How to Get $250K in Tax-Free Money Every 2 Years

Looking to keep more of your hard-earned money from the tax man? Well, you're going to love this tax exclusion.

How You Can Exclude up to $250,000 Tax-Free on the Sale of Your Primary Residence

Provided you meet the following requirements, you can receive up to $250,000 tax-free when you sell your primary residence. If you are married, filing jointly, you can exclude up to $500,000 tax-free. Here are the criteria that must be met to take this exclusion…

• You owned the residence for any two of the last five years.
• You occupied the residence for any two of the last five years.
• You haven't used the exclusion within the last two years.

The two years of ownership and the two years of usage don’t have to be the same two out of five years. Here’s an example that explains this point…

Example: Katie & Dan rent from a landlord for one full year. In Year 2, Katie & Dan decide to purchase the home from the landlord, and live in it for a full year. In Year 3, 4 and 5, Katie and Dan rent out the home to the Joneses. Upon the sale of the home, Katie and Dan would be allowed to use the exclusion, because they have owned the home for two out of five years (Years 2, 3, 4, & 5), and they have used the home as their primary residence for two out of the last five years (Years 1, and 2).

For those who own summer homes, or more than one residence, you can use the exclusion to avoid capital gains taxes (up to $500,000) on ALL your homes, provided you meet the requirements.

Example: Mary sells her home for a $210,000 gain and uses the tax exclusion. She then moves into her summer home in Florida and lives there for two years. After the two-year period has ended, she sells her second home. She may use the exclusion again—every two years. How’s that for a great tax strategy?

Depreciation Recaptured

Note: If you've taken any depreciation on your home after May 6, 1997, any gain up to that amount of depreciation will be taxable at your normal rates, up to a maximum of a special long-term capital gain rate of 25%, as long as you have owned the property for at least one year. If, however, you have owned the property for less than one year, the prior depreciation taken will be taxed at your ordinary income tax rates. Let’s look at an example.

Example: Jessica sells her home for a $230,000 gain. Over the past seven years, Jessica had used her home as a home office and claimed depreciation on the office portion. If the total depreciation taken after May 6, 1997 was $8,000, then Jessica must pay tax on $8,000 at the rate of 25% when she sells the home. If Jessica had owned the house for less than 12 months, then the tax rate on this depreciation would be at her ordinary income tax rates (which could be much higher than 25%).

How to Exclude Up to $250K on Investment & Rental Property

Let’s assume you own a house that you rent to tenants. You have been renting this house to tenants for the past four years, and the house has significantly appreciated in value. You would like to sell the house and pocket the gain. Unfortunately, you’re going to be stuck paying several thousand dollars in taxes when you sell the home. To make use of the exclusion, here's what you do…You will need to move into the rental home and live in it for a full two years. After the two-year period is over, you can sell the home and exclude up to $250,000 of the gain if single, or $500,000 if married and filing jointly. One caveat, however: You will be required to pay tax on any prior depreciation you took on the rental property. The following example explains this…

Example: Amy owns a townhome that she rents out which has appreciated by $120,000. Amy has taken a total of $10,000 in prior depreciation on the townhome. If Amy sells the townhome, she would have to pay tax on the entire $120,000 of the gain. If, however, she moves into the townhome and lives there for two years, she would only have to pay tax on the depreciation taken (25% of $10,000 which equals $2,500).

How to Gain $1 Million Dollars Tax-Free

A married couple that I recently met (at a local REIA), have developed the following financial plan to capitalize on this tax exclusion…

For each of our primary residences, we’re planning to live in them for two years then rent them out for three, then sell. We’ll take the capital gains tax free since we lived there two out of the last five years each time.

Not a bad strategy. You would only need *four* $250K exclusions, and you've got $1 million tax-free. But that's "easier said than done." It's pretty tough to get a home to appreciate $250K in only 5 years. If you buy below market value and purchase in areas that are experiencing strong growth, it's certainly possible to get $80K appreciation every five years. That would translate to an average price appreciation of $16K a year. That's a reasonable expectation, assuming you bought the home below market value. Also, in some areas, price appreciation could be significantly higher than $16K/year.

If you amass $80K in tax-free gains every 5 years, then you'd only need 13 properties to generate one million tax-free. Hmmmm.