Section 136: Foster Care Payments, Taxability, and the EIC Election

Under federal tax rules for foster care payments, the money you receive from a state or local government (or a state-licensed placement agency) for caring for a foster child or foster adult in your home is generally not taxable. Internal Revenue Code Section 131 excludes these payments from gross income, and the same exclusion reaches “difficulty of care” payments for individuals with disabilities and, through IRS Notice 2014-7, certain Medicaid waiver payments to in-home caregivers. The exclusion has limits, though, and in some situations you’ll want to elect to count the payments as earned income anyway so you can claim credits like the Earned Income Credit.

Which Foster Care Payments Are Tax-Free

Three things have to line up for a payment to be excluded from your income. If any one is missing, the exclusion doesn’t apply.

First, the payment has to come from the right source: a state or local government, or a foster care placement agency that’s licensed or certified by the state to make payments on the program’s behalf.¹ Payments from private individuals or organizations that sit outside the state’s foster care program don’t qualify.

Second, the payment has to go to a foster care provider, meaning the person actually maintaining the foster individual in their home.

Third, the person being cared for has to be a qualified foster individual: someone living in your home who was placed there by a state or local agency, or by a state-licensed placement agency.¹ There’s no age limit in the basic definition. The individual can be a child or an adult, so long as the placement went through proper channels.

When all three boxes are checked, the payment is treated as support for the foster individual rather than income to you. Your monthly stipend from the state simply doesn’t appear on your federal return.

Difficulty of Care Payments

Many providers receive additional compensation for caring for individuals who need more intensive support because of a physical, mental, or emotional disability. These difficulty of care payments have their own rules under Section 131.¹

To qualify, the payment must compensate you specifically for extra care that the state has determined is necessary because of the individual’s disability, the care must be provided in your home, and the paying agency must designate the payment as difficulty of care compensation. An agency that simply raises your base rate without labeling the increase as difficulty of care creates ambiguity about how the exclusion applies.

The cap here is by headcount, not dollars. You can exclude difficulty of care payments for up to 10 qualified foster individuals under age 19 and up to 5 individuals age 19 or older.¹ A similar cap of 5 applies to regular foster care payments for individuals over 19. Few foster homes come close to these ceilings, so in practice most difficulty of care payments are fully excludable.

Medicaid Waiver Payments

IRS Notice 2014-7 extended the Section 131 exclusion to a group of caregivers who often don’t think of themselves as foster parents. If you’re paid through a state Medicaid Home and Community Based Services program to care for someone who lives in your home, those payments are treated as difficulty of care payments and can be excluded from your income.²

Your relationship to the care recipient doesn’t matter. You could be a parent caring for a disabled adult child, a spouse, or someone unrelated. What matters is that the care recipient lives in your home and that the Medicaid waiver program is administered by a state or certified Medicaid provider. The same headcount limits apply: no more than 10 individuals under 19, or 5 age 19 and older. The IRS has also clarified that the exclusion reaches payments from non-waiver Medicaid Home and Community Based Services, not just traditional waiver programs.

When Foster Care Payments Become Taxable

The exclusion isn’t unlimited. Two situations produce income you’ll need to report.

The first is compensation for professional services. If an agency pays you a separate fee for services beyond basic foster care, such as therapeutic services, case management, or professional counseling, that payment is taxable. This is where audits tend to focus. If your payment agreement breaks out a portion as a professional service fee, that portion is ordinary income no matter how many foster children live in your home.

The second is going over the numerical caps. Care for 12 children under 19, and payments attributable to 2 of them become taxable because the exclusion stops at 10. Same principle if you care for more than 5 individuals age 19 or older. This is narrow but real for large group homes.

How you report any taxable portion depends on whether your foster care activity rises to the level of a business. An activity is a business if your primary purpose is earning income and you carry it on with regularity and continuity.³ If it is, taxable amounts go on Schedule C and trigger self-employment tax. If it isn’t, the taxable amount goes on Schedule 1 as other income.

The Election That Can Unlock the Earned Income Credit

Excluding your foster care or Medicaid waiver payments can quietly cost you money. Both the Earned Income Credit and the refundable portion of the Child Tax Credit require earned income. If everything you receive is excluded under Section 131, your earned income for credit purposes can drop to zero, and the credits vanish with it.

