Save Fuel, Taxes and the Environment with a Hybrid

If rising gas prices have you thinking about buying a more fuel-efficient car, you'll want to learn more about the tax credit available to Americans who buy qualifying hybrid vehicles. Hybrids combine an electric motor with a gasoline-powered engine, producing fewer emissions.

Beginning this year, consumers who buy environmentally friendly hybrid cars and SUVs may be eligible for an income tax credit of up to $3,400. The exact amount depends on the make and model of the hybrid and the number of vehicles manufactured. The vehicle does not have to be used in a trade or business to qualify for the credit.

New and Improved Savings
The new tax credit is better than the previous tax deduction of $2,000. That's because a tax credit directly cuts your tax bill, reducing the tax you owe, dollar for dollar. A tax deduction, by contrast, reduces your taxable income.

The credit was created in the Energy Policy Act of 2005. It may only be claimed by the original owner of a new, qualifying hybrid vehicle and does not apply if you purchase a used hybrid. Additionally, the tax credit is denied if you purchase the car with the intention of turning around and reselling it.

Save Thousands
The formula used to compute the tax credit involves calculating the hybrid's fuel economy and total expected lifetime fuel savings. The better a hybrid does in these two computations, the larger the tax credit.

The IRS has released an official list of vehicles eligible for the credit and the 2006 tax credit amount buyers can claim on returns filed in 2007. Here are some examples:

• 2006 Ford Escape Hybrid Front WD, $2,600
• 2006 Ford Escape Hybrid 4WD, $1,950
• 2006 Mercury Mariner Hybrid 4WD, $1,950
• 2006 Lexus RX400h 2WD and 4WD, $2,200
• 2006 Toyota Prius, $3,150

Understand the Fine Print
The new tax break is a nonrefundable credit. This means the credit can reduce your regular income tax liability to zero, but it won't produce a tax refund. So if you purchase a hybrid that comes with a tax credit of $2,200, and your tax bill is $2,000, you'll lose $200 of the tax value of the credit. The excess credit cannot be carried over to another year.

If you are eligible for multiple tax credits, there are special ordering rules that determine which credit to take first. The hybrid tax credit is taken last, after all other tax credits have been taken. You should also be aware that the hybrid tax credit does not reduce your alternative minimum tax.

Act Now
The credit is available for 60,000 vehicles from each automaker. Consumers seeking the hybrid tax credit may want to buy as soon as possible since once an automaker has sold 60,000 hybrids, the tax credit for that automaker's hybrid is slowly reduced over the next five consecutive quarters. No credit is allowed after the fifth quarter.

Here's how it works: Beginning January 1, 2006, the full amount of the allowable credit is available through the quarter that the automaker sells 60,000 hybrid vehicles. For the next two subsequent quarters, taxpayers may claim 50 percent of the credit. For the fourth and fifth calendar quarters, the taxpayer is eligible to claim 25 percent of the credit. The 60,000th vehicle limitation applies to the total of all the qualified hybrid models sold by the manufacturer, not to each qualified hybrid model. The credits end completely in 2010.

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