Parents, stepparents and other people
raising children need to be aware of a significant
change in the way "qualifying children" are defined
under the tax law for the purpose of claiming several
INVESTORS: Don't Forget Tax-Favored
Treatment for Gains From Broad-Based Equity Index
The current federal income tax rates
on long-term capital gains are so low, you should
generally try to satisfy the more-than-one-year
holding period rule before selling appreciated
securities held in taxable investment accounts.
That way, you’ll pay no more than the 15 percent
maximum federal rate on long-term capital gains.
However, you may not always invest
for the long term. For instance, you may sometimes
speculate on stock index movements by making
short-term trades in ETFs (exchange traded funds)
like QQQ (which tracks the NASDAQ 100 index) and
SPDR (which tracks the S&P 500 index). Of
course, your short-term ETF trading profits will
be taxed at ordinary income rates, which can be as
high as 35 percent.
Fortunately, a special
taxpayer-friendly exception applies to profits
from trading in broad-based equity index options.
The tax law treats these broad-based options as
Section 1256 contracts. This is good for
your 2005 tax return, because gains and losses
from going long or short in Section 1256 contracts
are automatically considered to be 60 percent
long-term and 40 percent short-term. (Source:
Internal Revenue Code Section 1256(a)(3))
In other words, your actual holding period
for the option doesn’t matter. The tax-saving
result is that your 2005 short-term profits from
trading in broad-based equity index options will
be taxed at a maximum effective rate of only 23
percent [(60 percent times 15 percent) plus (40
percent times 35 percent) equals 23 percent]. The
effective tax rate is even lower if you’re not in
the top 35 percent bracket.
You can trade broad-based equity
index options that track major stock indexes and
major industry sectors like oil, pharmaceuticals,
defense, and biotech.
A qualifying child can enable a taxpayer
to claim several tax breaks, such as head of household
filing status, a dependency exemption, the child tax
credit, the child and dependent care credit and the
earned income tax credit. In the past, each of these
items defined a qualifying child differently, leaving
many taxpayers confused.
Working Families Tax Relief Act set a uniform
definition of a qualifying child, beginning with the
2005 tax year. This standard definition applies to all
five of the tax breaks listed above, with each benefit
having some additional rules.
in the process of standardizing the definition of a
qualifying child, some unexpected consequences have
occurred. Some taxpayers who could claim child-related
tax breaks in the past are no longer eligible and other
people may benefit in ways that Congress never
In general, four tests must be met in
order to be a taxpayer’s qualifying child:
- Relationship – The
child must be the taxpayer’s child or stepchild
(whether by blood or adoption), foster child, sibling,
stepsibling, or a descendant of one of these.
- Residence – The child
must have the same principal residence as the taxpayer
for more than half the tax year. Exceptions apply, in
certain cases, for children of divorced or separated
parents, kidnapped children, temporary absences, and
for children who were born or died during the year.
- Age – The child must be
under the age of 19 at the end of the tax year, or
under the age of 24 if a full-time student for at
least five months of the year, or be permanently and
totally disabled at any time during the year.
- Support – The child
cannot provide more than one-half of his or her own
support for the year.
qualifying child is claimed by two or more taxpayers in
a given year:
- The child will be the qualifying child
of the parent.
- If more than one taxpayer is the child’s
parent, the qualifying child goes to the one with whom
the child lived for the longest time during the year,
or, if the time was equal, the parent with the highest
adjusted gross income (AGI).
- If no taxpayer is the child’s parent,
the taxpayer with the highest AGI gets to claim the
Here are a couple of examples of taxpayers
who could be affected by the law:
- An over-age-19 child living in a
parents' home could potentially claim a younger
brother or sister as a qualifying child for purposes
of the dependency exemption, the child tax credit, and
other benefits — if the parents have income that is
too high to benefit from those tax breaks. This may
be true even if the older sibling provides no
support to the younger child, because the new law only
requires that the child not provide more than half of
his or her support. With the right set of
circumstances, this could benefit families with an
older child living at home and earning too much money
to be claimed as the parents' dependent. (Congress may
amend the law in the future to eliminate
Loser - A taxpayer who lives with, and
supports, a child who is not his or her own, generally
does not get tax benefits for a qualifying child if he
or she lives with but is not married to the child's
As noted above, each of the child-related
tax breaks has its own set of rules in addition to the
four qualification tests that must be met. If you are
supporting a child, your tax adviser can provide more
information in your situation.