Tax credits break down into two broad categories — nonrefundable and refundable. Nonrefundable credits can wipe out your taxes. But if the credit is higher than your tax liability, you lose it. It disappears.

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DEDUCTIONS AND CREDITS
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Refundable credits are nifty. You get money back from the IRS, even if you paid nothing in. Of course, they are also a major target of tax fraud. Refundable credits attract bogus tax preparers, who churn out thousands of fraudulent tax returns. Just last month, the IRS announced a 30-month prison sentence for Luciano Martinez, a Plano, Texas, tax preparer.

Martinez was responsible for between $400,000 and $1 million worth of bogus refunds, due to excess expenses and fraudulent Hope Credit claims. Read more about that case and others on this IRS page.

Credits are easier to understand if we group them together by related types of expenditures.

Education credits

We lost the Hope credit, so we’re just down to two choices — the American Opportunity credit and the Lifetime credit. You may select only one per student, per year. But if you have more than one student in your household, you might be able to take advantage of each credit.

American Opportunity credit (refundable): Up to $2,500 tax credit per student is based on 40% of your tuition and fees. It also covers costs of books, supplies and course-related equipment. You can use this for four years of college (no grad school). An added bonus when you have no tax liability: $1,000 of the credit is refundable.

Lifetime Learning Credit (nonrefundable): This $2,000 credit, per tax return, is based on tuition and fees only. You can use this credit year after year, because it covers undergraduate, graduate and job-skills courses.

Read more about education credits and tuition-and-fees deductions on the IRS site.

Child-related credits

These are probably the most-used credits. And some, like the earned-income credit and additional child tax credit, are the most abused. In fact, the IRS has said that tax returns claiming an EIC are routinely run through an extra screening process before refunds are issued.

Earned-income tax credit (refundable): On your 2010 return, the credit is worth up to $3,050 for one child, $5,666 ($5,751 in 2011) for three children. It is $457 with no children ($464 in 2011). To get this credit, you must have income from a job, or business profits. Your total income must be less than certain limits. You cannot have more than $3,100 of investment income ($3,150 in 2011).

In the past, workers could get part of this money in advance, as part of their payrolls. But due to the budget crunch, the Education Jobs and Medicaid Assistance Act of 2010 repealed the advance earned-income tax credit payments. Learn more about the EITC on this IRS page.

Child tax credit (nonrefundable): Worth up to $1,000 per child. Although this credit is limited to your tax liability, the additional child tax credit is refundable, and can apply to each child. Learn more on this IRS page.

Child and dependent care credit (nonrefundable): This credit ranges from $600 to $1,050 per child, for up to two children. However, the higher credit is based on such a low level of income — people earning $15,000 or less are not apt to have taxes as high as $1,050. Although both parents must work to qualify for the credit, there are two ways to get this credit if one or both parents do not work. When either parent is a full-time student or permanently disabled, there’s a special phantom income allocation. If you have over $3,000 in expenses per dependent, in certain cases, some expenses may be used as medical deductions. Job-related benefits may reduce the credit. Read more on this IRS page.

Home-related credits

Home-buyer tax credits (refundable): There are two credits, both refundable. There’s up to $8,000 for people who bought homes for the first time, and up to $6,000 for people who owned a home for at least five out of the last eight years. To qualify in 2010, you must have entered into the binding purchase contract by April 30, 2010. You must have finalized the purchase and moved into the new home by September 30, 2010.

There are so many variations in contracts and circumstances. Some are unclear. One person asked, “If I made an offer by April 30, does my purchase qualify?” Only if the offer was accepted by the seller on April 30. An offer isn’t a binding contract. The IRS has outlined many scenarios on their website. See the IRS page.

And TaxMama is regularly providing information about this complex topic on MarketWatch and on TaxMama.com. See the TaxMama site.

Home energy credits (nonrefundable): There are two credits we can get for fixing up our homes: the nonbusiness energy property credit and the residential energy efficient property credit, and both are nonrefundable.

The nonbusiness energy property (NBEP) credit is worth 30% of the cost, up to $1,500, reported on Part I of Form 5695. The new limit is described in the instructions to Form 5695 — you’ll love this:

“For 2011 NBEP improvements, the maximum NBEP credit allowed is $500 reduced (but not below zero) by the total of your NBEP credits for 2006 through 2010. In addition, the credit allowed for windows for 2011 is limited to $200 reduced (but not below zero) by the total of your credits for windows from 2006 through 2010.”

The residential energy efficient property credit is worth 30% of the full price, with no limit on the cost or the credit. Also reported on Form 5695, this credit applies to solar, geothermal power and wind turbines. Folks who are passionately green will want to participate in this credit, wherever possible.

But before investing tens of thousands of dollars, believing you will recoup the costs, look at the numbers. Bear in mind that some systems will need repair or replacement within 10 years or less. So ask the questions and shop around for long-term, full-service warranties. Also, find out if your city, state or utility offers rebates or credits, too. See this site for more information.

