ATTENTION ADOPTIVE PARENTS: the government has a gift for you.

First, the bad news: your US Representative won’t be at the shower.

The good news? Uncle Sam wants to reward you monetarily for all the hard work, emotional strain and sleepless nights you are spending, have spent or can look forward to spending during the adoption process.

This reward is the Adoption Expense Tax Credit, a dollar for dollar reduction of income tax liability for expenses directly related to adopting a child. Sounds easy, right? Unfortunately, it’s not. Actually, as tax credits go, the rules surrounding this one are relatively complicated. This post will explain some of the details of this credit, how it is calculated and why it is a benefit to adoptive parents.

How is the Adoption Expense Tax Credit calculated?

For 2009, the Adoption Expense Tax Credit is limited to $12,150 of “qualified adoption expenses” per adopted child. Qualified adoption expenses include any expense which is “reasonable and necessary” and directly related to a legal adoption. Certain expenses like attorney fees and court costs easily fit this definition. But that’s not all…adoption fees, travel expenses and other expenses that, as noted, are directly related to an adoption can also be used to calculate this tax credit.

There are some limits, though. Qualified adoption expenses do not include amounts spent in violation of state or federal law (easiest example here: bribes to adoption officials) nor do they include expenses incurred in adopting a step-child. Moreover, qualified expenses include only expenses incurred to adopt an “eligible child” who is a child that is under age 18 and is unable to care for him or herself (unless emancipated, a child under 18 will probably always be considered an “eligible child”).

It is important for adoptive parents to keep track of their adoption expenses. No particular records are required to take the credit, but parents should be ready to prove expenses in case of an audit.

Example: Matt and Jenny adopt Cindy, an eligible child for purposes of the Adoption Expense Tax Credit. Matt and Jenny’s expenses related directly to the adoption include adoption agency fees, attorney fees and court costs totaling $15,000. Matt and Jenny’s Adoption Tax Credit is limited to $12,150.

How and When can the Adoption Expense Tax Credit be taken?

The Adoption Expense Tax Credit is calculated and reported on IRS Form 8839, which is attached to the IRS Form 1040. When the credit can be taken is dependent on (1) when the eligible expenses are paid; (2) when the adoption becomes final; and (3) whether the adoption is of a US citizen/resident or a foreign child (did you think I was kidding when I said this credit is complicated?)

Adoptions of US citizens or residents are the most favored under this credit. This is because the intended adoption of a US citizen or resident need not be successful in order to claim the credit. Qualifying expenses incurred during any year prior to an adoption becoming final can be the basis of the credit for the next taxable year. Qualifying expenses incurred during a year in which the adoption becomes final or after the year in which the adoption becomes final can be the basis of the credit for the year in which the expense is paid.

Example: Matt and Jenny’s adoption of Cindy becomes final in 2009. In 2006 Matt and Jenny incurred $5000 of expenses in an attempt to adopt Julie which was unsuccessful. In 2007 and 2008, Matt and Jenny incurred $6000 of expenses in each year to adopt Cindy. In 2009 Matt and Jenny incurred $10,000 of expenses to adopt Cindy. Matt and Jenny’s credit for 2006 is $0, for 2007 is $5000 (2006 expenses), for 2008 is $6,000 (2007 expenses) and for 2009 is $12,150 (2008 and 2009 expenses of $16,000 limited to maximum of $12,150).

Expenses related to the adoption of children who are not citizens or residents of the United States can only be the basis of a tax credit if the adoption is finalized. In that case, all expenses paid prior to or during the year the adoption is finalized are treated as paid in the year the adoption is finalized.

Example: Same facts as those above, except Cindy is born to Chinese parents in China. Matt and Jenny’s credit is limited to $12,150 for 2009 (2007, 2008 and 2009 expenses total $22,000, which sums are treated as having been paid in 2009).

Here are some additional details…just to keep your head spinning. The adoption of a US citizen or resident is finalized when a judge with proper jurisdiction slams the gavel and signs the adoption order or decree. Easy enough.

The rules surrounding whether a foreign adoption will be considered final for purposes of the tax credit are a bit more convoluted. Generally speaking, a foreign adoption is either finalized in the foreign country from which the child comes or in the state of the child’s adoptive home. An easy way to determine finalization of adoption is to look at the type of IR visa the child receives from the US Department of State. If the child receives an IR-3 visa, the adoption is final as of the date of the adoption decree from the child’s home country. If the child receives an IR-2 or an IR-4 visa, the adoption will not be considered final until a decree or order of adoption is issued from the US state in which the child’s adoptive parents reside.

Example: Matt and Jenny bring Cindy home from China under Cindy’s IR-4 visa, issued immediately after a Chinese court grants custody of Cindy to Matt and Jenny in 2008. Matt and Jenny bring Cindy to their home in Chicago. An Illinois court decrees the adoption in 2009. For purposes of the tax credit, the adoption is final in 2009. If Cindy had been granted an IR-3 visa, the adoption would have been considered final in 2008.

Clint Costa is an attorney and certified public accountant practicing business law, tax, real estate and estate planning with the Chicago law firm of Shaheen Novoselsky Staat Filipowski & Eccleston, P.C. Clint lives in the Edison Park neighborhood of Chicago with his wife Julie. Clint can be reached at 312-621-4400, or by email at ccosta@snsfe-law.com.