In order to generate more demand for new automobiles, Congress passed legislation creating the Car Allowance Rebate System, better known as the Cash for Clunkers program. Congress initially funded the program with $1 billion and, due to better than expected demand, followed that investment with another $2 billion.

The program allows prospective car buyers a $3,500 or $4,500 credit towards the purchase of a new vehicle from a qualified dealer provided that certain efficiency standards are met. The credit, which is not considered taxable income to the car buyer, is provided at the point of purchase.  Each owner is only allowed one credit.

The credit is not only exempt from the car buyer’s taxable income but also reduces the sales tax.  The Alabama Department of Revenue has ruled the credit to be a reimbursement for a trade-in that is therefore not subject to sales tax.  The sales tax that is paid on a new car purchase in most cases will provide a federal tax deduction; federal hybrid vehicle tax credits may still be available depending on the model you choose.  As you can see, there are a multitude of incentives to replace that old “clunker” with a shiny, new, fuel efficient model, but the funding for the rebate program is ending August 24, 2009, so you need to act now to take full advantage.