Are you handy--a contractor, carpenter, or just good at home repair? If you're the type of person who can upgrade a fixer-upper home by yourself, you can end up earning a substantial amount of tax-free income if you buy and live in the home for at least two years.
Here's how it works. You buy a fixer-upper and live in it. During this time you perform substantial improvements. For example, you could completely restore an old house in disrepair; or you could purchase a house in somewhat better condition and do more modest upgrades, such as redoing the kitchen or bathroom, updating plumbing and electrical, or adding a room.
You perform all or most of the labor yourself, so you only have to pay for materials.
After you've lived in the house for at least two years, you sell it. Because the improvements increased the value of the home, you earn a substantial profit on the sale. However, none of this profit is taxable because you qualify for the $250,000/$500,000 home sale exclusion. The work you did upgrading the home resulted in income, but that income is tax-free.
Example: Jack, an unmarried carpenter, purchases an old Victorian house in Northern California for $300,000. The home is in a good neighborhood, but in need of substantial repairs and upgrades. Over the next two years Jack completely rehabilitates the house. He spends $50,000 for materials, but nothing for labor since he does all the work himself. Jack sells the house after living in it for two years. The renovated house sells for $500,000. Jack has earned a $150,000 profit on the sale: $500,000 sales price - $300,000 basis - $50,000 materials costs = $150,000 profit. Because the house was Jack's principal residence for more than two years out of the five years preceding the sale, Jack qualifies for the $250,000 home sale tax exclusion for single homeowners. This means his entire $150,000 profit is tax-free. Jack ended up earning $150,000 off his labor, but had to pay no taxes on the income.
You can do this over and over again so long as you live in each home for at least two years, you'll qualify for the home sale exclusion--$250,000 if you're single, $500,000 if you're married filing jointly.
Obviously, this technique works best for people who can do home improvements on their own or are willing and able to learn.
The $250,000/$500,000 home sale tax exclusion was not designed to enable handymen and handywomen to earn tax-free income, but that has been one unintended effect of the law. It does give handy people a strong incentive to purchase run down homes and fix them up.
See Nolo's Homeowner Deductions and Credits section for related articles on real estate taxes.