Adoption can be an incredibly expensive, but an incredibly rewarding, undertaking.
Fortunately, the IRS offers two tax breaks for adoption and each is quite generous.
You can take either the adoption credit, which will result in a direct reduction of your income tax liability, or the adoption benefits exclusion, which will reduce your taxable income, and thus your income tax liability.
To qualify for either tax benefit, the adopted child must be under the age of 18, and you must have a qualified adoption expenses for that child.
As a general rule, you can claim either the adoption credit or the adoption benefits exclusion, but usually not both.
The Adoption Credit
The adoption credit can be particularly beneficial, because the credit represents a reduction in your tax liability. Given the generous amount of the credit, it is possible that it may reduce your tax liability to zero, and possibly for the next few years.
Here are the highlights:
Maximum credit. The maximum credit you can claim for the 2015 tax year is $13,400. That’s a dollar-for-dollar credit based on qualified adoption expenses (see below).
Income limit for the adoption credit. In order to be able to take the credit, your income cannot exceed $241,010. And that’s your modified adjusted gross income, or MAGI. However, the credit begins to phase out once your MAGI reaches $201,010. Up to that income level, you can take the full credit. Between $201,010 and 241,010 you can take a partial credit. At $241,010, the credit disappears completely.
Qualified adoption expenses. This includes expenses that are directly related to the adoption of a child, and must be “reasonable and necessary”. Examples include adoption fees, legal fees (including court costs), and travel necessary to facilitate the adoption.
The credit is “non-refundable”. Which is to say that it can do no more than reduce your tax liability to zero. It cannot create a refund if you owe no tax, or if the credit exceeds the amount of income tax that you owe.
Adoption credit carryover. If the credit exceeds your income tax liability in the year of adoption, you can carry the unused portion of the credit forward, and use it to reduce or eliminate your tax liability the following year. In fact, you can carry the unused portion of the credit forward for up to five years. At the end of the five year period, any unused portion of the credit will be forfeited.
Adoption Benefits Exclusion
Some employers offer employer-provided adoption assistance. If you are adopting a child, and you work for one of the employers who provide this benefit, you can exclude a large amount of the benefit from your taxable income.
Maximum exclusion amount. The amount of the exclusion is $13,400 – the same amount as the adoption credit. This means that you can exclude from income up to $13,400 in employer-provided adoption assistance used connection with the adoption of your child.
Income limits. The income limits for the adoption benefits exclusion is the same as it is for the adoption credit.
Qualified adoption expenses paid. The amount of the employer paid adoption benefits can be excluded from your taxable income to the degree that it was used to pay for qualified adoption expenses. Any amount in excess of those expenses will be taxable as ordinary income.
When Can You Claim Both?
When qualified adoption expenses exceed $13,400, you may be eligible for both the adoption credit and the adoption benefits exclusion. You must first apply the expenses to the adoption benefits exclusion, which is $13,400. Any amount beyond this can then be used for the adoption credit.
Also, if the adoption benefits provided by your employer are less than $13,400 – and you paid more in expenses than the benefit – you can claim the adoption credit for the un-reimbursed portion of expenses paid.
When Adopting a “Special Needs” Child
There’s a special benefit if you are adopting a child who is determined to be “special needs”. The definition of “special needs” with respect to adoption is not the same as the legal definition, as you’ll see below.
- The child is a citizen or resident of the United States or its possessions when the adoption effort began;
- A state determines that the child cannot or should not be returned to his or her parent’s home; and
- The state determines that the child probably will not be adoptable without assistance provided to the adoptive family.
As you can see, there’s no determination of the child’s abilities, just their ability to be adopted. If the adopted child is determined to be a special needs child, you’re eligible for the maximum amount of the credit for the year the adoption is finalized, even if you did not pay qualified adoption expenses.