There has been a ton of confusion about whether money received through the Cash for Clunkers program is taxable.  What follows is my opinion of both the cause of the confusion and the reality of the situation.  Much of the confusion is based on a news article quoting Minnehaha County (South Dakota) Treasurer Pam Nelson.  In the article Some Surprised by ‘Clunker’ Tax, she is quoted as saying (regarding CARS participants)   “They didn’t realize that would be taxable. A lot of people don’t realize that. So they’re not happy and kind of surprised when they find that out”

When people started hearing that the Cash for Clunkers credit was taxable, they may have falsely concluded that it was subject to federal income tax.  This does not seem to be the case.  The official CARS website specifically states that the credit is not taxed as income to the consumers that participate in the program.  So you will not have to pay federal income tax on the credit as you might for a forgiven or canceled debt.

That is not to say that the Cash for Clunkers’ credit is free from tax.  In many states (South Dakota is presumably one of those), sales tax is paid on the purchase price of a new vehicle, minus the trade-in value.  Since the Cash for Clunkers program was a credit, not a trade-in, the deduction won’t apply.  So if you bought a $25,000 car and got $4,500 for a trade-in (not a clunker), you would pay sales tax on a purchase of $25,000-$4,500, or $20,500.  If instead, you bought a $25,000 car and got $4,500 through the Cash for Clunkers program, you would pay sales tax on the full $25,000. In that sense, the $4,500 cash for clunkers credit is taxed.

State and local sales taxes vary, and should be much less than federal income tax rates in most cases.  You should also note that you probably aren’t technically being taxed on the full amount of the credit.  The value you would have received, had you traded in your car without the credit, also needs to be considered.  It’s that value that you are basically being taxed on.  If your trade-in was worth $500, you would have paid sales tax on the purchase price minus $500.  As long you got more from the credit than you pay due to the extra sales tax, you still got a better deal.

Here’s the necessary calculation:

Multiply your sales tax rate times what your trade-in was actually worth and compare that to the difference between the credit you received and the actual worth of the trade in.  If the former is greater, taking the Cash for Clunkers credit cost you more.  If the latter is greater, Cash for Clunkers saved you money.

For example, if your state and local taxes are 7% and your clunker was worth $1000, you’ll pay $70 more ($1000 * 7%) in taxes, but would have spent $3,500 less ($4,500 credit - $1,000 car value), for a net savings of  $3,430.  If instead, your clunker was worth $4,250, you’ll pay $297.50 more in taxes and spend $250 less, for a net loss of $47.50.  So this tax on clunker credits generally only hurts people whose clunkers were worth close to the maximum value of the credit.  If the clunker incentive caused you to pay a higher price (there are some reports of people paying full sticker price!), then you might be worse off.

Of course, even if you saved money on the transaction itself, you may have hurt your finances in other ways, as outlined in my original post on the subject: Cash for Clunkers, A Clunker of a Law.