August 10, 2008 - We are in the process of adopting a child this year, which is an exciting, but costly process. What tax deductions are available for adoption expenses?

Two tax benefits are available to offset the expenses of adopting a child. For 2008, adoptive parents may be able to claim a credit against their federal tax for up to $11,650 of "qualified adoption expenses" (see below) for each adopted child. That's a dollar-for-dollar reduction of tax-the equivalent, for someone in the 25% marginal tax bracket, of a deduction of over $46,000. Also, adoptive parents may be able to exclude from their gross income up to $11,650 for 2008 of qualified adoption expenses paid by an employer under an adoption assistance program. The credit is nonrefundable and both the credit and the exclusion are reduced (phased out) if the parents' income exceeds certain limits (see discussion below).

Adoptive parents may claim both a credit and an exclusion for expenses of adopting a child. But they may not claim both a credit and an exclusion for the same expense.

Qualified adoption expenses. To qualify for the credit or the exclusion, the expenses must be "qualified adoption expenses." These are the reasonable and necessary adoption fees, court costs, attorney fees, traveling expenses (including amounts spent for meals and lodging) while away from home, and other expenses directly related to the legal adoption of an "eligible child".

Qualified adoption expenses don't include expenses connected with the adoption of a child of a taxpayer's spouse, expenses of carrying out a surrogate parenting arrangement, expenses that violate state or federal law, or expenses paid using funds received from a federal, state, or local program. Expenses that are reimbursed by an employer don't qualify for the credit, but benefits provided by an employer under an adoption assistance program may qualify for the exclusion.

Expenses in connection with an unsuccessful attempt to adopt an eligible child before successfully finalizing the adoption of another child can qualify. Expenses connected with a foreign adoption (i.e., one in which the child isn't a U.S. citizen or resident) qualify only if the child is actually adopted.

Eligible child. An "eligible child" is a child under the age of 18 at the time the qualified adoption expense is paid. A child who turned 18 during the year is an eligible child for the part of the year he or she is under age 18. A person who is physically or mentally incapable of caring for himself is also eligible, regardless of age.

When to claim the credit or take the exclusion. If the qualifying expenses are paid before the year the adoption becomes final, the credit is claimed for the year after the one in which the expenses are paid. If the expenses are paid in the year the adoption becomes final or in a later year, the credit is claimed for the year in which the expenses are paid. For example, say $3,000 was paid in 2006, $2,000 in 2007, and $4,000 in 2008, when the adoption becomes final. The taxpayer claims a $3,000 credit in 2007 (for the 2006 expenses). The $2,000 of 2007 expenses and the $4,000 of 2008 expenses are combined to be claimed in 2008.

Employer-provided adoption benefits are excludable from the employee's gross income for the year in which the employer pays the qualified adoption expense.

In the case of a foreign adoption, neither the credit nor the exclusion may be taken until the year in which the adoption becomes final.

Adoption credit is nonrefundable. The adoption credit is a nonrefundable credit. The amount of the credit can't exceed the sum of your regular and alternative minimum tax, reduced by the sum of your other nonrefundable credits. Thus, while the credit can reduce your tax, it won't cause you to get a refund check.

Phase-out for high-income taxpayers. The credit allowable for 2008 is phased out for taxpayers with adjusted gross income (AGI) over $174,730 and is eliminated when AGI reaches $214,730. The 2008 credit is reduced by a percentage equal to the excess of AGI over $174,730 divided by $40,000. For example, say taxpayers who could otherwise claim a $2,000 credit have an AGI of $184,730 in 2008. Their $184,730 AGI minus $174,730 equals $10,000, and $10,000 divided by $40,000 is 25%. Accordingly, the taxpayers "lose" 25% of their credit ($2,000 times 25% is $500) and can only claim a credit of $1,500. (Special rules for determining AGI apply in some cases.) The phase-out rules for high-AGI taxpayers apply for the exclusion as well.

Different rules apply to taxpayers who adopt a child with special needs.

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