July 19, 2009 - I heard recently about a new program that gives an incentive for trading in older, less fuel-efficient vehicles. Can you explain how that program works?

On June 24, the President signed the Supplemental Appropriations Act of 2009. Title XIII of the Act (the "Consumer Assistance to Recycle and Save Act," colloquially known as the "cash for clunkers"), gives a cash incentive for individuals and businesses to trade in older gas-hogging vehicles for new, more fuel-efficient ones. The new vehicle would have to be purchased between July 1 and November 1 of 2009.

For passenger autos, the voucher amount is $3,500 if the new fuel efficient automobile is a passenger automobile and its combined fuel economy (CFE) is at least 4 mpg higher than the CFE of the eligible trade-in vehicle. The voucher is $4,500 if the new fuel efficient vehicle's CFE is at least 10 mpg higher than the CFE of the eligible trade-in vehicle. The determination of the voucher amounts for trucks is a bit more complex and should be reviewed for each circumstance.

Trade-in vehicles eligible for the voucher program are those that at trade-in time: are in drivable condition; have been continuously insured and registered to the same owner for at least one year; were manufactured less than 25 years before the trade-in date; and in the case of an auto, achieve a CFE of 18 mpg or less. A single person may get only one trade-in voucher and only one voucher is available for joint registered owners of a single eligible trade-in vehicle.

The voucher, which will be sent by the Treasury to the dealer, will offset the new vehicle's purchase price or lease price for a qualifying lease. A qualifying lease is a lease of an auto for at least five years. The selling dealer must use the voucher in addition to any other rebate or discount that it advertises or the manufacturer offers, and the voucher can't be used to offset a rebate or discount. There are other restrictions on the dealer, such as having to scrap the traded-in vehicle, except for certain salvaged parts.

The vouchers are not treated as gross income of the vehicle purchaser for Federal tax purposes. If the voucher payment were allowed in addition to a trade-in allowance, the tax-free feature could easily be measured. For example, a $3,500 tax-free payment would be worth $875 more than a $3,500 taxable payment to a taxpayer in the 25% marginal tax bracket. But because the voucher precludes a trade-in allowance and is really only valuable to the extent it exceeds such an allowance, the value of the tax-free feature is hard to measure given that a non-business car owner who trades in a vehicle generally has no gain or loss on the trade in. Thus, if a trade-in on a car originally purchased for $20,000 would yield $500 and the voucher amount is $3,500, in most cases, the extra $3,000 will be worth $3,000 after taxes both to an individual whose income is too low to pay taxes and to a high-earner who pays substantial taxes.

Since the voucher is not treated as gross income, a business that utilizes the program is treated as if it traded in the old vehicle and received zero for it. Its basis in the new vehicle would be the amount it pays net of the voucher and any other rebates. If the purchaser is a business that has depreciated the old vehicle down to zero (or it has a very low basis), trading it in via a regular transaction generally would not result in recapture. The basis of the new vehicle would equal the amount paid for it.

For a business, trading in a qualifying vehicle with a low or zero basis definitely beats selling it for an amount equal to or less than the voucher's value. In fact, it may even pay to forego a higher sale price and instead trade in the old vehicle and get a tax-free voucher. For example, if a business paying tax at an effective tax rate of 30% sells a zero-basis truck for $6,000, it would have $4,200 left after paying a $1,800 tax. If the business trades in the old truck and qualifies for a tax-free $4,500 voucher under the new program, it would be $300 ahead.

Return to Tax Talk.