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Home Improvements - Backdoor Tax-Free Income

Congress didn't mean to, but when it passed the home sale exclusion rules it created a "handyman's special" tax shelter. The exclusion of up to $250,000 of gain on the sale of a principal residence for single individuals or up to $500,000 for marrieds (discussed later), creates a tax break that can be used by you in an unintended way if you're handy and make your own home improvements. Gain excluded when you sell your home is not limited to gain from market appreciation. If you can personally install improvements to your home that increase its value beyond your cost for materials, you can pocket the increase in value from your labor tax-free when you sell the home. In effect, you are selling your labor but don't have to pay tax on the payment you receive for it. It's like receiving tax-free compensation.

Example. Assume you're good with tools and decide to add a room to your house. You use $8,000 worth of materials and build the room with your own labor, and maybe with a little help from handy friends. The extra room brings you $15,000 more for your house when the house is sold three years later. You receive the $7,000 "income" attributable to your labor ($15,000 - $8,000) tax free under the home sale exclusion rules.

That's not bad. But what if you take it a step further?

Now suppose you buy a "handyman's special" house, move in, renovate it over a two-year period, then sell it at a profit. If the renovated house is your principal residence, the gain can be wholly tax free, assuming it doesn't exceed the $250,000 (or $500,000) exclusion limits. This would be true even if you house-hopped every two years after a renovation.

House Hopping. This extraordinary tax break may lead some homeowners to house hopping - that is, buying, improving and then selling house after house. The strategy would be workable in areas of the country where home prices are rising. Carried out over a period of years, it would permit earning large amounts of tax free income. Of course, family and social considerations have to be taken into account, in addition to the career and economic aspects.

But suppose you're not handy or don't have the time or inclination to make home improvements. There may be another opportunity.

High Price Housing Areas. If you live in a high price housing area with appreciating values or plan to move to one, you might be able to shield substantial amounts of gain from tax without doing much in improvements. For example, suppose you live in a house in an area with rapidly appreciating values you bought for $200,000, all cash, and the house is now worth $450,000. You might make out well if you sell the house, invest $300,000 of the proceeds in a new house in the area, pocket $150,000 in tax free cash and hope to repeat the process in two or more years when the new home has appreciated in value to, say, $400,000. On an after-tax basis, house-hopping could be a highly profitable investment in an area with fast rising home prices.

Observation. If you use a mortgage to finance the purchase of the house, you "leverage" your investment by reducing the amount of cash you need to purchase the house. This means that when you sell the house, the return on your out-of-pocket cash investment is higher, perhaps dramatically so. But there is a downside to mortgage leverage, and the bigger the mortgage the greater the danger. If the market goes south and the house is hard to sell, you have keep making the mortgage payments or the lender can foreclose on the house.

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