So far, 2002 hasn’t been very good for stock market investors, with all the major indexes showing losses. Maybe it’s time to look for an alternative. Have you considered a tax-free bet on real estate?

Tax-free?

That’s right  you can take profits out of a real estate investment without triggering the 20 percent capital-gains tax that a stock investment is likely to entail.

But there’s a catch: The investment has to be in your own home, and your profit can’t exceed $500,000. Still, half a million dollars is a lot of profit to earn tax-free.

Homeowners have long been able to avoid taxes on profits realized from selling primary residences. But until 1997, you could only do this by purchasing another home within two years of selling the old one, and the new property had to cost more than you received for the old one.

But the federal tax reform in ’97 changed that. A married couple now can escape tax on up to $500,000 in home-sale profits; a single person can avoid up to $250,000.

To qualify, the home must have been owned and occupied as a primary residence for a total of at least two of the previous five years, though the occupancy can be broken into any number of smaller blocks. Also, a taxpayer who takes this exclusion cannot take it again for two years.

There are a few variations on the rule, according to CCH Inc., a Riverwoods, Ill., tax-information firm:

l A person who has lived in a home for at least one of the past five years and become incapacitated can count time in a nursing home or other facility as part of the two years.

l A married person who loses a spouse can claim the $500,000 exemption, rather than the $250,000 exemption for single people, so long as he or she sells the home in the same year the spouse died. Moreover, the cost basis used to figure the profit is the home’s value when the first spouse died rather than the original price paid. This could reduce any tax due, since the more recent value is likely to be higher.

Attractive rules

A friend of mine who’s been a homebuilder for 20 years found the rules so attractive that he gave up working for others and simply builds himself a new home every two years, then sells it.

And another of my buddies buys a home every two or three years, then throws on additions and other improvements. He uses the home’s higher value to refinance with a larger mortgage, pulling money out of the house for living expenses until he’s ready to move on.

Most of us don’t have the skills for this or don’t want to live this way.

But the rules make home improvements a more attractive investment option even for those of us who plan to stay put awhile. Prior to the 1997 change, major improvements that led to a higher sales price drove the homeowner to buy a more expensive home after selling.

In many cases, that led people to spend more than they wanted to, and it often forced them to put all the profit from one home into the next one, even though they’d have preferred to spend it or to invest it in another way. Now you’re not compelled to take on more home than you want, and profits truly can be taken out and used any way you like.

Profit, by the way, is the difference between “adjusted sale price” and “cost basis.” Take the sales price and subtract selling expenses such as broker’s commission. From the result, subtract the original price paid as well as the costs of capital improvements such as additions and remodelings.

Diving in? Be careful

If investment gain is your goal, pick your improvements carefully. Surveys generally show that the best payoff comes with kitchen and bath remodelings. Swimming pools tend to be money losers  meaning they add less to the value of the property than they cost. That’s because lots of buyers don’t want pools.

Also, it may not make sense to spend a lot having pros repaint the inside of the house. So many homeowners do their own painting that they’re not willing to pay much more for a home that’s professionally painted.

These surveys typically look at what an improvement would do to the home’s value if the property were sold immediately. Most homeowners, though, don’t plan to sell immediately. They can enjoy the profits that come later with the greater price appreciation that builds up on a home that is more valuable.

Obviously, the less you pay for an improvement, the better your chances at turning a profit on it. Doing work yourself can pay off  if you do it well.