The IRS now lets you choose. You can elect to include all of your otherwise-excludable payments as earned income when calculating the Earned Income Credit and the refundable portion of the Child Tax Credit.² The election is all-or-nothing: include all the payments for credit purposes, or include none. Either way, the payments still stay out of your taxable income. You’re only telling the IRS to count them when it decides whether you qualify for these credits and how large they should be.

For a foster parent caring for multiple children on modest income, the election can be worth thousands in refundable credits. Run the numbers both ways before you file.

Claiming a Foster Child as a Dependent

A foster child placed in your home can be your qualifying child for dependency purposes, which opens up several more benefits. The IRS treats an eligible foster child the same as a biological or adopted child for the relationship test.⁴

You still have to meet the standard qualifying child rules:

Residency: the child lived in your home for more than half the tax year. Temporary absences for school, medical care, or detention count as time lived with you.⁵
Age: under 19 at year-end, under 24 if a full-time student, or any age if permanently and totally disabled.⁵
Support: the child didn’t provide more than half of their own support during the year.

A child placed with you partway through the year can still qualify if the child lived with you for more than half the time the child was alive that year. Meet the tests and you can claim the Child Tax Credit, worth up to $2,200 per qualifying child for 2025.⁶ A qualifying foster child also counts toward the number of children used to calculate the Earned Income Credit.

How to Report the Payments on Your Return

If your payments are fully excludable and no tax form gets issued, there’s nothing to do. The money simply doesn’t appear on your return. The complication comes when the paying agency issues a Form 1099-NEC, 1099-MISC, or W-2. Receiving a form doesn’t make the money taxable; it just means you have to reconcile the form with the exclusion so your return matches IRS records.

For Medicaid waiver payments, the IRS has specific instructions. If your payments are reported on a W-2 with Code II in Box 12 and Box 1 is blank or zero, and you’re not electing to include the payments as earned income for credit purposes, you don’t need to report the W-2 amounts on your return at all. If Box 1 has an amount, report it on Form 1040 line 1a and the Box 12 Code II amount on line 1d, then enter the nontaxable total as a negative number on Schedule 1, line 8s.²

If your payments come on a 1099-NEC or 1099-MISC and you don’t operate a business, enter the amount on Form 1040 line 1d and offset it on Schedule 1, line 8s. If you file Schedule C, include the full amount as income on line 1, then deduct the nontaxable portion in Part V (Other Expenses) with a notation referencing the exclusion.²

Agencies that know payments are excludable under Notice 2014-7 aren’t supposed to issue a 1099-NEC for those amounts.² Some do anyway. Don’t ignore the form. Report and offset it as described so the IRS sees a matched filing.

Keep copies of placement agreements, payment statements, and any documentation from the agency identifying payments as foster care reimbursements or difficulty of care compensation. These are your defense if the exclusion is questioned. Statements that split base care amounts from service compensation are especially useful, since only the care portion is excludable.

The Adoption Credit for Foster-to-Adopt Families

Foster parents who adopt a child from foster care can claim the federal adoption credit for qualified expenses, including adoption fees, attorney costs, court costs, and travel. For 2025, the credit covers up to $17,280 per child in qualified adoption expenses.⁷ The credit begins to phase out when modified adjusted gross income exceeds $259,190 and disappears entirely above $299,189.

If a state or tribal welfare agency determines the child has special needs, you can claim the full credit amount even if you paid little or nothing in actual expenses.⁷ This matters because many foster-to-adopt transitions involve minimal out-of-pocket cost, with the state covering most fees. Without the special needs designation, you’d be limited to what you actually spent.

Expenses reimbursed by your employer, paid by a federal or state program, or claimed under another credit or deduction don’t count. Surrogate parenting arrangements and stepchild adoptions are also excluded.⁷ Home study fees incurred before you’ve identified a specific child do qualify, which helps because that cost often hits early.

1
Office of the Law Revision Counsel. 26 USC 131 – Certain Foster Care Payments
2
Internal Revenue Service. Certain Medicaid Waiver Payments May Be Excludable From Income
3
Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship)
4
Internal Revenue Service. Dependents
5
Internal Revenue Service. Qualifying Child Rules
6
Internal Revenue Service. Tax Benefits for Parents and Families
7
Internal Revenue Service. Adoption Credit