Understanding taxes when buying and selling a car

When it comes to buying and selling a car, cutting out the middleman has plenty of perks. Buying a car from a private seller will usually result in a lower price tag. Selling your car yourself will net you more money than what you'd get for a trade-in—but buying or selling from a dealership also has its conveniences, such as getting help in figuring out any necessary tax payments.

The laws on taxes for private party used-car sales vary by situation, state, and in some cases, even by city. It may seem hard to understand, but it's not an insurmountable task. CarGurus breaks it down.

FAQs

Are there any tax benefits when trading in a car versus selling it privately?

Trading in a car to a dealership instead of selling it privately can save you on taxes for any new vehicle you purchase. The trade-in value of the vehicle can be deducted from the price of a new car, lowering the out-the-door price and thus the amount of taxes that need to be paid on it.

How does sales tax on cars work when buying or selling across state lines?

The state where you pay vehicle registration fees is the one that charges the sales tax, not the state where you made the vehicle purchase. So, if you live in Massachusetts (a state that has sales tax) but buy a car in New Hampshire (a state with no sales tax), you will still have to pay tax to your home state of Massachusetts when you go to get your license plates. Traveling out of state to buy a used vehicle will not save you from paying state sales tax.

Can the cost of improvements or repairs made on a car be deducted from taxes when selling it?

If you bought an older vehicle for cheap, made improvements, and are selling it for more than you originally paid, you will have to report that when you file your federal and state income taxes, and you may find you owe.

If I'm selling a car for less than I paid for it, can I claim a loss on my taxes?

If, like most people, you are trying to sell your used car for less than you spent on it, then you will not have to pay sales tax. The Internal Revenue Service considers all personal vehicles to be capital assets. Selling that vehicle for less than your purchase price is considered a capital loss, which does not need to be reported on tax returns.

How do gift taxes work if I want to give my car to a family member or friend?

Most states have a process for gifting cars to family members. The family member receiving the car will still need to get the title transferred and re-register the vehicle—paying any fees that may apply. You'll also have to pay off any liens beforehand.

These transactions also fall under your state's gifting laws, so see what gifting taxes may apply. This will be different from the taxes in a standard transaction. And if you sell a car to a family member or friend, the tax law is the same as if you were selling to any other party.

Who Pays Sales Tax on a Private Car Sale?

You must pay vehicle sales tax when you buy a used car if you live in a state that has sales tax. However, you do not pay that tax to the car dealer or individual selling the car. You will pay it to your state's Department of Motor Vehicles or equivalent agency when you register the vehicle.

Do You Pay Income Tax When You Sell a Car?

Selling a vehicle for a profit is considered a capital gain by the IRS, so it does need to be reported on your tax return. But figuring out the dollar amount of that gain is not as simple as comparing your purchase price to your sale price.

You'll need to add the cost of the improvements you made to the car to your original purchase price (listed on the bill of sale you received when you first bought the car). An improvement is anything that's long-term, like new paint, a new sound system, or upgraded mechanical components. It does not include regular maintenance costs like oil changes or brake replacements. Again, paperwork is important—it's best to have receipts detailing the cost of each improvement to help you remember exact figures and to use as proof if needed. Keeping track of the details makes it easier to check your figures with an online tax calculator, too.

If you spend $7,000 on a car and an additional $1,000 on improvements, but you sell the car for $7,000, it's considered a capital loss, and you don't need to pay tax on the sale. But if the original sales price plus the improvements add up to $8,000 and you sell the car for $10,000, you'll have to pay capital gains tax on your $2,000 profit.

How to Avoid Paying Tax on a Used Car

Living in a state without sales tax is the only fool-proof (and legal) way to avoid paying sales tax on a car. Alaska, New Hampshire, Oregon, Delaware, and Montana don't charge sales tax on used cars, and the latter two also don't tax new cars. But be aware that some states allow local governments to charge local taxes, so you may not be totally in the clear.

Some out-of-state residents have also tried to exploit Montana's lack of sales taxes through a loophole. By setting up a limited-liability corporation in Montana, and registering a vehicle to that entity, car buyers can avoid paying sales taxes no matter where they live.

However, many states are aware of this practice and will still try to collect taxes.

Conclusion

Trading your car in at a dealership has its benefits—including a nice tax break—but selling privately can earn you more money up front. However, if you're selling a car, it's a good idea to add up all the improvement costs and determine the total value of your car—if you sell it for any more than that number, you'll be liable for capital gains tax.

Additionally, most shoppers need to stick to a budget when looking for a new car, so understanding your tax situation is important when deciding whether or not to sell your car privately.