Read an Excerpt
J.K. Lasser's 1001 Deductions and Tax Breaks 2006
By Barbara Weltman
John Wiley & SonsISBN: 0-471-73309-1
Chapter OneYou and Your Family
Do the old cliches still ring true? Can two still live as cheaply as one? Are things really cheaper by the dozen? For tax purposes, there are certain tax breaks for building a family.
This chapter explains family-related tax benefits, including:
Child tax credit
Earned income credit
Dependent care credit
For more information on these topics, see IRS Publication 501, Exemptions, Standard Deduction, and Filing Information; IRS Publication 503, Child and Dependent Care Expenses; IRS Publication 504, Divorced or Separated Individuals; IRS Publication 968, Tax Benefits for Adoption; and IRS Publication 972, Child Tax Credit.
Each taxpayer (other than someone who is another taxpayer's dependent) automatically is entitled to a deduction just for being a taxpayer. The amount of the deduction, called the exemption amount, is a fixed dollar amount ($3,200 in 2005). However, if a taxpayer is considered to be a "high-income taxpayer," he or she loses some or all of this deduction.
You can claim a deduction for yourself, called a personal exemption. In 2005, the exemption amount is $3,200 (each year it is indexed for inflation). Table 1.1. shows you the value of your personal exemption for your tax bracket in 2005 (the amount of taxes you save by claiming it).
There are no conditions to claiming this deduction; it's yours because you are a taxpayer and the law says you are entitled to it.
Each spouse is entitled to his or her own personal exemption. On a joint return, two personal exemptions are claimed. If you are married but file a separate return, you can claim both deductions (an exemption for you and an exemption for your spouse) if your spouse has no income and is not the dependent of another taxpayer.
However, you cannot claim the personal exemption if you can be claimed as a dependent on another taxpayer's return. For example, a child who is the parent's dependent cannot claim a personal exemption on the child's own return.
If a parent waives a dependency exemption for a child, the child can then claim the exemption on his or her own return (the child is no longer treated as a dependent). This may be advisable, for example, when the parent cannot use an education credit because the parent's income is too high, but the child can use the credit to offset his tax liability (see Chapter 3).
High-income taxpayers may lose some or all of their deduction for exemptions as explained below (see Pitfalls). But the phaseout of personal and dependency exemptions is being eliminated. The reduction of this phaseout starts in 2006; there is no phaseout of exemptions by 2010.
You may lose some or all of the personal exemption (as well as dependency exemptions discussed later) if you are a high-income taxpayer. The write-off for exemptions is phased out for taxpayers with adjusted gross income above a set amount; once AGI reaches a set level, no write-offs are permitted. Table 1.2 shows where the phaseout of exemptions begins and the AGI level at which no exemptions can be claimed.
Once your AGI exceeds the beginning of the phaseout range, the deduction for personal and dependency exemptions is reduced by 2 percent for each $2,500 of AGI over the beginning phaseout number.
You cannot claim any personal or dependency exemption for alternative minimum tax (AMT) purposes, a shadow tax system designed to ensure that all taxpayers pay at least some tax. A large number of exemptions can substantially reduce or even eliminate any regular tax. So if you have a large number of exemptions, you may trigger or increase AMT liability. You may wish to engage in some tax planning to minimize or eliminate your AMT liability.
Where to Claim the Personal Exemption
You claim the exemption directly on your tax return in the "Tax and Credits" section of Form 1040 or the "Tax, Credits and Payments" section of Form 1040A; no special form or schedule is required. If you are filing Form 1040EZ, the exemption amount is built into the tax table (you can file this return only if you are single or married filing jointly with no dependents); you don't have to subtract it anywhere on the return.
If your AGI exceeds the beginning of the phaseout range, use a worksheet in the instructions for the return to figure the phaseout of your exemption.
A fixed deduction ($3,200 in 2005) is allowed to every taxpayer who supports another person and meets other tests described below. The deduction is called a dependency exemption. However, if a taxpayer is considered to be a "high-income taxpayer," he or she loses some or all of this deduction.
You may be entitled to a dependency exemption for each person you support if certain conditions are met. Like the personal exemption, each dependency exemption in 2005 is a deduction of $3,200.
There are two classes of dependents: qualifying children and all other qualifying relatives. Different conditions apply to each class of dependents.
