Buying Tips

Save Money With Hybrid Tax Credits, Car Donations and Car Leasing

Your car can save you money at tax time — if you consider hybrid tax credits, car donation or leasing a car. But saving money on taxes doesn't always mean saving money.

Sometimes it makes sense to make a charitable car donation or to make an environmental statement with your auto. Leasing a car, if you're self-employed, or are not fully reimbursed for its business use by your employer, may be another story.

Hybrid tax credit
The government will reward you for buying certain hybrid-electric and alternative-fuel vehicles. And there are some pretty impressive hybrid tax credits to be had, depending on which environmentally friendly model you buy.

Tax credits are much better than tax deductions because the full amount comes right off the top of any tax you owe — and, unlike deductions, you don't have to itemize. Tax deductions reduce your tax burden in accordance with your tax bracket. That means if you get a tax deduction for a $300 purchase and are in the 31 percent tax bracket, you're really only getting a cash tax savings of about $100. But if it was a credit (and you owed at least $300 in tax) you'd get the full $300 cash tax savings.

For 2006, there's one (non-hybrid) alternative-fuel vehicle — the Honda Civic GX, which runs on compressed natural gas — that gets a credit. The GX credit is also the largest credit available: $4,000. Diesel vehicles, such as several offerings from Volkswagen, may become eligible for credits as ultra low-sulfur diesel (introduced in the U.S. in October 2006) becomes more widely available, says the American Council for an Energy-Efficient Economy. There's only one diesel vehicle with a credit, too, the 2007 Mercedes-Benz E320 Bluetec. It will earn a $1,500 credit when it is available but at the moment it is not emissions-certified for California, Maine, Massachusetts, New York and Vermont.

Toyota's credits aren't as impressive as they would have been if you acted a few months ago. That's because credits are only available on the first 60,000 eligible vehicles an automaker sells. Toyota's Prius has sold so well that credits are being phased out for all Toyota/Lexus vehicles. For the Prius, the once-$3,150 credit went to $1,575 on September 30 and will be cut in half again on April 1. Credits on other Toyota/Lexus vehicles will be similarly cut and eliminated altogether by September 30. Ford and Honda are expected to start cutting their tax credits in late 2007.

"There are not a lot of credits available to the average taxpayer so this is a unique opportunity," says Barbara Lipson, a certified public accountant and tax specialist for Frank & Co. in McLean, Virginia. "If someone is thinking about buying a hybrid, they should do it sooner rather than later."

But there are some caveats. First, you'll pay a premium on any hybrid or alternative-fuel vehicle compared to the same gas-only vehicle (the Toyota Camry Hybrid vs. regular Camry, for example). Depending on the model, it could be several years before the money you save in gas and on taxes offsets that additional cost. (See "Do Hybrids Make Financial Sense Yet?".) Fortunately, hybrid premiums have come down in recent months, and several of the hottest sellers are now priced below their MSRP for the first time, making them a better financial deal than ever before.

Next, you need to determine if you can take advantage of the full amount of the credit, depending on whether you're affected by the Alternative Minimum Tax (AMT). Speaking with an accountant is the best way to determine eligibility.

Finally, credits help you if you owe taxes for the year in which you bought the car — not the year before or any years after, according to CPA Rhonda Monro of Romeo, Michigan.

The IRS details the tax credits on qualified hybrid vehicles. There may be state tax incentives, too: Check the U.S. Energy Department's chart of state and federal tax incentives and laws.

You used to be able to take a deduction based on the book value of a car donation, even if there was little chance you'd ever find a fool who would have paid that much. Now, if your car is worth more than $500, you only get the amount the charity is able to sell your vehicle for. And you must have this sale price in writing. Best-case scenario: If the charity chooses to keep the car, say, for use in homeless pet pickups, then you can deduct the full book value as long as it's under $5,000. If it's over $5,000 and you want to take a deduction for that higher amount, you need an official appraisal. (Alternatively, you could limit the amount of the deduction you take to $5,000 on a higher-value donation without obtaining an appraisal.)

"Financially it does make more sense to sell it, but this [deduction] is designed to encourage [charitable] behavior," says Lipson.

Adam Goldfein, radio talk show host of AutoScoop and a former car dealer, says unless a nonprofit group needs your car to do its charitable work, you should sell your car and give the group a cash donation instead. It will save the organization time and save both of you money. For more details on how to decide between selling or donating your car, see "Does Car Charity Donation Still Make Sense Under Tougher IRS Rules?"

Lease a car for business
The folks who write the tax code, no strangers to fancy cars, have made sure self-employed people (or those who use a car in business, but are not fully reimbursed for its use by their employer) can have nice wheels without spending too much. Anyone who uses their vehicle for business and is leaning toward an upscale model should at least consider leasing a car.

That's because if you lease a car, you can write off a percentage of the monthly payment that corresponds with the percentage of time the car is used for work. If you buy, you can write off depreciation (also based on the percentage of time you use the car for business) based on a very prescribed, illogical schedule that limits depreciation expense in a fashion that has the effect of treating luxury cars as economy cars.

Let's say you leased a $30,000 car with a $300 monthly lease payment and you used the car 75 percent of the time for business. You would be able to write off $2,700 the first year of the lease. If you bought the car outright and used it 75 percent of the time, you'd only be able to write off $2,220 in depreciation during the first year. But depreciation for the buying scenario starts to look better the second year. In Year Two, your maximum depreciation would be $3,600 — more than your deductible lease payment would be.

If we used an example of a two-year lease for a $64,000 luxury car, the case for leasing becomes much stronger (again, subject to possible limitations based on whether or not you, like an increasing number of taxpayers, get hooked by the alternative minimum tax calculation). The depreciation you may take each year remains the same as for the $30,000 car ($2,220 Year One, $3,600 Year Two), but if you lease this luxury car, 75 percent of your monthly lease payments of $1,075 would be deductible, or $9,675 per year — more than four times the amount of Year One depreciation and nearly three times the amount of Year Two depreciation you would have been eligible to deduct if you had bought the car instead of leased.

Lipson cautions that leasing is "not always going to give a bigger deduction. It's something you need to look at carefully."

Also offsetting the tax advantages: Lipson notes there's a sum of money known as the "lease inclusion amount." It reduces the amount of deductible lease expense for vehicles by larger amounts as the leased-vehicle price goes above $15,200 for cars, $16,700 for trucks and SUVs and $45,000 for electric hybrids. It gradually increases each year you lease the car. For example, if you leased the above $30,000 car that you were using 75 percent of the time for business, the lease inclusion amount would be $72 the first year, $157 the second year and $233 the third year. In our $64,000 luxury car example, the reduction in deductible lease expense for the lease inclusion amount is inconsequential — a $236 reduction of the first year's eligible lease payments of $9,675 or a net deduction of $9,412 and a $517 reduction of the second year's lease payments.

Because leases vary widely, Lipson says, you need to consider what costs are included in the lease, the terms, termination fees and the deductions you are going to get for the whole period you have the car, not just the first year.

And, of course, our experts recommend talking to your tax advisor before making any decisions on leasing a car for business.

Jayne O'Donnell is an auto writer for USA TODAY.