Behold, a Tax Loophole

Thanks to a recent tax simplification law designed to clarify who can claim a child as a dependent, some upper-income families with both younger children and older "boomerang" kids living at home could benefit from an unintended loophole.

One leading tax expert predicts that Congress will likely shut it down once the embarrassing gaffe becomes widely known. But it is unlikely any congressional action would affect 2005 returns due this year.

Under the old rules, to claim a child as a dependent and get the benefit of the $3,200 personal exemption and the $1,000 child tax credit for those younger than 17, you had to provide more than half of that person's support. But now a sibling can claim a brother or sister as a dependent even if he or she doesn't pony up one dime for support -- as long as the parents don't also claim the child as a dependent.

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The new definition of a qualifying child is also the key for claiming head-of-household filing status and the earned-income tax credit for low-income families.

Kathy Burlison, director of tax implementation for HR Block, says the big winners of this accidental tax break are upper-income families who lose the benefit of the child tax credit when their joint income exceeds $110,000 and even wealthier families whose ability to claim personal exemptions is phased out once their joint income tops $218,950. "The key message here is sometimes you have to look not just at your own tax return, but that of your whole household for tax saving opportunities," she says.

To illustrate, Burlison cites the example of a married couple with $240,000 of income and two children, Larry, 21, and Gail, 15. Larry is not in school and earned $13,000 last year, so he can't be claimed as a dependent because of his age. (If he were a full-time student, he could qualify as a dependent through age 24.) Under the new rules, Gail can be claimed as a dependent child by either her parents or by her brother.

Because of their income, the parents get no child credit for Gail, and her dependency exemption is squeezed, resulting in a tax savings of $866. But if Larry claims his sister as a dependent, he qualfies for tax savings of nearly $3,500, thanks to the dependency exemption, child credit and an earned-income credit worth $2,662. It may be legal, but is it right?

"It appears that this approach is allowed under the current law, even though it obviously isn't the intended result," says tax expert Kaye Thomas of Fairmark.com. "But to see thousands of dollars in tax benefits going to kids living at home with upper-income parents is just bizarre."