Late last year, when the Internal Revenue Service published guidance about capital gains tax exclusions on the sale of your home, giving millions of home sellers an early Christmas present, it also sent a little package of cheer to home-based business owners who sell their home.

As long as your qualified home-based business is in the same dwelling as your primary residence -- rather than some unattached structure on your property -- you don't have to allocate a home sale's capital gains between the home and the business, according to "Exclusion Of Gain From Sale Or Exchange Of A Principal Residence," U.S. Department of Treasury Decision 9030, published Dec. 24, 2002 in the Federal Register, Vol. 67, No. 247.

The provision is among the latest round of Congressional tinkering with the Taxpayer Relief Act of 1997. Law makers have been adjusting the landmark tax package since it was enacted more than a half decade ago.

Among numerous provisions, home sellers have most enjoyed the provision that says when you sell your home, up to $500,000 of capital gains is excluded from federal taxes for married couples who file a joint tax return. Up to $250,000 is excluded for those filing separate or single-filer returns. To qualify for the exclusion when you sell your home, you must have lived in your home as your primary residence for two of the past five years.

The tax relief law, which applies to sales made after May 6, 1997, also said if you qualify for and take the home-office deduction, that portion of your home designated as a work place was not eligible for the exclusion.

"If you used 10 percent of your home for a home-based business, 10 percent of the gain on the sale would be subject to capital gain taxes and you couldn't use the exclusion on that portion," said Marie Sternberger, an enrolled agent from Sunnyvale, CA.

That forced some home-based business owners to forego the home-based business deductions for two years in order to maintain the two-out-of-five primary residency requirements for the full capital gains tax exclusion.

That's no longer necessary.

Provided you meet the primary residency and other requirements, even if you operate a business from your home, you are entitled to the full tax exclusion on capital gains realized from the sale of your home, according to the IRS.

What's more, if you sold your home and were not able to take full advantage of the $500,000/$250,000 capital gains tax exclusion you can amend your tax return to do so. If you've already taken full advantage of the exclusion, it's not necessary to file an amended return.

There is a three-year statue of limitations on the amended return, meaning you likely can amend only the 1999, 2000 or 2001 returns.

"It's three years from the later of the due date of the return, including any extensions, or the date you actually filed," said Marie Sternberger, an enrolled agent in Sunnyvale, CA.

Don't forget, the Taxpayer Relief Act still requires that if you sell your home and you've taken a depreciation deduction, you still must recapture (or pay back) that depreciation at the rate of 25 percent. That's hasn't changed.

"It's (the new rule for home-based businesses) still a good deal, if you think about your tax reduction," said Sternberger.

Home-based business deductions (office, payroll, labor, auto, travel and entertainment expenses, business asset depreciation, supplies, items purchased for resale, etc.) reduce your net profit which in turn reduces your self-employment taxes and your income taxes.

"The home-office related tax reduction you are getting exceeds the 25 percent recapture amount," says Sternberger.

(Note: Along with, Treasury Decision 9030, additional capital gains exclusion law tinkering is available in the related Treasury Decision 9031 "Reduced Maximum Exclusion of Gain From Sale or Exchange of Principal Residence" also published in the Dec. 24, 2002 edition of the Federal Register.)

Tomorrow: How to qualify for the home-office deduction.

Published: January 16, 2003

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