Loophole born on claiming siblings

Call it the law of unintended consequences at work. A new law designed to standardize the definition of who qualifies as a child for tax purposes has opened a loophole that could be exploited by upper-income families that have young children and older, "boomerang" kids living at home.

Under the old rules, in order to claim someone as a dependent and get the benefit of the $3,200 dependency exemption and the $1,000 child tax credit, you had to provide more than half of a child's support. Now, however, a sibling can claim a brother or sister as a dependent — even if he doesn't pony up one dime for support — as long as the parents don't also claim the child as a dependent.

One intention of the law was to make it easier for low-income, multigenerational households to qualify for all applicable tax credits. But Kathy Burlison, director of tax implementation for H&R Block, says the big winners could be upper-income families who start to lose the child tax credit when their joint income exceeds $110,000, and wealthier families whose ability to claim personal exemptions phases out once their joint income tops $218,950.

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 in 2005. He can't be claimed as a dependent because of his age. Under the new rules, however, either Gail's parents or her brother can claim her as a dependent.

Because their income is too high, the parents get no child credit for Gail and her dependency exemption is squeezed, with just $866 in tax savings. But if Larry claims Gail as a dependent, he qualifies for total tax savings of nearly $3,500, thanks to the dependency exemption, child credit and an earned income credit worth $2,662. "Sometimes you have to look not just at your own tax return, but also at those of others in your household to find tax-saving opportunities," says Burlison.

Tax expert Kaye Thomas of Fairmark.com predicts that Congress will close the loophole once the embarrassing gaffe becomes widely recognized — and roundly criticized. But that's not likely to happen before the April deadline for filing 2005 returns.

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