For a qualifying child, there are four conditions:
1. Being your child.
2. Modified support test.
3. Citizenship test (see end of "Conditions" section).
4. Joint return test (see end of "Conditions" section).
BEING YOUR CHILD. For purposes of a qualifying child, your children include your natural children, stepchildren, adopted children (including those placed for adoption), and eligible foster children (those placed with you by an authorized adoption agency or court). A qualifying child also includes grandchildren and brothers and sisters (including stepsiblings). The child must be under age 19, under age 24 and a full-time student, or permanently disabled (any age).
Your child must live in your household for more than half the year. A child kidnapped by someone other than a family member continues to be treated as a member of your household until the year in which he or she would have attained age 18.
MODIFIED SUPPORT TEST. A qualifying child must not have provided more than half of his or her own support (you do not have to show you paid more than half the child's support). Amounts received as scholarships are not counted as support. There is no gross income test for a qualifying child as there is for a qualifying relative explained below.
Special rule for divorced or separated parents: The exemption belongs to the noncustodial parent if these conditions are met:
The child receives more than half of his/her support from the parents.
A decree of divorce or separation agreement between the parents states that the noncustodial parent is entitled to claim the dependency exemption or the custodial parent signs a written declaration that he/she will not claim the exemption.
If there is no divorce decree or separation agreement with a statement on the dependency exemption for the noncustodial parent or the custodial parent fails to sign a written declaration waiving the exemption, then a so-called tiebreaker rule applies. Under this rule the exemption belongs to the parent with whom the child resided for the greater amount of time, or if equal time, then to the parent with the higher adjusted gross income. Thus, the custodial parent will usually prevail because the child is a member of the custodial parent's household for more time during the year than the child is a member of the noncustodial parent's household.
In the case of a child whose parents divorced before 1985, the dependency exemption can be claimed by the noncustodial parent as long as he/she provides at least $600 for the support of the child during the year. The fact that the noncustodial parent is behind in child support payments has no impact on claiming the exemption (as long as the $600 threshold is met).
There are five tests for claiming a dependency exemption for someone who is not a qualifiying child. You must satisfy all of them:
1. Relationship or member of the household test.
2. Gross income test.
3. Support test.
4. Citizenship or residency test.
5. Joint return test.
RELATIONSHIP OR MEMBER OF THE HOUSEHOLD TEST. The person you claim as a dependent must either be a relative (whether or not they live with you) or a member of your household. Relatives who do not have to live with you in order to qualify as your dependent include:
Child, adopted child, or stepchild (other than a qualifying child).
Grandchild (other than a qualifying child).
Great-grandchild (other than a qualifying child).
In-law (son, daughter, father, mother, brother, or sister).
Parent or stepparent.
Sibling, stepbrother or stepsister, half-brother or half-sister.
Uncle, aunt, nephew, or niece if related by blood.
Any other individual, including, for example, a cousin, must be a member of your household for the entire year (not counting temporary absences).
GROSS INCOME TEST. The person you claim as a dependent must have gross income of less than the exemption amount-$3,200 in 2005.
Gross income means income that is subject to tax. It does not include tax-free or excluded items, such as municipal bond interest, employee fringe benefits, or gifts. Social Security benefits are gross income only to the extent they are taxable (which may be 50 percent or 85 percent, depending on the recipient's income and Social Security benefits).
SUPPORT TEST. You must provide more than half of the person's support for the year (or meet the multiple support rules discussed later). Generally, this test does not present a problem; you may be the person's only means of support.
But where the person pays some of his or her own support while receiving help from you and other sources, you need to look closely at whether you pay more than half of the person's support. "Support" is different from "income." You need to look at what is spent on personal living needs and not what the person receives in the way of income. Government benefits payable to the person, including Social Security benefits, are treated as the person's own payment of support (whether or not actually spent on personal living needs).
EXAMPLES OF SUPPORT ITEMS
Education expenses (If your child takes out a student loan that he or she is primarily obligated to repay, the loan proceeds count as the child's own payment of support).
Lodging (If the person shares your home, support is based on the fair rental value of the room or apartment in your home, including a reasonable allowance for heat and other utilities).
Medical expenses (for details see Chapter 2).
Recreation, including the cost of a television, summer camp, dance lessons, and a wedding.
