Prior to January 1, 2006, people purchasing hybrid vehicles were eligible to claim a significant tax deduction. Now they can claim a monstrously large tax credit.

IRS Issues Tax Credit Amount For Toyota Camry Hybrid

The government attempts to modify the behavior of taxpayers by applying or reducing taxes on certain activities. Alcohol and cigarettes are viewed as health risks, so the government adds excessive taxes to them to try to discourage their use. On the energy front, the government is in favor of people buying hybrid vehicles as part of the effort to reduce our nation's oil dependence. To facilitate this policy, the government is giving people who buy hybrids a huge tax windfall.

To understand the windfall, you need to understand the difference between a tax deduction and tax credit. A deduction is something you reduce from your gross income. A $1,000 deduction may save you $200 to $400 depending on your tax bill. A tax deduction is a positive thing, but pails in comparison to a tax credit.

A tax credit is not deducted from your gross income. It is deducted directly from the amount of tax you owe. Using the previous example, you would figure out how much tax you owe for the year and then deduct $1,000 from it. Put another way, the tax credit represents a dollar for dollar savings on the actual amount of taxes you owe, a huge savings.

To promote hybrid cars, the federal government lets purchasers claim a tax credit amount set by the IRS. The credit can be as high as $3,400, but is often a bit less. The IRS has just released technical guidance indicating it will allow taxpayers to claim a tax credit of $2,600 if they purchase a 2007 Toyota Camry Hybrid after January 1, 2006.

For example, if you go out and purchase the car tomorrow, you are going to be very happy when you prepare your taxes for 2006. Let's assume you do your taxes next March for 2006 and find out you owe $10,000 to the IRS. You would apply the $2,600 tax credit to that amount, reducing your tax bill to $7,400. Not bad, eh?

Richard A. Chapo is with BusinessTaxRecovery.com - providing information on taxes.