Credits vs Deductions

As always in discussing tax matters, many people, including those in the media, don't understand the difference between a tax credit and a tax deduction. Even Rush Limbaugh, who is normally very accurate, frequently uses the terms interchangeably.

A tax credit is a dollar for dollar reduction in taxes. However, there are two types of credits. The most common type is the nonrefundable credit. This allows your income tax, but not your Self Employment tax, to be reduced to zero. Any credit above the amount needed to reduce the income tax to zero is essentially forfeited.

The other kind of credit is the refundable type. The most common example of this is the Earned Income Credit. With this, any excess credit after reducing your income and Self Employment taxes to zero can be refunded to you in cash.

Deductions, on the other hand, are used in calculating your taxable income. Your taxable income will determine the rates and amount of income tax you are assessed for the year. The amount of tax you save from a deduction is based on your marginal tax brackets. The higher tax bracket you are in, the more tax you will save. Conversely, if you are in a low tax bracket, your tax savings will be minimal. I tire of hearing people assume that a tax deduction will equate to a dollar for dollar reimbursement. That could only happen if they were in the 100% tax bracket, which thankfully doesn't currently exist in the USA. Of course, if certain people had their way, we would have tax rates that high.

Hybrid Vehicle Deduction
I mention this distinction yet again because of the recent IRS announcements regarding the special $2,000 deduction that is available to buyers of vehicles that use gas & electric hybrid forms of power. Too many people are treating this as if it's the same as a $2,000 rebate from the dealer. I'm sure people will, in their mental calculators, reduce their effective purchase price by a full $2,000, just as we are encouraged to do with mail-in rebates. Of course, I'm sure car salespersons will be misrepresenting this as equivalent to a $2,000 rebate in their sales spiel.

So, let's see how much a $2,000 tax deduction will actually yield a person in tax savings. As you can see in the tax rate schedules, the most common rates are 15% and 27%. Someone in the 15% bracket would have his/her taxes reduced by $300. A person in the 27% bracket would save $540 by claiming this special deduction. My understanding is that the three hybrid fuel vehicles that IRS recently certified for the special deduction sell for between $20,000 and $25,000; so the effective reduction in purchase price isn't really that much.

One of the reasons for the confusion around this special deduction is that there is also a special 10% nonrefundable tax credit available for the purchasers of qualified fully electric powered vehicles, with a maximum credit of $4,000. This is claimed with Form 8834.

IRS Announcement
Purchasers of the following new vehicles can claim the special $2,000 deduction. This one-time deduction must be claimed for the year in which the vehicle was first used.
Honda Insight for model years 2000, 2001 and 2002.
Honda Civic Hybrid for the 2003 model year.
Toyota Prius for model years 2001, 2002 and 2003.

Taxpayers can claim this deduction whether or not they itemize their deductions with Schedule A. For previously filed tax returns, taxpayers can file amended returns to claim this credit. There is no special IRS form for this deduction yet. You just write the $2,000 in the Adjusted Gross Income section on Page 1 of your 1040 (Line 32 on the 2001 1040) and attach a copy of your purchase receipt.

KMK
- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 9/13/2002 10:38:00 AM Send this post: