Legally avoiding capital gains taxes on flips, and keeping your sanity

In 1997, Congress passed the Taxpayer Relief Act that, among other things, changed the way capital gains taxes were assessed on home sales. Prior to this Act, you only avoided capital gains taxes if you purchased a home that was equal or more expensive than your previous one. Sellers over age 55 could take a one-time-only exemption of up to $125,000 in profits.

But this Act is a boon for home sellers, and to a lesser extent, home flippers. Why? Because since May of 1997, you can write off up to $250,000 in profits if you are single, and up to $500,000 in profits if you are married. But wait, there's more! This isn't a once-in-a-lifetime opportunity, you can now do this every two years, for the rest of your life!

There are a few catches, of course. (This is the Federal Government after all.)

1.) This only applies to your primary residence. You have to live in and own the home for two of the last five years. Those years don't have to be continuous, but they do have to add up to 730 days out of the last five years.

2.) You can only take the exemption every two years. You can't live in the home for two years, move to another one and live there for two years, then sell both at the same time and take two exemptions.

Thus ends the list of catches. Pretty sweet for a Federal program.

My husband and I have taken advantage of this four times. I sold my condo and netted $25,000 right after we got married. We sold his house and netted $135,000 a few years later. We flipped a house and netted $65,000 and took all that money and put it into a house we practically rebuilt and netted $180,000 in the middle of the housing bust. (I still think about the projected profits on that property had the market not taken a nosedive. We could have gotten very close to the top of the married-couple profit limit. Sigh.)

So how do you take advantage of this program and pay no capital gains taxes on a flip? Easy, live there as your primary residence while you are flipping. Wait, what?!?

We have lived in every house we have flipped thus far. Every house we have flipped has been a major overhaul. Not a room left untouched. We have done at least 90% of the work ourselves, so it takes most of those two years just to complete the flip anyhow.

I'm not going to try to lie to you and tell you it is the most fun I have ever had, living in a house that is under active construction. But it is doable and all that free money is a huge incentive to make it work. We took vacations and mental-health days to avoid burnout.

And it wasn't all bad. Drywall days are the worst, and washing dishes in the bathtub because the kitchen is torn apart certainly weren't among my fondest memories. But cashing that giant check made it all worthwhile.

Keys to keeping your sanity while living through the flip

So how DO you live through all that mess and still be mentally competent? Prepare in advance. While you can't predict everything, there are some things you can do to make your experience smoother sailing.

Organize yourself
This is a vital point to hammer home. If you do not have an organized place to work, you will descend into chaos, which will drive you straight to the mental hospital. Know where your tools are. Know what the next few steps are on any project, and have backup projects to work on when you hit a snag or finish faster than you expect. (Top tip: You will never finish faster than you expect.)

Knowing where your tools are is a HUGE time saver. I have multiple copies of numerous tools because I couldn't find it when I needed it, and I needed it right then and there. Somehow, I always live close to a big box home improvement store, and sometimes it was just easier to go buy another. Get yourself a tool belt, and wear it proudly. Be the pro you are.

Knowing the order of things to be done can also be a huge time saver - if you run into a snag with one project, your entire workday isn't wasted. Just move on to the next phase or project until you can resume the first task.

Prepare for demolition and drywall mess
OK, this is kind of a misnomer, because there is no way to prepare for the level of mess that demolition and drywall creates. Think of a toddler with an open bottle of baby powder. Times a million.

You can tape and tarp as much as you want, but drywall dust will get everywhere. When you tear down the old, the dust gets into every crack and crevice you didn't even know you had. When you put the new drywall up, the mess finds all new cracks and crevices you didn't know you had. In fact, drywall is one of the jobs I recommend hiring out. They do it better and faster than you, for slightly more than it would cost you in materials in the first place. Honestly, it would be a bargain at 12 times the price.

The only way to possibly prepare for these steps of the process is to get as much of your stuff out of the house as possible. Put it in storage or put it in the garage. Even putting it in some other part of the house with doors closed and a towel in front of the space at the bottom of the door will help, although don't be fooled into thinking that will eliminate the mess, because it won't.

Clean as you go
It goes without saying that your home isn't going to be in pristine condition at all times. Construction is messy. But it doesn't take much time to tidy up at the end of your workday, and you should plan a little time to make sure you aren't tracking dust into other parts of the house. Put your tools back where they belong so you can find them when you need them. We always set up tool shelves in a central part of the house so we could find them easily. In theory. But every once in a while we wouldn't put it back in the right spot, couldn't find it, and had to run to purchase a new one. I have 12 utility knives. That I can find right now. Sigh.

Plan downtime
We always lived in our flips, and we had two years to complete the work before we could sell, to avoid capital gains taxes. So we planned breaks. Some were full-blown vacations, while others were just a weekend away or even simply a night off. Taking a mental health break is vital to avoiding a meltdown.

Keep your focus
The whole reason for living in a home during a flip is to save money. Whether on rent or avoiding capital gains taxes when you sell, living in a flip can save you significant cash. It can also test your reserve. Keeping your focus on the end result can help you keep your sanity.

So how about you? Have you ever lived in a house you are flipping? How did it go? Do you have any tips to add?