Car leasing and taxes: Things to know before you sign

Young Hispanic woman looking at a car in a dealer showroom.Image: Young Hispanic woman looking at a car in a dealer showroom.

In a Nutshell

Leasing a car can be an attractive way to get a new vehicle with all the latest technology and features. But there’s a lot to consider besides just how low your monthly payment might be. Before you take the plunge, ponder this information on car leasing and taxes.
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This article was fact-checked by our editors and Christina Taylor, MBA, senior manager of tax operations for Credit Karma. It has been updated for the 2020 tax year.

As a way to score some shiny new wheels, car leasing has a lot going for it.

Generally, monthly payments and down payments for a lease are lower than monthly payments on a loan for a vehicle. And at the end of the lease term, you don’t have the hassle of trying to sell the vehicle if you don’t want to keep it. You can return it and buy or lease something newer.

Car leasing may fit your lifestyle if you’ve got a lower monthly budget for a car payment and want more car for your money, or you like having a new vehicle every few years.

However, leasing a car doesn’t get you out of vehicle-related tax obligations. On the other hand, it also doesn’t automatically disqualify you from any car-related tax deductions you might be eligible for.

Let’s check out some tax implications of car leasing.

Leasing 101

First thing to consider: Do you fully understand the difference between car leasing and buying a car?

When you buy a car, you’re paying the full cost that you and the seller agreed upon. You’re paying to own the vehicle.

If you buy it outright with cash (way to go!) the car is yours when you pay and drive it off the lot. Finance it, and you’ll have a monthly loan payment. You’ll “own” the vehicle, but the finance company or bank that loaned you the money for the purchase will have a claim on the vehicle until you finish repaying the loan.

If you decide to lease a car, you’re not paying for the car — you’re paying for the use of the vehicle for the length of your lease term. New cars are generally depreciating assets, so the leasing company that owns the car can reasonably expect the vehicle will be worth less at the end of your lease than it was when you started. So during the lease term, you’re essentially paying the cost of that depreciation, plus charges, fees, and yes, taxes.

At the end of the lease term, you return the car — or buy it if your lease agreement allows.

Those are the basics of leasing versus buying a car, but there’s a lot more to know, including the need to negotiate the best possible terms for your lease agreement.

Car leasing and sales tax

Unless you live in one of the five states that currently don’t charge sales tax (Alaska, Delaware, Montana, New Hampshire and Oregon), you’ll have to pay state sales tax to acquire a vehicle. This is true whether you pay cash, take out a loan or lease the vehicle. Depending on where you live, your vehicle purchase or lease may also be subject to county or municipal sales taxes.

Keep in mind, sales tax is different from all the state fees you may have to pay to register, title or inspect a vehicle you lease or buy. For example, even though Delaware has no state sales tax, it currently charges a document fee of 4.25% of the purchase price of a vehicle or the NADA book value, whichever is more. And depending on where you live, your vehicle may be subject to a yearly state property tax.

If your vehicle lease is subject to state sales tax, how much you have to pay and when you must pay it will vary by state.

Some states may charge sales tax on any down payment you make for your car lease. Some might tax the full amount of the vehicle while others may only levy a sales tax on the depreciation you’re paying during the lease term.

Depending on the state, you may be able to roll the sales tax into your monthly lease payment (a common tactic). Or you may have to pay the full tax at the beginning of the lease, which could make the cost of leasing comparable to buying.

With so many variables, it’s crucial to understand how sales tax will be attached to your lease, how much you’ll have to pay, and when you’ll need to pay it. Be sure to get a full explanation from the leasing company or dealer, or check out your state’s department of motor vehicles website.

Deducting sales tax on a car lease

If you pay sales tax on your car lease, you may be able to take a deduction for it on your federal income taxes. The so-called SALT deduction has been around for a while, and it allows eligible taxpayers to deduct certain state and local taxes, such as property tax and income tax or sales tax.

In December 2017, Congress passed tax reform legislation that capped the SALT deduction at $10,000. The change took effect starting with the 2018 tax year. You can now deduct either state, local and foreign property taxes, state and local real estate taxes, and either state, local and foreign income taxes or state and local sales tax. However, you can’t have it all. You must choose either sales tax or income taxes to deduct. And you must itemize in order to take the deduction.

Which option is best for you — deducting state, local and foreign property tax, in addition to income tax or sales tax, or taking the standard deduction in lieu of any qualifying SALT deductions — will depend on multiple factors.

For example, if you own a home and live in a state with high property taxes, you may decide that itemizing makes sense for you. And while you’re deducting state and local property taxes, you may opt for deducting sales tax as well, especially if you live in a state that doesn’t have a personal income tax.

However, if your total itemized deductions don’t exceed the standard deduction ($12,200 for single filers and $24,400 for those married filing jointly), you may choose not to itemize at all — in which case you can’t deduct the sales tax you pay on your vehicle lease or purchase.

Car leasing as a business owner

Leasing a car if you’re self-employed can have a different effect on your taxes. If you use your leased vehicle for your business, you may be able to deduct some or even all the vehicle’s operating costs. This will depend on how much of the vehicle’s use is for business purposes and how you deduct business expenses.

When you use your leased car for business, you can either use the standard mileage rate deduction or deduct actual expenses. To deduct all or part of your lease payment, you must use the actual expense method. You can only deduct the part of your lease payments that are for the business use of the vehicle.

When you choose the actual expense method, you may also be able to deduct other vehicle-related costs, such as depreciation, maintenance, repairs, gas, insurance and registration fees.

But taking a business deduction for your leased vehicle isn’t quite as simple as it may sound.

If your lease term is for 30 days or more (and it probably is), and you use your vehicle for business, you may also have to reduce the deduction for your lease payment by an inclusion amount for each tax year of the lease.

If the fair market value of the vehicle when you began the lease exceeded a set amount, you’ll have to figure your inclusion amount using the fair market value (the capitalized cost when you signed the lease), and the IRS formula and tables for calculating the amount. You can learn more about this stipulation in IRS Publication 463.

Alternatively, you can simply take a business deduction using the standard mileage rate.

If you choose the standard mileage rate deduction, you can’t deduct any part of your lease payment or other actual business-related vehicle costs, like maintenance, repairs, gas, insurance or registration fees. And if you decide to use the standard mileage rate for your leased car, you’ll have to continue with that method for the duration of the lease.

Bottom line

If you’re leasing a car for personal use, the tax impact of leasing isn’t much different from that of buying a car. However, if you’re self-employed, leasing a car can offer additional tax advantages you may want to consider.

Just be aware that there are rules on how businesses can deduct vehicle-related expenses, including the cost of a car lease. If you’re not sure how to deduct business-related vehicle expenses, it might be a good idea to seek advice from a tax professional.

Relevant sources: CFPB: Financing or Leasing a Car | Alaska Dept. of Revenue: Sales and Use Tax | Delaware Dept. of Revenue: Learn About Gross Receipts Taxes | Montana Dept. of Revenue: Businesses Purchasing Goods for Resale | New Hampshire Dept. of Revenue Administration: Frequently Asked Questions | Oregon Dept. of Revenue: About sales tax in Oregon | IRS: Press Release | U.S. House of Representatives: Tax Cuts and Jobs Act

Christina Taylor is senior manager of tax operations for Credit Karma. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.

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