Hybrid Car Tax Credit: Tax Question of the Day

Throughout the tax season I will be answering one tax question per day.

Today's question comes from an anonymous reader in California who picked up the phone and called me. I figure if a question is that important, I had better share it with the rest of you. The reader asked, "I just bought a hybrid car. How will I know how much of a tax credit I will be getting? And more importantly, how will the IRS know that I bought one of the first 60,000 models?"

First, let's start with the basics. People who buy a hybrid car or truck in 2006 may be eligible for a federal tax credit, ranging from $400 to $3,400. The car must be purchased on or after January 1, 2006, and the dollar amount of the credit is determined by several factors, including fuel efficiency. I have collected all known information in my article: Hybrid Car Tax Credit.

What We Know

The IRS will certify certain makes and models as "qualified vehicles." The certification process will rely on data submitted by car manufacturers. Also, car manufacturers will be able to issue written documents to car buyers. The documents will let car buyers know what the maximum dollar value of their tax credit will be. The procedure for issuing this documentation was recently released by the IRS, so very likely car manufacturers are still digesting the information and making plans for sending notices to car buyers.

We also know that the tax credits start to phase out after 60,000 hybrid vehicles are sold. The phase out rules are applied at the manufacturer level, and are measured in quarters. After the first two quarters of 2006 (that is, the first six months), car manufacturers will see how many hybrid cars and trucks they sold, and send a report to the IRS. Everyone who buys a hybrid car or truck in the first six months of 2006 will receive the maximum tax credit, even if car manufacturers sell more than 60,000 hybrid vehicles. Also, the 60,000 sales number is determined at the manufacturer level. So popular hybrid makers will have their tax credits phased out more quickly than less popular makes.

What We Don't Know (Yet)

We don't yet know which hybrid models will end up being certified and at what dollar amount. However, there are estimates of the tax credits, as provided by the American Council for an Energy-Efficient Economy. It is possible that the dollar amounts will be different, but I do expect that all the models listed will eventually be certified as qualifying vehicles.

We also don't know what tax forms will be needed to claim the credits. Remember, the credit will apply against your 2006 taxes (to be filed in early 2007), so there's still plenty of time for the IRS to draft the appropriate tax forms and instructions. Very likely, the tax form will be similar to other forms where people can claim tax credits. In other words, I don't expect that you will need to attach a copy of any documentation you obtained from your dealer or manufacturer. However, you should keep ALL documents relating to your hybrid for at least four years after you sell your car. In particular, please keep your sales contract, vehicle registration, and tax credit certificate. You may need any or all of these documents in the event of an IRS audit.

We also don't know how long you will need to keep your hybrid, whether you will be able to sublease your hybrid, or give the car to another family member. I bring this up because the tax law states that taxpayers will need to recapture the tax credit if the hybrid is sold to another party. The IRS will clarify how long people need to own the car in order to avoid the recapture rules.

Bottom Line

You will know how much of a tax credit you are eligible for because the car manufacturer should issue you a written document. You should also estimate your 2006 taxes just after finishing your 2005, either by using the tax planning features of your tax software, or asking your tax professional to print out a projected 2006 tax scenario. You will need this estimate in order to find out if you can utilize the entire dollar amount of your tax credit.

More Information

The following resources are recommended for learning more about the hybrid tax credit:

• Hybrid Car Tax Credit Essentials - including the format of the manufacturer tax documentation
• Hybrid Car Tax Credit Limits - and a suggested tax strategy
• IRS Guidance for Car Manufacturers

Throughout the tax season I will be answering one tax question per day. Do you have a question? Visit the Ask a Tax Question page. Disagree with my answers? Post your comments in the Tax Forum.