Also, do not confuse tax credits with tax deductions! Tax credits and tax deductions are very different. Tax deductions act to reduce a taxpayer’s tax burden, but not as much as a tax credit. The IRS subtracts a tax deduction as a percentage from the amount of income that is taxed, while a tax credit acts as a dollar-for-dollar reduction in what a taxpayer owes.
Let’s go over a few examples to clarify:
Scenario 1: You sign a contract for the purchase of your new home for $100,000 between January 1 and April 30, 2010 and qualify for the first-time homebuyer ARRA tax credit. Under this scenario you will receive 10% of the purchase price or up to $8,000. Ten percent of $100,000 equals $10,000. Therefore, you will receive $8,000 because you can only receive up to $8,000 with the ARRA tax credit. The $8,000 will be credited to you dollar-for-dollar when you file your 2010 income tax return. For example, if you owe $2,000 on your 2009 income taxes, you will receive $6,000 ($8,000 tax credit - $2,000). If the government owes you money for your 2009 income taxes, you will receive what the government owes you plus the $8,000 tax credit.
Scenario 2: Same facts as above, but you purchase a $70,000 house. Here, you would only receive $7,000 as a tax credit (i.e. because 10% of $70,000 is $7,000). But remember, the $7,000 will be credited to you dollar-for-dollar when you file your 2010 income tax return. So, as you can see, any homes with a purchase price of $80,000 or more will qualify for the full $8,000 tax credit, while homes with a purchase price below $80,000 will only receive 10% of the purchase price.
NOT Part of ARRA (just used to clarify distinction between tax credits and tax deductions):
Scenario 3: Same facts as Scenario 1, but instead you receive a tax deduction instead of a tax credit. Here, we would also need to know your adjusted gross income (i.e. AGI) to determine your tax bracket. For example, if you made $50,000 in gross income in 2009, and your adjusted gross income was $40,000 you would fall into the 25% federal tax bracket. Here, 25% of $8,000 is $2,000. Therefore, your taxes would be reduced by $2,000; not $8,000 like the tax credit. You can clearly see that a tax credit goes much further than a tax deduction. Tax credits credit a taxpayer dollar-for-dollar while tax deductions only reduce a percentage of taxpayer’s tax.
Don’t worry about Scenario 3 for purposes of the ARRA. We included Scenario 3 simply to show the difference between a tax credit and tax deduction.
Next, let’s explore if you meet the requirements to qualify for the tax credit.