Last year's health care legislation included temporary changes that make the federal adoption credit more taxpayer-friendly than ever before. This is good news for adoptive parents, because adoptions often cost thousands of dollars. Those in the process of adopting or planning to get started may want to pay expenses before yearend, because the favorable tax changes are scheduled to expire on Dec. 31, unless Congress surprises us by extending them. Here's what you need to know.
Adoption Credit Basics
The adoption credit has been around for years and was liberalized as part of the Bush-era tax cuts. It was then liberalized even more by the 2010 health care legislation -- but only for 2010 and 2011.
Specifically, the maximum credit was increased by $1,000 to $13,170 for 2010 and to $13,360 for 2011. If you adopt several children, a separate credit can be claimed for each eligible child. For instance, if you adopt two eligible children, the maximum credit for 2011 would be a whopping $26,720. The credit was also made refundable for both years. That means the credit is first used to cut your federal income tax bill dollar-for-dollar. Any remaining credit after your tax bill has been reduced to zero is refunded to you in cash.
Starting next year, the maximum credit will be about $1,000 less, and it will no longer be refundable. That means the credit can only be used to reduce your tax bill to zero; any excess credit can be carried forward up to five years.
How to Claim the Credit
You can claim the credit for qualified expenses to adopt someone younger than 18 or a physically or mentally disabled person of any age.
The maximum credit equals 100% of qualified expenses up to the applicable annual limit of $13,170 for 2010 or $13,360 for 2011. For higher-income folks, the credit can be reduced or eliminated under the phase-out rule (more on that later).
Qualified expenses include adoption fees, attorney fees, court costs and travel expenses. However, the credit cannot be claimed for expenses to adopt your spouse's child.
If the child is a U.S. citizen or resident, the following timing rules apply.
* For expenses paid in a year before the adoption becomes final, claim the credit with your return for the year after the year of payment.
* For expenses paid in the year the adoption becomes final, claim the credit with that year's return.
* For expenses paid in a year after the adoption becomes final, claim the credit with the return for the year the expenses are paid.
* For a foreign-born child, you generally claim the credit for cumulative qualified expenses with the return for the year the adoption becomes final. However for expenses paid after that year, claim the credit with your return for the year of payment.
Under these rules, you can potentially claim a credit for the same child in more than one year. However, the limit on qualified expenses applies to the cumulative costs to adopt the child.
For example: Say you paid $10,000 of qualified expenses in 2010 for an adoption that became final last year. This year, you paid an additional $5,000 to wrap things up. On your 2010 return, you could claim a credit of up to $10,000. On your 2011 return, you could claim a credit of up to $3,360 (based on the qualified expense maximum of $13,360 reduced by the $10,000 you already took into account in 2010).
You claim the credit by attaching a filled-out Form 8839 (Qualified Adoption Expenses) to your Form 1040. Because the credit is refundable for 2010 and 2011 (meaning you can collect it even if you owe no federal income tax), you must attach documentation to prove you have completed an adoption or have one underway. For details, see the Form 8839 instructions available at www.irs.gov.
Special Rules for Special-Needs Children
If you adopt a special-needs child, you need not spend anything to claim the maximum credit. The only limiting factor is the phase-out rule if your income is high enough to be affected.
For example, the maximum 2011 credit for a special-needs child is $13,360 (reduced by any credit claimed for the same child in an earlier year) even if you had no qualified expenses.
A special-needs child must be a citizen or resident of the U.S. or a U.S. possession (such as Puerto Rico or Guam) at the time the adoption began, and the child must be determined by a state (or the District of Columbia) to require adoption assistance due to ethnic background and age; a medical condition; or a physical, mental, or emotional handicap.
Phase-Out Rule for High-Income Taxpayers
For 2011, the adoption credit is phased out between adjusted gross income (AGI) of $182,520 and $222,520. For 2011, the phase-out range is $182,210 to $222,210. Because the income threshold is set fairly high, relatively few adoptive parents are affected by the phase-out rule. However, married individuals who file separate returns are ineligible for the adoption credit, regardless of income.
Because of the way the adoption credit timing rules work, getting an adoption finalized this year rather than next year could line you up for greater tax savings because you would fall under the more-generous credit rules that apply for 2011. If your adoption was finalized in 2010 and you are still incurring expenses, paying them this year instead of next year could be helpful for the same reason.