How the Hybrid Tax Credit Works

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First of all, we should note the difference between a credit and a deduction, because one will leave you paying a little more. It turns out a credit is slightly more helpful than a deduction. A tax credit reduces the amount of money you owe the IRS right away. For example, if you earn $40,000 per year and are taxed at 10 percent, you'll owe the IRS $4,000. A tax credit of $500 will reduce the amount you owe to $3,500. A tax deduction is subtracted from your income before taxes, however. So a deduction of $500 reduces your taxable earnings to $39,500, and 10 percent of $39,500 will leave you owing $3,950.

So, right off the bat, changing the policy to a tax credit looks better for owners of these fuel-efficient vehicles. And it's possible to get a federal income tax credit of up to $3,400, a significant amount of money for most taxpayers. But there are some important rules to be aware of when purchasing a new hybrid with the tax credit in mind.

First of all, you can only use the credit for new hybrid cars placed in service on or after January 1, 2006. If the vehicle was bought prior to January 1, 2006, sorry -- you're out of luck. The owner also needs to buy the hybrid before December 31, 2010, which is when the Energy Policy Act of 2005 will end. This is because lawmakers in Congress have set aside a certain period of time for the tax credits to work their magic; when the time comes, they'll look at the effect the tax incentives had during that time period and revise their policies accordingly.

Another qualification for the hybrid tax credit involves the car owners and where they primarily use the car. Qualified hybrid car owners have to do most of their eco-friendly driving in the United States. Also, the credit is only available to the original owner -- it won't work if the car is resold. It's also important to note that leasing a hybrid won't necessarily get you a credit, since the leasing company actually has the right to claim the credit.

The IRS keeps a list of the qualified cars and related credit amounts on its Web site, so if you're wondering if a certain hybrid you bought within the correct time period qualifies for a tax credit, you can go to the IRS Web site to find out. The organization also adjusts the credit amount according to a schedule. What schedule, you ask? Read the next page to find out.

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The amount of credit you'll get for the purchase of your new, eco-friendly driving machine

changes depending on how many cars a manufacturer sells. So, the longer you wait the less credit

you'll receive. How does the IRS

schedule this out?

One important point to understand

is that new hybrid owners will get the full credit amount available before the vehicle manufacture

sells its 60,000th qualified hybrid car. After the company sells 60,000 vehicles, however, the credit

amount starts to diminish

according to a quarterly schedule. Here's where the quarters fall on the calendar:

Taxpayers can claim the full tax credit up to the end of the first calendar quarter after the quarter within which the manufacturer sells its 60,000th qualified hybrid. This sounds a little tricky (and it is), so here's an example. Let's say a car manufacturer sells its 60,000th hybrid vehicle on March 23 of any year. This falls in that year's first quarter. Shortly afterward, you decide to buy a model of this particular hybrid -- let's say two weeks later, on April 6. Your purchase date falls within that year's second quarter. Even though this is the second quarter of the year, you still qualify for the full tax credit since it's the quarter after the quarter in which hybrid number 60,000 was sold off the lot.

Once you hit the third quarter, however, the credit starts to phase out. If you had waited until the third or fourth quarter to buy the vehicle, between July 1 and December 31, you would only be eligible for 50 percent of the full credit amount. If the tax credit began at $3,000, for instance, you'd get only $1,500. Beginning at the fourth calendar quarter after the 60,000-vehicle mark, the credit decreases again to just 25 percent of the full amount. The credit ends completely starting with the sixth calendar quarter. So, with this schedule, you essentially get a year and a half to claim some kind of tax credit.

To claim this credit, you have to fill out Form 8910 and attach it to your tax return, which you can view and print in PDF format at the IRS Web site. Aside from federal tax incentives, it's also worth noting that state and local governments may offer tax credits or deductions for hybrid vehicles, so don't forget to check other appropriate Web sites for additional details.

For more information about the hybrid tax credit and fuel-efficient vehicles, follow the links on the next page.