Real estate investors are using a 2-part strategy to build equity and avoid capital gains tax

• Real estate investors are using a two-part strategy to build equity and sidestep capital gains tax.
• Step one is buying a fixer-upper with potential. Then, you rehab to add value while living in it.
• If you live in the home for two years before selling, you can capitalize on an IRS rule.

Real estate investor Whitney Ekins-Hutten flipped her first property in 2002 with the help of friends, who she paid in "beer, sushi, and pizza."

Over the past two decades, her strategy has evolved from flipping to long-term rentals to partnerships. Her investments helped her achieve financial freedom and allowed her to quit her job in 2019.

"There are so many ways to get started in real estate," said Elkins-Hutten, who is a financial educator and the author of "Money for Tomorrow." "When somebody tells me they can't get started, it's usually lack of perseverance or lack of creativity and resourcefulness."

She started with live-in flipping, which involves rehabbing a home to increase its market value while living in it.

While labor intensive, "it's what I needed to do in order to get the money," said Elkins-Hutten, who used the cash to buy long-term rentals and generate cash flow.

"The beauty of this strategy is you need a place to live," said Carl Jensen, who has done seven live-in flips with his wife Mindy. "You'd be in a much riskier situation if you had bought a separate house that you need to flip as soon as possible because you're just pouring money into it, whereas we're just paying the mortgage on our primary house."

There are sacrifices — you're essentially living in a construction zone — but it's a good way to test the rehab market and see if it's for you.

It can also be lucrative, and relieve you of paying income taxes when you sell. The Jensens, who are wrapping up their eighth live-in flip, estimate they've profited just over $1 million between their first seven, and have paid zero capital gains taxes on their property sales, thanks to an IRS rule.

Here's how the Jensens and Elkins-Hutten have built equity and sidestepped capital gains taxes in two steps.

1. Buy a fixer-upper with potential

Flipping properties is all about adding value — and it's difficult to do that if you buy the prettiest house on the block, said Mindy: "One thing that we have always focused on is finding that dumpy house in the great neighborhood."

They're patient and would rather wait for what they consider a great deal than jump on an OK deal.

"You make your money when you buy," said Mindy. "You don't want to get into a bidding war and overpay by 10, 20, $30,000. That could be your whole profit. There's always another house, so definitely don't fall in love with something."

A major benefit of using the flip as a primary home is that you could qualify for a first-time home buyers loan, noted Elkins-Hutten, meaning you could "go in at 3% down or 5% down on a property to start off."

2. Renovate the property and sell after at least 2 years to avoid capital gains tax

If you buy a home with a good foundation, the rehab will be time-consuming but not necessarily hard, said Carl, who did almost all of the renovation work himself: "Anyone can learn how to do flooring. It's not that hard to swap out a toilet. You can go on YouTube and figure that out in a couple of minutes."

If you're doing more of a significant and expensive rehab, Elkins-Hutten recommends looking into an FHA 203(k) mortgage, which rolls the cost of a home and the cost of repairs into one loan.

"It's a little harder to get, but the cool thing is that the bank is subsidizing a lot of that. You're going to have to use licensed contractors and all of that, but it's a great opportunity to use other people's money to get started to build your own bucket of equity," she said.

You'll want to wait at least two years before selling your live-in flip to capitalize on an IRS rule known as the Section 121 Exclusion. This lets taxpayers exclude up to $250,000 ($500,000 for a couple filing jointly) of the gain from the sale if they've used the home as a primary residence for at least two of the five years preceding the sale.

The main requirement is that you must use the home as your main residence for at least two of the five years preceding the sale. If you're selling a vacation home, for example, you can't use the exclusion.

Note that you can only use the exclusion every two years.

The Jensens used the exclusion for the first time in the early 2000s. After buying a home for $135,000, replacing the carpet, painting the walls and front door, and redoing the bathrooms, they sold it for $235,000, they said.

"Because we lived in it and owned it for two of the past five years, we paid no taxes on the capital gains," explained Mindy. While their gains were around $100,000, they could have excluded up to $500,000 since they were both on the title.