Can a Tax Credit Result in Negative Tax Liability?

Tax liability is the amount of tax owed on your level of income, not the amount of refund or balance due on your tax return. The liability is based on your level of taxable income minus adjustments, exemptions, deductions and credits. It is entirely possible to have zero or even negative tax liability.

Tax breaks come in two flavors: A deduction is the amount you subtract from your income, such as for mortgage interest payments, charitable contributions, and unreimbursed business expenses if you itemize. You take a standard deduction if you don't have enough to itemize. Deductions reduce your taxable income. In contrast, credits are subtracted from your tax liability. They reduce the tax owed dollar for dollar. Deductions result in lower tax liability at a lower ratio depending on your tax bracket.

Credits also come in two varieties: refundable and nonrefundable. Nonrefundable credits are subtracted from your tax bill only up to the amount you owe, so the best you can do is to owe nothing. Refundable credits can exceed what you owe, and that's where you may end up with negative tax liability and a nice refund. They include the adoption credit, the credit for undistributed capital gain, the first-time homebuyer credit, the health coverage tax credit, the earned income credit, the additional child tax credit, and the American Opportunity Credit.

If you adopted during the tax year, file Form 8839 to claim the adoption credit. File Form 5405 for the first-time homebuyer credit (it expired in 2010, but you can still claim it on an amended return if you qualify). Use Form 8885 for the health coverage tax credit and Form 2439 for the undistributed capital gain tax credit. File Form 8863 for the American Opportunity Credit. Note that this credit has a refundable and a nonrefundable portion based on the amount of educational expenses paid. Claim the additional child tax credit on Form 8812.