Gasoline prices keep climbing, prompting many motorists to consider trading in their gas guzzlers for models that are much friendlier to the environment and their bank accounts. Unfortunately, tough, the tax value of the most popular hybrid vehicles keeps decreasing.

Provisions in the law that three years ago created a tax credit for purchasers of fuel-efficient vehicles mean that manufacturers — and their customers — must pay a tax price for being the favorites.

In 2007, Toyota became the first to face the tax credit phaseouts, which are mandated when an automaker sells a certain number of its gas-saving vehicles.

Last Jan. 1, Honda hybrids also became less tax-advantageous. The credit for that manufacturer’s energy-saving autos was cut in half. And the tax write-offs for the various Honda hybrids drop again, this time to a quarter of their original amounts, on July 1.

Counterintuitive calculations

Essentially, the most popular hybrids, which usually are the most fuel-efficient, will lose their associated tax break more quickly than poorer selling makes and models. The Energy Policy Act of 2005, which established a new tax credit system to reward purchasers of IRS-approved hybrids, mandated the tax benefit’s reduction once a carmaker sells its 60,000th hybrid.

It seems counterintuitive, but Congress included the legislative limit to help out American automakers, who are substantially behind their Japanese counterparts when it comes to hybrid technology. The hope was that once the credit is gone, energy- and tax-conscious drivers would opt for other models that are less-efficient, but still afford some tax savings.

Toyota hit the 60,000 sales mark in June 2006 and the phaseout schedule meant the end of the credit for any of its hybrid vehicles, including those bearing its luxury Lexus nameplate, on Oct. 1 2007. Before it was eliminated, buyers could claim a reduced credit on their tax returns depending on when they bought the vehicle.

Honda purchasers started dealing with similar reduced-credit calculations at the beginning of 2008. When the year began, all Honda hybrid credits were cut in half for purchases made in the subsequent six moths. The credit amounts will be reduced again to 25 percent of each Honda hybrid’s original amount for another six months until.

And on Jan 1, 2009, buyers of a Honda hybrid won’t able to claim any tax credit for their new car.

The dates and credit amounts are confusing, especially since they are applied to each automaker separately. And that’s just one of several components of the rather convoluted law.

But if you bought one of the autos, you need to make note of them because they determine your tax break when you file your 2007 return, which for taxpayers who got an enxtension could be as late Oct. 15. Individuals who amend a previous filing to claim the credit also need to know their precise hybrid purchase date to make those changes.

Below are the basics hybrid car shoppers should know.

Tax credit for autos:
  • First, there is no set tax credit amount. Precisely how much you can subtract from your final IRS bill depends on which eligible vehicle you buy. So careful car shoppers now must take into account not only miles per gallon and price, but also each auto’s varying tax break.
  • Second, the list of IRS-certified vehicles is not fixed. As automakers produce qualified hybrids, they will be added to the roll, meaning consumers could be comparison shopping without all the possible data. Five additional Toyota/Lexus models, for example, were approved just days before that automaker’s credit was reduced Oct. 1, 2006.
  • Finally, the hybrid credit amount will be incrementally reduced and ultimately eliminated. That’s not unusual when it comes to tax laws, but in this case the reduction schedule is particularly vexing because the law didn’t set one specific date on which the credit cuts will begin. Instead, the phaseout dates will be determined on a manufacturer-by-manufacturer basis, tied to each automaker’s individual hybrid sales.

That forces the car companies and their customers into a bit of a guessing game. They have to keep their eyes on sales reports and calendars, as well as on the IRS’s “OK” list, to make sure they get the biggest possible tax break or don’t lose the tax savings entirely.

60,000 and counting down

The credit countdown starts when a manufacturer sells 60,000 of the fuel-efficient vehicles. The tax break then is reduced over five subsequent calendar quarters after that 60,001st hybrid hits the road.

So although the credit technically is available through 2010, Toyota can no longer tout the tax benefit when marketing its vehicles. Honda dealers will find out how that feels in January.

Meanwhile, other automakers whose hybrids aren’t as hot could conceivably use the tax credit as a sales promotion all the way up to Jan. 1, 2011.

In essence, the most popular hybrid models, which also provide the most tax savings, have the shortest credit life.

Paying for popularity

The credit-cut clock started ticking in June 2006 for Toyota, the acknowledged leader, primarily due to the popularity of its Prius model.

In June 2006, Toyota sold its 60,000th hybrid. That included not only the Prius, coveted by celebrities and not-so-famous drivers alike, but also versions of the automaker’s Camry, Highlander and luxury Lexus models.

In total, 13 Toyota/Lexus hybrids were credit-certified. And under the credit guidelines, the tax break phased out for all of those vehicles, not just the popular Prius.

In effect, earlier buyers of hybrids tend to receive the greater tax rewards. That’s particularly true once a manufacturer hits the 60,000 sales mark. The longer you wait, the more your credit is reduced, until it disappears entirely.

