What Critter-3 said about dollars sent to the FSA is true. Any dollars shown in Box 10 on the W-2 (which the employer transfers to your FSA) are not taxable IF AND ONLY IF they are shown to have been used for child and dependent care expenses, according to form 2441.
As you wrote, "it should be free of tax if they are used for dependent care". The problem is that they weren't used for dependent care expenses, because they exceeded the $3,000 limit for one child, as documented by the 2441.
What you should try to do - if your employer will let you according to the terms of the FSA - is try to carry forward the $1,985. It won't help you this year, but you will be able to apply it to dependent care expenses next year.
The real problem is that Child and Dependent Care expenses doesn't work the way that most taxpayers think. You are not allowed to deduct all the dollars that you spent on child care, but only dollars that you can show meet the rules on the 2441, and which don't exceed $3,000 for one child or $6,000 for two or more. The rest of the dollars bring you no tax benefit.
Also, the $5,000 for the FSA must meet the rules of the 2441. In your case, with one child, your tax benefit can apply to only one child, so a limit of $3,000. Since the remaining $1,985 cannot satisfy the rules of the 2441, then it must be automatically added back to your taxable income (because the entire $4,985 was removed from Wages in box 1 before the W-2 was printed.
You might look at the TurboTax FAQ "The Ins and Outs of the Child and Dependent Care Credit" but note that this article is focused on the credit and not the deduction but both are a function of form 2441.
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