If you are an avid real estate investor who likes to keep rental properties for a reasonable period before selling, then there is a way for you to make $125K tax-free over and above the rental income you receive.  For this scenario, we will assume you are single simply because those that are married (even though you could double your tax-free income potential) would not want to do what is required.

If you are a real estate investor and single, then you could incorporate a strategy that allows an extra tax-free income, up to $125K annually, in addition to the rental income you receive already.  This program takes time to set up, but you may already be in a position to get it started.  The only drawback is it requires you to move every 2 years, which is why it is likely that married couples do not want to do this, especially if you have children.

How does it work?

It is actually very simple.  You acquire a reasonable number of properties, you must have at least one rental property to make this work, but the more you have, the easier it will be to implement.  The IRS allows for a capital gains exclusion for up to $250,000 in gains on the sale of a property if you are single.  The two main requirements are that you owned the property at least two out of the last five years (not a company), and that you personally lived in it at least two out of the last five years.

The plan requires you to move every two years in order to meet the IRS guidelines for claiming the deduction prior to selling the property.  You may even be able to get started by purchasing a new home to live in while renting your current residence for the next 3 years.  Remember that the IRS does not specify when the 2 years must be, so it could be the first 2 years of the last 5 and you could still claim the exclusion.

Now that you know how it can be tax-free, what are the limitations?

We discussed some of the limitations regarding the exclusion, but there are some others that need to be discussed as well.  Remember that the gains are from the difference between the tax basis you kept record of and the proceeds from the sale of the property.  If you are like many investors, and you depreciated the property to save on taxes already, you will most likely still be required to pay the depreciation recapture tax on the depreciated amount.  Also, there are some other tax related issues for rental properties you will need to factor in, such as how repairs versus replacements work for taxes.

Can you sum this up for me?

Yes, here is the summary of what you can do to receive up to $125K annualized tax-free income while earning rental income as well.  You purchase rental properties and earn the rental income while you own them.  Remember to maximize your tax deductions using proper techniques during the ownership, but you will have to weigh the benefits of depreciating the property.  While you earn this rental income, the property is likely appreciating in value (over time, not necessarily immediately), so in two years you could have a property that appreciated up to $250K and you would be able to sell it and potentially receive that gain tax-free.  The main requirement is that you move into one of your properties every two years.  Married couples can theoretically double this income following the same strategy, but the requirement to move every two years may be too hard on the family.