This table shows what various buyers of a Prius, which had an original credit of $3,150, faced as they bought their particular autos at different times.

Tax credit events and deadlines for Toyota Prius buyers
Date Event Available credit
Jan. 1, 2006 Tax credit becomes available for Prius hybrids purchased on and after this date — through Dec. 31, 2010. $3,150
June 2006 Toyota sells a total of 60,000 hybrids — all models. $3,150
July 1, 2006 through Sept. 30, 2006 (first quarter after sales target reached) Prius purchased during this period are still eligible for full credit. $3,150
Oct. 1, 2006 through March 31, 2007 (second and third quarters after sales target reached) Prius purchased during this period are eligible for 50 percent of original credit. $1,575
April 1, 2007 through Sept. 30, 2007 (fourth and fifth quarters after sales target reached) Prius purchased during this period are eligible for 25 percent of original credit. $787.50
Oct. 1, 2007 and beyond No tax credit allowed for Prius purchases. $0

And while the table uses the Prius’ dollar amounts, the percentage limits apply to all Toyota or Lexus hybrids bought during the five post-60,000-sales quarters. (In other words, dollar amounts vary with the model.)

Now Honda buyers will have to do similar phaseout math on their 2008 returns for any purchase made this year. The original, full-credit amounts for the 15 eligible Honda vehicles still apply for 2007 purchases and tax filings, but the tax breaks for each of the carmaker’s hybrids were cut in half for the first six months of this year. The next phaseout level (25 percent of the original credit) will kicked in July 1 and run through Dec. 31.

When 2008 ends, so do the credits for all Honda hybrids.

Some things are constant

Although the various credit amounts are different for each make and model and change depending on overall manufacturer sales, there are a couple of constants when it comes to the alternative fuel/hybrid vehicle credit.

First, to get the credit you have to do more than sign a purchase contract. The IRS requires that the vehicle “be placed in service.” That means the date you drive it off the dealer lot determines your credit amount.

Secondly, the only taxpayer who can claim the credit is the vehicle’s original owner. And the qualifying auto must be new; the credit does not apply to a used hybrid.

Finally, while the credit can help you reduce your tax bill, it has its limits. It is a nonrefundable credit and its name means just that. It can help you zero out your tax bill, but it won’t get you a check from Uncle Sam.

Honda is the leader in another fuel-efficient auto area, the compressed natural gas, or CNG, vehicle. The energy legislation that created the hybrid credit also included tax breaks for three other fuel-efficient vehicles: advanced lean burn, fuel cell and alternative fuel.

Alternative-fuel vehicles run on compressed or liquefied natural gas, liquefied petroleum gas, hydrogen or any liquid that is at least 85 percent methanol. Honda’s Civic GX operates on compressed natural gas and its 2005 through 2008 model years have been certified as tax-break eligible by the IRS.

CNG vehicles have two advantages over hybrids when it comes to taxes. The credit is usually larger and it does not phase out.

Home highway advantage

Domestic manufacturers have remained a lap down to Toyota and Honda in the hybrid race. That’s why the provision penalizing the Japanese hybrid leaders was added to the energy bill.

But it hasn’t helped as much as lawmakers or Detroit executives might have liked. Judging from the numbers so far, not to mention the Big Three U.S. automakers’ financial woes, industry analysts say that it will be years before buyers of American brands face any tax credit reductions.

Energy conservation advocates generally appreciate the tax effort to encourage drivers to switch to fuel-saving hybrids. Many, however, say that politics trumped a more aggressive — and to their way of thinking — a more sound, approach to reducing U.S. driver dependence on gasoline.

“It’s obvious that our government has a problem with creating an energy policy with any kind of vision,” says Bradley Berman, editor of HybridCars.com. “The creation of the 60,000 cap was by and large designed to cut some slack to Detroit automakers, who are way behind.”

Berman says the credit isn’t likely to convert someone who was not even considering a hybrid. At best, it will simply make a potential hybrid buyer look a little more closely at all the alternative fuel makes and models.

Overall automotive costs are a bigger drive when it comes to picking a particular car, says Berman.

“Gas prices have a greater impact than the tax credit. People tend not to think of a large purchase in the big picture over the course of several years,” he says.

“There are too many factors — maintenance, resale value, interest rate on your loan — that have a pretty significant impact over the long-term analysis of whether an auto purchase is a sound financial decision.”

Cindy Knight, environmental communications administrator for Toyota in Los Angeles County, agrees, saying it was difficult for Toyota to determine whether the company’s hybrid-leading sales were helped more by the tax break or high gasoline prices.

“We think that the tax credit is really nice,” says Knight. “But we’re not sure that it really influences a buyer. There’s a combination of factors that makes a hybrid a popular choice right now.”

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