Car credits, and more

In addition to all the credits already mentioned, there are always a variety of credits related to alternative fuel vehicles. These tend not be refundable credits. And most of the juicy credits have expired due to the popularity of the early models of each car. Before you buy an alternative fuel vehicle, thinking you’re going to get a credit, be sure to look up your prospective vehicle on the IRS website. Read more about the alternative fuel vehicle credits on the IRS site.

This is just a brief overview of credits you may be able to use. You might find others by searching the IRS website for “credits.” Another place you can find credits is Part 6 of IRS Publication 17. See Publication 17 on the IRS site.

Anything that ends up on your Form 1040 is summarized or mentioned right there. Anyone preparing their own tax return should become familiar with Pub 17. It’s got a wealth of useful information.

By Eva Rosenberg, MarketWatch
Eva Rosenberg is the founder of TaxMama.com and an enrolled agent licensed to represent taxpayers before the IRS. Visit her new website at TaxMama.com.

If our beloved Washington politicians ever get serious about tax reform, one of the first priorities should be stripping out “targeted” tax breaks. They are bad public policy for two reasons.

First, they are used by politicians and bureaucrats to micromanage the economy by picking winners and losers. It’s increasingly obvious that the so-called experts in Washington are not smart enough to be given this power.

Second, targeted tax breaks encourage governmental corruption because those who benefit are willing to pay whoever they need to pay to get the goodies.

But let’s get specific. I quickly came up with five sterling examples of dumb tax breaks that need to be swept out (there are many, many more, but I’m only allowed so many words). Prepare to get mad, because your ox might be gored.

Exemption for Forgiven Home Mortgage Debt

Say you take out a mortgage to buy a primary residence. You later default, and the lender takes the property back after forgiving part of the mortgage balance. Ordinarily, forgiven debt –including forgiven home mortgage debt — counts as taxable income unless you are bankrupt or insolvent, in which case the forgiven debt is tax-free. Fair enough. But in 2007, Congress enacted a special provision that allows tax-free treatment for up to $2 million of forgiven home mortgage debt — even if you are not bankrupt or insolvent. Because the $2 million limit is so high and because you don’t have to be bankrupt or insolvent, even millionaires can qualify for this ill-conceived tax subsidy. Nice work Congress.

Credits for Energy-Efficient Home Improvements

On my 2010 return, I claimed a $1,500 tax credit for installing energy-efficient windows in my home (the credit has since been reduced to $500). The $1,500 was a nice bonus for me, but it sure wasn’t good public policy. Why should other taxpayers be subsidizing my home improvements? Answer: they shouldn’t.

It gets worse. If you install more exotic (and expensive) energy-efficient home improvements like a solar water heating system or a geothermal heat pump, you can collect a tax credit equal to 30% of the cost. There’s no limit on the credit amount, there’s no phase-out rule for high-income taxpayers and vacation homes are eligible. So middle-income taxpayers are now subsidizing home improvements for billionaires’ vacation homes in Aspen. Do you see anything wrong with this picture?

Credit for Burying Hot Air

Legislation enacted in 2008 created a new tax credit for capturing carbon dioxide from industrial facilities and then storing it in “secure geological formations” or using it as a tertiary injectant in enhanced oil and gas recovery projects; tertiary injectants are pumped into the ground to force out more oil and gas. So this is literally a tax credit for capturing and disposing of hot air, which explains why it made sense to Congress.

Percentage Depletion for Oil and Gas Wells

Eligible oil and gas producers are allowed to deduct 15% of revenues as a so-called percentage depletion write-off. Here’s the problem: you should only be able to deduct things that actually cost you money. The 15% depletion write-off is based on revenue rather than expenses. In other words, the deduction has nothing to do with economic reality. While I’m all for energy independence and expanding domestic oil and gas production, it’s time to give the heave-ho to this longstanding but ill-conceived tax break.

Deduction for Domestic Production Activities

The quick history of this break goes like this: First Congress considered simply lowering the corporate income tax rate to stimulate domestic job formation. But that idea was too straightforward to allow for micromanagement, so Congress thought about inventing a targeted tax break for manufacturers. Sensing blood in the water, the lobbyists assaulted Washington in full force. The end result was the so-called “domestic production activities deduction.” With dazzling complexity, it gives big write-offs to, among others, producers of films and sound recordings, software developers, construction contractors, architects, farmers, and even honest-to-gosh manufacturers, too. However, if you run a restaurant, your domestic production activity was deemed unworthy of the deduction. Conclusion: It’s all about the lobbyists, baby.

Some people, including me, advocate for lower taxes. Others favor higher taxes. Whichever direction we choose, we need to go there with a simpler and fairer system. If we choose lower taxes, make it happen with across-the-board rate cuts that benefit everyone who pays taxes. Let the economic chips fall where they may. If we choose higher taxes, make it happen with across-the-board rate increases that spread the pain as widely as possible, with no exceptions for politically favored constituencies. Keep these thoughts in mind, because the winds of change are blowing, and the 2012 election will be here before you know it.

By Bill Bischoff
MarketWatch.com
April 14, 2011