Act (“TCJA”) has resulted in many changes in the tax laws. One little-noticed change affects trade-ins of vehicles uses for business. Let’s go over the tax changes for business vehicle trade-ins.
Old tax law: Tax-deferred exchange of trade-in business car
Until 2017, you could do a tax-deferred exchange of a business vehicle – also known as a Section 1031 exchange. With such an exchange, there would be no tax due on the sale of your trade-in.
Instead, the tax basis (value for tax purposes) of the trade-in would be subtracted from the basis of the new vehicle. Such tax-free exchanges were done all the time when business owners traded in their old vehicles for new.
Example: Brenda, a self-employed contractor, purchased a pick-up truck for $50,000 several years ago that she used 100% for business. After years of depreciation deductions, she fully deducted the cost.
In 2017 the car had a tax basis (value for tax purposes) of $0. She could sell the car for $26,000 and pocket the money. But if she does so, she must pay tax on her $26,000 gain ($26,000 selling price – $0 basis).
Instead, during 2017, she trades in the car on a replacement vehicle with $50,000 sticker price. She pays the dealer $24,000 cash. She pays no 2017 taxes on the $26,000, and the new vehicle has a basis of $24,000-the additional cash she paid to buy the replacement vehicle.
The new law and trade-in vehicles
Unfortunately, the new tax law eliminates Section 1030 tax-free exchanges for all personal property, including vehicles. Tax-free exchanges are still allowed for real property. The prohibition took effect on January 1, 2018.
This means that you may no longer treat the trade-in of a business vehicle as a non-taxable event. Instead, when you trade-in an old vehicle for a new one, you must pay income tax on your gain, if any.
To the extent your gain is due to the depreciation deductions you took on the vehicle in a prior year, you pay tax at ordinary income tax rates, not usually lower capital gains rates. The good news is that you don’t have to pay self-employment tax on such gains.
Example: Assume that Brenda from the above example trades-in her old pick-up for a new one in 2018 with a $50,000 sticker price. The dealer pays her $26,000 for her old pick-up and she pays $24,000 cash. Her new pick-up has a tax basis of $50,000 which she can depreciate.
The sale of her old pick-up results in a $26,000 gain ($26,000 – $0 basis = $26,000 gain). She reports this gain on IRS Form 4797 and pays income tax on it at her ordinarily 2018 income tax rates, not capital gains rates. However, she need not pay self-employment tax on the gain.
What’s the tax basis of a business vehicle?
To know how much gain you’ll receive when you sell a business vehicle, you must keep track of its tax basis. Your tax basis is the vehicle’s original cost, plus improvements, minus all your annual depreciation deductions.
You have depreciation deductions each year even if you use the standard mileage rate for your deduction. A portion of the standard rate is for depreciation.
The portion of the business standard mileage rate treated as depreciation is 22 cents per mile for 2014, 24 cents per mile for 2015, 24 cents per mile for 2016, 25 cents per mile for 2017, and 25 cents per mile for 2018.
Thus, if you drive your car 10,000 miles for business in 2018 and use the standard mileage rate, you take a $2,500 depreciation deduction (25 cents x 10,000 = $2,500). You must subtract this amount from your car’s tax basis.