Today's active real estate market, along with current tax laws, has opened up opportunities to invest in fixer-upper homes and make a nice tax-free profit.
The reason has to do with a tax law, passed in 1997, that increased the amount you can exclude from taxes after selling a home. If you qualify, you can walk away with as much as $500,000 tax-free if you're married and filing a joint tax return and $250,000 if you're single.
The tax law restrictions are much friendlier than they used to be. For example, homeowners can find a less expensive home at any age and get as much as $250,000 or $500,000 of tax-free profit. Before the 1997 law, a replacement home had to be of equal or greater value or you had to be older than 55 — and then, you could only avoid as much as $125,000 of capital gain.
To reap the current tax benefit, you must live in your principal residence for two out of the past five years. Here's where the money-making opportunity comes in. There's no limit to the number of times you can renovate and resell a house for the tax-free profit, as long as you own and live in the house for the required two years.
How Lucrative Can this Be? Let's say you find a structurally sound home that needs cosmetic work and buy it for $200,000 - a substantial discount from surrounding, better-maintained properties. You move in and spruce the place up in your spare time, spending $20,000 on paint, wallpaper and new carpeting. Two years later, you sell the house for $330,000 and pay $10,000 in closing costs. Your profit is a cool $100,000. (This is calculated by taking the $330,000 sales price and subtracting the $200,000 original cost, $20,000 fix-up expenses and $10,000 closing costs.)
If building sweat equity appeals to you, it's perfectly legal to move on to another house and repeat the process. The best part: You don't owe a cent in federal taxes.
Now compare this profit to earning a salary. In the 25 percent tax bracket, if you make $100,000 annually, you owe $25,000 in federal taxes — and that doesn't include Social Security, Medicare and any state taxes.
As you can see, selling homes for a profit can be a great way to earn tax-free dollars. In most cases, the key is finding the right house in the right neighborhood and spending the time to improve it. You get the fulfillment of turning an eyesore into an asset — and tax-wise, it may beat "regular work."
Hang on to receipts. Records relating to home improvements will come in handy if your profit exceeds the $250,000 amount for single taxpayers or $500,000 for married couples filing jointly. Qualified expenses can affect the adjusted basis, which is used to figure gain on the sale of a home.
Choose improvements carefully. Some fix-up projects do little to boost the resale prices and eat into profits.
Consider all costs. When evaluating a property, don't forget to factor in costs such as mortgage points, credit report fees, escrow charges and appraisal fees.
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