Adoption Tax Credits

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By Roy Lewis
June 7, 2002

Uncle Sam understands that adoption proceedings can be an expensive undertaking, which is why the Small Business Job Protection Act created a nonrefundable credit for qualified adoption expenses and a new exclusion for employer-provided adoption assistance programs. Congress created these new tax benefits because of a belief that the financial costs of the adoption process should not be a barrier to adoption and to encourage not only regular adoption, but also adoption of children with special needs. And the Economic Growth and Tax Relief Reconciliation Act of 2001 went even farther to expand the credit. Let's take a look.    

Adoption credit overview
The law allows a credit for the amount of qualified adoption expenses that you pay during the tax year. The credit is limited to $10,000 of aggregate expenses for each child. The dollar limitation is for adoption expenses for each child, cumulative over all taxable years. It's not an annual limitation, but a child-by-child limitation. Adopt two children, and your limitation rises to $20,000, but the maximum credit you can take for each child is still $10,000.

The year that the credit is allowed will depend on whether the child is a U.S. citizen or resident.

If the expenses of a domestic adoption are paid before the year the adoption becomes final, the credit is allowed for the taxable year after the year the expenses were paid. If the expenses of a domestic adoption were paid or incurred during or after the year the adoption becomes final, the credit is allowed for the year of payment. A credit for the expenses of a foreign adoption is not allowed until the tax year that the adoption becomes final. What does this mean exactly?  Let's look at an example.

Imagine that Lee and Karen pay qualified adoption expenses of $3,000 in 2001, $4,500 in 2002, and $1,500 in 2003 for a domestic adoption of a non-special needs child. The adoption becomes final in 2003. Lee and Karen are allowed a credit of $3,000 in 2002 (representing the expenses paid in 2001). They will also receive a credit of $4,500 in 2003 for the expenses actually paid in 2002. They will also be eligible for an additional $1,500 credit in 2003 for the actual adoption expenses paid in year 2003, and eligible for the credit in 2003 since the adoption was final in 2003.

If Lee and Karen paid the same expenses for a foreign adoption, they would not have been able to take any of the credit until 2003 -- the year in which the adoption became final.

If you pay qualified adoption expenses but the adoption is not successful, you are allowed to claim the credit in the next taxable year following the year that the expenses were paid.

Before you begin to see adoption tax credit dollar signs dance before your eyes, note that this is a nonrefundable credit. It will only reduce your taxes to zero, but not below. All's not completely lost, though. If your credit exceeds your income tax liability, you can carry the excess credit forward for five years. In addition, the adoption credit can now reduce both your regular tax and your Alternative Minimum Tax.  

Qualified adoption expenses
For your expenses to be available for the adoption credit, they must be "qualified." The tax code defines qualified expenses as those that are reasonable and necessary, and directly related to the legal adoption of an eligible child. They include court costs, attorney fees, and even traveling expenses while away from home. They do not include the costs of any surrogate parenting arrangement or the costs of adopting your spouse's child. Expenses are not qualified if they're paid in violation of federal or state law. Also, none of these expenses can be reimbursed under an employer adoption program or any other state or federal program.

Eligible children

Not only must the expenses be qualified, but the child must also be "eligible," that is, either:

  • Under age 18, or
  • Physically or mentally incapable of caring for himself or herself.

In addition, there are special (and even more liberal) adoption credit rules if you adopt a child that has special needs. A child with special needs is defined as:

  • A child who is a U.S. citizen or resident, and
  • Who cannot or should not be returned to his/her parents' residence (as determined by the applicable state agency), and
  • Who probably will not be adopted without assistance because of a specific factor or condition. Examples of those factors or conditions would include a child's ethnic background, age, membership in a minority or sibling group, medical condition, or physical, mental, or emotional handicap.

Adoptions of children with special needs
As we mentioned above, adopting a child classified as having "special needs" can allow for an even bigger tax break. In 2002, the rules are the same for both special needs and non-special needs adoptions. But beginning in 2003, the adoption of a special needs child will allow for a $10,000 credit -- regardless of how much in "qualified adoption expenses" you actually paid. In other words, if your expenses total just $7,500, you'll still get a full $10,000 credit. That's right! It's not a misprint. 

Look at the example of Lee and Karen above. If their adoption had involved a child with special needs, they would have received a total credit of $10,000, even though they only paid $9,000 in adoption expenses. Heck, the credit would be $10,000 even if they only paid $1,200 in qualified adoption expenses.  Simply understand that beginning in 2003, the credit for the adoption of a child with special needs is $10,000, regardless of the amount of qualified expenses actually paid. Sweet.   

Marital status
The adoption credit is available to single people and married couples alike. If you're married, though, at the close of the tax year, you and your spouse must file a joint return in order to claim the credit. When one spouse dies during the year and a joint return is allowed for the survivor and deceased spouse, the credit is allowed only if a joint return is filed. A person legally separated under a decree of divorce or separate maintenance is not considered married. Certain individuals, while not legally divorced, may be considered unmarried for purposes of the credit. If you file a separate return for the year, maintain a household for a qualified individual for more than one-half of the year, and if your spouse is not a member of the household at any time during the last six months of the year, you will likely be considered unmarried for the purposes of the adoption credit.

Income limitations
The adoption credit is phased out for taxpayers with modified adjusted gross income over $150,000. The phase-out is complete at modified AGI of $190,000. This means that those folks with income equal to or in excess of $190,000 can't claim the credit at all. Those with income below $150,000 can claim the full credit.  And those with income between $150,000 and $190,000 will find their credit reduced ratably. These income limitations apply to single people and married couples alike. So if your income falls between the phase-out amounts, make sure that you understand the phase-out rules and understand the extent to which your credit might be reduced, or even eliminated.    

We use the term "income" above. But we're really talking about adjusted gross income (AGI). And not just regular AGI, but modified AGI. To calculate modified AGI for the purposes of the adoption credit, disregard exclusions for foreign earned income and housing costs, income from specified U.S. possessions, and income from Puerto Rico sources. For most people, your modified AGI will be exactly the same as your normal AGI. But if you have foreign earned income or exempted income from Puerto Rico, your computations are a bit more complex.

Reporting compliance
A taxpayer claiming the adoption credit must file IRS Form 8839 with either Form 1040 or Form 1040A. You can't claim the credit when filing with Form 1040EZ. You must also identify all eligible children on your return, including, if known, the name, age, and taxpayer identification number (TIN) of each eligible child.

Adoption taxpayer identification numbers
It can be difficult to obtain a child's Social Security number while in the midst of an adoption. The IRS understands this and offers a way to obtain a temporary taxpayer identification number in order to comply with the adoption credit reporting requirements. It's commonly called an adoption taxpayer identification number (or ATIN in tax-speak). This is a temporary number issued by the IRS to a child in a domestic adoption when the parents are unable to obtain the child's existing Social Security number or are unable to apply for a new Social Security number until the adoption is final. An ATIN can also be used to claim the dependent exemption for the child and the childcare credit, but not the earned income credit.

An ATIN can be obtained by filing Form W-7A with the IRS along with a copy of legal placement documentation. The ATIN will remain in effect for two years. If you need to keep the ATIN in effect for a longer period of time, an extension is available. For more information, get Form W-7A from the IRS.

If adoption is in your future, learn more about the rules by reviewing IRS Form 8839 and the associated instructions. To really get into the meat of the adoption rules, read IRS Publication 968.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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