Federal Adoption Tax Credit NOTICE:

This is not legal advice and should not be relied upon without first consulting your adoption attorney.

This tax credit is more valuable than a tax deduction because allowable expenses are subtracted dollar for dollar against your tax liability. For example, if you owe $5,000 in federal taxes and have $3,000 in qualified adoption expenses, your tax bill is reduced to $2,000. If your tax bill is smaller than the credit, the unused portion of the credit may be carried forward for up to five years.

According to IRS Publication 968, qualified expenses include "reasonable and necessary" adoption fees, attorney fees, and some travel costs, including necessary transportation, meals, and lodging. Expenses related to surrogate parents or adopting a spouse's child do not qualify for the credit. The credit also does not apply to expenses reimbursed by  the government or private programs or for which an income  tax deduction or credit already is allowed. Adoptive parents should carefully review the IRS guidance, preferably with a tax professional, to clarify what expenses qualify for the credit according to IRS guidelines. 

IMPORTANT UPDATE
Adoption Tax Credit (contributed by Mark McDermott from the American Academy of Adoption Attorneys; Susan Stockham from the American Academy of Adoption Attorneys; and Mike Roush, Lobbyist for the American Academy of Adoption Attorneys) 

The adoption expense tax credit and the exclusion of  income from employer adoption programs were modified and made permanent as part of the tax bill signed by the President on June 7, 2001. Below is information that may help you explain the changes to clients and others. The answers are based on past IRS guidance and best conjecture and do not reflect official Treasury Department policy since the IRS has not had a chance to issue new guidelines. 

In a nutshell what are the changes the new tax law made in adoption benefits?
Except as noted, after Dec.31, 2001 it:

  • -increases the adoption tax credit for all adoptions to $10,000;
  • -makes the credit permanent for all adoptions;
  • -allows the special needs credit to be $10,000, regardless of expenses, beginning in 2003;
  • -increases to $150,000 (previously $115,000) the income amount at which the credit has phased down to zero;
  • -makes the exclusion of income from employer adoption assistance programs permanent, increases the exclusion to $10,000, and increases the income level below which you can claim the full exclusion to $150,000;
  • -applies a cost of living adjustment to the credit and the exclusion beginning in 2003;
  •  -the adoption credit is allowed against the alternative  minimum tax permanently. 
What presently are qualifying expenses for all adoptions and after Dec. 31, 2002, for non-special needs adoptions?
Q ualifying adoption expenses are 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, and whose principal purpose is for, the legal adoption of an eligible child. In the case of the adoption of a U.S. citizen or resident the credit can be taken even if the adoption never becomes final; in the case of an adoption of a child not a citizen or resident of the U.S. the credit can only be taken if the adoption becomes final.

When can the credit be taken?
In the case of a special needs adoption after Dec. 31, 2002. the credit is allowable in the taxable year in which the adoption becomes final. In non-specials needs adoptions and special needs adoption before Dec. 31, 2002. the answer depends on whether the eligible child is a U.S. citizen or resident.