IRS Tax Rules on Sale of Home Aid Providers

January 2003

It just became a lot easier for family child care providers to avoid paying capital gains taxes when they sell their homes.

This is because of a final IRS home sale regulation (Treasury Decision 9030) enacted on December 24, 2002. This regulation reflects changes to the law passed in 1997 as part of the Taxpayer Relief Act. Under the 1997 law, taxpayers could exclude from taxes up to $250,000 ($500,000 for most joint returns) of the gain on the sale of the home if the taxpayer both owned and used the home as a principal residence for at least two of the five years before the sale. This rule could be used again every two years. Taxpayers could count days (730) or months (24) to meet this two-year use goal.

Under the 1997 law, family child care providers could not count days towards this goal in which they conducted business in their home. This made it difficult for many providers to meet this two-year goal. Under this rule many providers had to allocate the profit on the sale of their home between their business and personal use and pay capital gains tax on the business portion.

This new rule represents a dramatic change. Providers can now count all days they are using their home towards the two year goal whether or not they are running their business on a particular day. There is no longer any distinction between a business and a personal day. A provider who cares for children Monday through Friday can now count this as five days of use of her home. Let's look at an example: If a single provider bought her home on January 1, 1996, sold it on January 1, 2002, and ran her child care business for the entire six years, she would avoid paying any taxes on the first $250,000 of the profit on the sale because she owned and used it for at least two of the last five years. This would be the same outcome even if the provider used one or more rooms in her home exclusively for business purposes.

This new rule means that providers will not need to conduct a like-kind exchange to avoid paying capital gains tax. Rules regarding exclusive-use rooms have not been changed. In other words, a provider may still claim a higher time-space percentage if she uses a room in her home exclusively for her business.

Under the 1997 law it was not clear whether providers could count the hours, rather than days, they were not in business to meet the two year goal. Under the new rule, counting hours is no longer relevant. Full days can be counted as long as the provider owns and lives in the home. Providers can count days even if they are away from the home for short absences, such as a summer vacation or other seasonal absences.

The new law does not change the provision that providers must still pay capital gains tax on any home depreciation claimed (or entitled to be claimed) after May 6, 1997. Providers who do not claim home depreciation will still owe tax on it when they sell their home.

Providers who have sold their home between 1999 and 2002, didn't meet the two year personal use goal, and paid capital gains tax on the business portion of the profit on the sale under the 1997 rules can now, under the new law, amend their tax return and get a refund of these taxes paid. April 15, 2003 is the deadline for amending the tax return for home sales in 1999.

The new rule makes several additional clarifications and changes:

• Capital gains taxes on the sale of vacant land that a provider owned and used as part of her principal residence will also be excluded from tax (up to $250,000 or $500,000 for both the home and land) if it's sold at the time of the sale of the home or within two years before or after the sale of the home. Vacant land that is sold by itself will be subject to capital gains taxes if the land was used in the child care business.
• If a provider uses a building for her business that is separate dwelling unit from her home, it will be subject to capital gains taxes when it is sold unless the provider can show two years of personal use, without counting days in which the business was operated. The new rule does not clarify if a provider's detached garage should be considered part of her principal residence and thus not subject to capital gains tax. I believe that it should be considered part of the residence because it is considered part of the definition of the home in IRS Publication 587 Business Use of Your Home. A provider who sets aside her basement area (even with a separate entrance) does not have a separate dwelling unit, unless there is no interior connection between the basement area and the rest of the home.


• In summary, the only three situations in which a provider would owe capital gains tax on the profit of the sale of her home are:
  
  
  1. The provider operated her business in a building separate from her home and did not have two years of personal use as a primary residence in the last five years of ownership.
  2. The profit on the sale of the home exceeded the $250,000/$500,000 exclusion amounts.
  3. The provider owned and used her home for less than two years before selling it and could not meet the reduced exclusion exceptions of a change in place of employment, health, or unforeseen circumstances (see below).
  
  If any of these three situations occur, the provider must allocate the business and personal portion of the gain and pay tax on the business portion of the gain. The business portion of the allocation will be based on the method used in claiming deprecation. This will usually be the Time-Space percentage. In other words, if the Time-Space percentage was 40%, then 40% of the gain is considered business gain and subject to tax. If the personal portion of the gain exceeds the $250,000/$500,000 limits, then tax is also owed on the excess amount above these limits.
• The new rule states that the IRS will not challenge a provider's position that her home sale after May 6, 1997 and before December 24, 2002 qualified for the exclusion of taxes under the 1997 law if the provider has made a "reasonable, good faith effort to comply" with the 1997 regulations. This seems to indicate that providers who counted hours to meet the two year goal during this time will not be challenged if audited.

If, in an rare situation, a provider did owe capital gains tax on the business portion of the profit on the sale of her home, the calculation to determine the tax has been modified by this new rule. If the depreciation claimed on the property is less than the gain on the sale of the property, the provider only owes capital gains tax on the gain in excess of the depreciation. For example, let's say a provider operated her business out of a separate building from her home and claimed $9,000 in depreciation on this property while it was used in business. She then sells the separate building for a $14,000 gain. The provider would owe capital gains tax only on the difference ($14,000 - $9,000 = $5,000), plus tax on the $9,000 depreciation (Section 1250 gain).

If the depreciation claimed on the property is more than the gain on the sale of the property, the provider would only owe capital gains tax on the gain, not the depreciation. For example, let's say in the above situation the provider sold the separate building for a $7,000 gain. The provider would owe capital gains tax (Section 1250 gain) on the $7,000, but would owe no tax on the $9,000 depreciation.

Reduced Maximum Exclusion of Home Sale Gain

The IRS also issued temporary regulations in a second Treasury Decision (9031) on December 24, 2002, that deals with the exclusion of gain on the sale of a home where the taxpayer has owned or used their home for less than two of the last five years before the sale or has sold a previous home within the past two years. In these situations, a taxpayer or provider may be eligible to exclude a part of the gain on the sale. The part that is excluded from taxes is limited to the percentage of the two years that the provider fulfilled the requirements. Thus, a provider who owned and used the home for one year (half of two years) would be eligible to exclude up to half of the regular amount, or up to $125,000 of gain ($250,000 for most joint returns).

To be eligible for this reduced exclusion, providers must sell their home for reasons of a change in place of employment, health, or unforeseen circumstances. Providers can meet the change of employment test if her primary reason for the home sale is a change in the location of her business or a change in her spouse's employment. If the move is at least 50 miles away because of a change in employment, it is automatically assumed that the primary purpose of the move is because of a change in employment.

If the home sale is due to advanced age-related infirmities, a need to move to care for a family member, severe allergies, or emotional problems, then these health reasons will allow providers to take advantage of the reduced exclusion rule.

The third trigger for the reduced exclusion is unforeseen circumstances. These are defined in the new rule as death, loss of a job in which the person (the provider's spouse) is eligible for unemployment compensation, a change in employment that results in the inability to pay housing costs and reasonable basic living expenses, divorce or legal separation under a decree of divorce or separate maintenance, multiple births from the same pregnancy, involuntary conversion of the home, a natural or man-made disaster, or act of war or terrorism that results in a casualty to the residence.

For more information, go to www.irs.gov. If you have questions about this rule, call us at 651-641-6675 or email rni@redleafinstitute.org.