Does a trade-in reduce sales tax? It depends on where you live

Because a trade-in is deducted from the total price of a car, you will pay less overall — which means less sales tax. The actual benefit depends on your state’s tax rate. It also depends on whether your state offers trade-in tax credits. If it does, there may be a cap on the amount that can be reduced from the total taxable amount.

Why does a trade-in reduce sales tax?

Almost every state allows you to deduct your trade-in amount from your next vehicle’s sale price before tax. So, if you want to buy a vehicle for $40,000 and the dealership offers you $15,000 for your trade-in, you will only be taxed on $25,000.

The savings add up quickly. Say the sales tax rate in your state is 6 percent. Rather than pay $2,400 in tax for a $40,000 purchase, you will pay $1,500 — $900 less in taxes.

Michigan has a $10,000 cap on how much your trade-in can reduce your sales tax. Ohio only allows trade-in deductions from new car purchases. There are three states where a trade-in can’t be used to reduce sales tax at all:

• California
• Hawaii
• Virginia

In this case, it may make the most sense to sell privately or shop your trade-in to get the best deal rather than trade in and buy from the same dealership. You can still apply your money from trading in as a down payment.

Trading a car in vs. selling

If you want the trade-in to be reduced from your total sales price, you must trade in your car at the same dealership you buy from. Otherwise, it is considered a sale, not a trade-in — and won’t reduce the tax you pay.

This may seem like a worse deal, but there are times when selling is better than trading in. If your state has a cap on how much your sales tax can be reduced — or does not reduce sales tax at all — you may be able to get more money by selling privately or at a different dealership.

And if the dealership you want to buy from lowballs your trade-in value, selling your current vehicle elsewhere could be enough to recoup the money you spend on taxes.

Imagine you would only save $500 on taxes by trading in and buying from one dealership but would make an extra $1,500 by trading in at another dealership. You should go with the option that nets you more money overall, even if you wind up paying more in sales tax.

How to trade in your car

Trading in your vehicle is essentially selling it to a dealership. There may be extra paperwork, but most dealerships should streamline the process.

1. Find the average sale price for your make and model. Websites like Edmunds or Kelley Blue Book show how much your vehicle is worth in your area.
2. Get quotes from multiple dealerships. Since trade-in value is negotiable, you should compare a few options to get the best deal.
3. Trade in your car at the dealership you plan on buying from. Even if it is not the best offer, this is the only way to reduce the sales tax from your next purchase.
4. Complete the paperwork for your trade-in and new or used car. These are technically separate transactions but can usually be done at the same time.

The bottom line

In most states, your trade-in can be used to reduce the total sale price of a car purchase before taxes. Although some states set caps on the total amount, you will still save money on taxes by trading in and buying from the same dealership.

You should also compare auto loans before heading to a dealership to maximize your savings. Knowing your trade-in’s value and coming prepared with outside financing puts you in the best position to negotiate a strong deal on your next car.