CITIZENSHIP OR RESIDENCY TEST. The person you claim as a dependent must be a U.S. citizen or national, or a resident of the United States, Canada, or Mexico.
JOINT RETURN TEST. If you are claiming an exemption for someone who is married, the person may not file a joint return with his or her spouse. However, this joint return test is not failed if a joint return is filed merely to claim a refund and both spouses have income under the exemption limit.
As described earlier in this chapter, elimination of the phaseout of the exemptions is scheduled to begin in 2006; by 2010, high-income taxpayers will no longer lose the benefit of personal and dependency exemptions.
MULTIPLE SUPPORT AGREEMENTS. Even if you do not provide more than half the support of another person, you may still qualify for the deduction if you contribute more than 10 percent of the person's support and, together with others, contribute more than half the person's support. Then each of the other supporters who contribute more than 10 percent must agree among themselves who claims the exemption (it cannot be prorated among the supporters).
In deciding which person should claim the exemption when more than one person qualifies, the decision should be based on who would benefit more. Factors to consider include:
Which person is in the higher tax bracket.
Whether such person is a high-income taxpayer subject to the phaseout of personal and dependency exemptions.
If all things are equal, then rotate from year to year who claims the exemption (for example, one year you claim the exemption for a parent and the following year your sibling claims it).
For rules on the phaseout of the dependency exemption for high-income taxpayers as well as the impact of the AMT, see earlier sections of this chapter.
If you support a domestic partner or lover and meet all of the tests, you can claim a dependency exemption only if the relationship does not violate local law. For example, in North Carolina, a man was prohibited from claiming the exemption for his live-in girlfriend because under North Carolina law this cohabitation was a misdemeanor. In contrast, a man in Missouri was permitted to claim the exemption for his live-in girlfriend because the relationship there was not in violation of state law.
Where to Claim the Dependency Exemption
You claim the exemption directly on your tax return in the "Tax and Credits" section of Form 1040 or the "Tax, Credits and Payments" section of Form 1040A; no special form or schedule is required. You cannot claim a dependency exemption if you file Form 1040EZ.
If your AGI exceeds the beginning of the phaseout range, use a worksheet in the instructions for the return to figure the phaseout of your exemption.
Child Tax Credit
The U.S. Department of Agriculture estimates that it costs $15,300 a year for a middle-class family to raise a child born in 2003 to age 17 (without adjustment for inflation). In recognition of this cost, you can claim a tax credit each year until your child reaches the age of 17. The credit is currently up to $1,000 per child. This credit is in addition to the dependency exemption for the child.
You may claim a tax credit of up to $1,000 in 2005 for each child under the age of 17. If the credit you are entitled to claim is more than your tax liability, you may be entitled to a refund under certain conditions.
Generally, the credit is refundable to the extent of 15 percent of earned income over $11,000 in 2005.
If you have three or more children for whom you are claiming the credit, you are entitled to an additional child tax credit. In reality, the additional child tax credit is merely a larger refund of the credit you are ordinarily entitled to. There are two ways to figure your refundable amount (the additional child tax credit) and you can opt for the method that results in the larger refund:
1. Fifteen percent of earned income over $11,000 in 2005.
2. Excess of your Social Security taxes (plus one-half of self-employment taxes if any) over your earned income credit for the year (the earned income credit is explained in the next main section).
To claim the credit, you must meet two conditions:
1. You must have a qualifying child.
2. Your income must be below a set amount.
QUALIFYING CHILD. You can claim the credit only for a "qualifying child." This is a child who is under age 17 at the end of the year and meets the definition of a qualifying child explained earlier in this chapter.
MAGI LIMIT. You must have modified adjusted gross income (MAGI) below a set amount. The credit you are otherwise entitled to claim is reduced or eliminated if your MAGI exceeds a set amount. MAGI for purposes of the child tax credit means AGI increased by the foreign earned income exclusion, the foreign housing exclusion or deduction, or the possession exclusion for American Samoa residents.
The credit amount is reduced by $50 for each $1,000 of MAGI or a fraction thereof over the MAGI limit for your filing status. The phaseout begins if MAGI exceeds the limits found in Table 1.3.
Excerpted from J.K. Lasser's 1001 Deductions and Tax Breaks 2006 by Barbara Weltman Excerpted by permission.
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