Buy and hold strategies have become more appealing in recent years. An increasing number of baby boomers and millennials prefer renting, driving rental rates and generating handsome monthly returns for homeowners. Holding property is also an excellent hedge against inflation as the economy heats up.
However, fix and flips are still relevant in today’s market, especially as buyers grow fearful of missing their moment and are willing to make offers above market rates for the sake of their peace of mind. But how can you ensure profitability when flipping houses?
This guide will explain in detail how to get started as flipper, identify fix and flip opportunities, determine whether a home is better suited as a rental or a buy and flip, maximize your sale price, and avoid common pitfalls. Given the depth of this article, we suggest that you bookmark it and read it in installments, or use the shortcut links below to jump to a section of your choosing.
- How do you flip a house for the first time?
- How do you find fix and flip opportunities?
- How do you calculate an appropriate offer price on a potential fix-and-flip?
- When evaluating a property, how do you decide to make it a rental or a fix and flip project?
- What are the pros and cons of fix and flip versus buy and hold projects?
- How do you keep a fix and flip project on-track and under budget during rehab?
- How can you market a fix and flip house to help it sell faster?
- What are common house flipping mistakes that lead to losing money?
- How do you make a comeback if you’ve lost money on an unprofitable house flip?
- Are there any benefits to flipping homes in smaller towns versus in larger markets?
- What tax consequences should you anticipate when flipping real estate?
TV shows such as Flip or Flop and Property Brothers make flipping houses look easy, but generating profits from a fix and flip requires the right team, plenty of planning and accurate analysis of the financials. To be successful, house flippers must find a property that are priced right, reliable contractors to do the work, affordable financing and a willing home buyer. Here are five steps for getting started as a fix and flip investor:
Analyze the Local Real Estate Market
Real estate is primarily a local business so it’s important to familiarize yourself with the neighborhoods where you want to invest. You should aim to become an expert on the local schools, areas demographics, neighborhoods that are up-and-coming and sales prices for various types of homes. Much of this information can be obtained from local realtors and visiting the community’s web site. Real estate sites such as Zillow and Trulia can provide data on home selling prices. By analyzing recent sales, you learn the types of properties attracting the most buyers and how much buyers are willing to pay. This will enable you to choose the right projects. Knowing what local buyers want can make all the difference between houses that sit on the market for months versus ones that flip readily.
Build Your Team
Surrounding yourself with a skilled team is essential for profitable flips. Your team is likely to include realtors, real estate attorneys, accountants, general contractors and lenders. The best way to build your team is through networking and referrals. A good place to start is by attending meetings of local real estate investment clubs, chambers of commerce and business networking groups. Most cities have at least one real estate investment club that meets monthly. You should also plan on speaking with as many realtors as you can, talking to both buying and selling agents. Realtors can give you access to properties on the Multiple Listing Service and are likely to be your best source of leads on properties.
Identify a Flippable Property
You should begin your search by identifying what types of homes are selling best in your neighborhood. If four-bedroom houses are popular, for example, rehabbing four-bedroom homes is likely to give you the best odds for successful flips. It’s also important to know who your potential buyers are. Some neighborhoods attract mostly empty nesters while others appeal to growing families. An older couple may prefer a ranch-style home and an affordable one or two-bedroom while a family with young children may require a three or four bedroom home with multiple bathrooms.
Leads on fix and flip properties can come from realtors, banks, lists of HUD repos and trustee sales, and even by talking with friends and family. Another source for properties is foreclosure auctions; however, you should expect to pay for your purchase with cash or a cashier’s check at the time of the sale. There are also potential pitfalls associated with foreclosure auctions. For example, some trustees allow bidders to inspect properties before an auction, but most auction sales are “as is”. Prospective buyers may not be allowed to inspect the property prior to purchase. Other auction issues include hidden liens against home titles. Occasionally the winning bidder must also deal with evicting squatters from foreclosed properties.
Structure the Deal
A useful guide for determining the value of a property is to examine data for similar homes in the surrounding neighborhood that have sold within the last six months. After you have established a value for the property, your next step is to calculate ARV (After Repair Value). ARV can tell you whether the fix and flip is likely to be profitable and is also used by many lenders to determine the maximum loan amount for a project. During your inspection of the property, you should work with a general contractor to put together a budget repair sheet that lists all the needed home repairs and their costs. The home purchase price and estimated cost of repairs is used to calculate ARV. Experienced flippers recommend the 70% rule, whereby you only take on rehab projects when ARV is less than 70% of the upgraded home’s estimated selling price.
After you have found the right house at an affordable price, the next step is to write up a purchase contract. The best way to avoid problems is to hire an experienced real estate attorney to write the contract, but if you don’t have an attorney, you may be able to obtain a template for a purchase contract from your realtor, the title company or the local real estate investment club.
Manage the Rehab Process
Working with a general contractor is usually the best method for keeping fix and flip renovations on track and within budget. The budget repair sheet created during the home inspection provides a blueprint for the specific tasks that need to be done. You can also use the budget repair sheet to obtain estimates from sub-contractors and track their progress, checking off the various items as work is completed. Depending on the scope of the project, you can expect the home renovation to take from one to four months. You and your general contractor should create a timeline for the completion of each project and make sure this schedule is followed. Carrying costs for holding a property can quickly escalate when there are delays. Your repair budget should also take into account unexpected repairs such as faulty wiring or windows that need replacing. Most expert rehabbers recommend setting aside at least 15 percent of the budget for unanticipated repairs.
One of the more challenging aspects of fix and flip investing is finding properties that are suitable for flipping. Discovering an attractive property that is located in a good neighborhood and available at an affordable price can require weeks of searching. In many California markets, competition for fix and flips is fierce and many rehabbers are experiencing the frustration of discovering great properties only to lose those listings to other buyers before an offer can be made.
To locate affordable, high-quality properties, fix and flip investors are starting to think outside the box, looking beyond conventional strategies such as MLS listings and hiring a realtor. Here are several non-traditional strategies rehabbers can try when prospecting for properties:
For investors who have the ability to pay cash, a foreclosure sale can provide a great source of fix and flip properties. Lists of foreclosure sales are published in the local newspaper several weeks prior to sales, which gives rehabbers time to visit the property. Foreclosed homes are usually sold “as is” and it is often possible to find great rehab projects at these auctions. The principal drawback of foreclosure sales is that bidders usually can’t inspect inside the home. If curtains are drawn, bidders are forced to guess about the condition of walls and floors. Foreclosure sales typically require the buyer to post 10% of the home’s purchase price in cash at the time of the sale. Buyers must also complete the purchase within 30 days or lose their 10% deposit.
For Sale by Owner
Some homeowners balk at paying a realtor commission on the sale of their home and opt to market their property directly by placing a “For Sale by Owner” sign in the yard and ads in Craigslist and the free weekly shopper newspaper. Since these homeowners often want a quick close and a hassle-free sale, it’s not unusual for “For Sale by Owner” properties to sell at below-market prices.
The Direct Approach
An alternative approach that occasionally yields good results is to drive around neighborhoods looking for fix and flip prospects. The best flip candidates are similar to others homes in the neighborhood, but showing signs of deferred maintenance. Once you have identified a property, the next step is to search its address at the Assessor and Property Tax Records office. For older homes, chances are good that the person paying the property taxes is also the homeowner. Rehabbers may also consult other public records such as property deeds for names of owners. If all this sounds too complicated, there are online databases such as Propertyshark that provide this type of information on properties for a $30 fee. Alternatively, fix and flip investors can ask neighbors for the name of the property owner or mail a postcard to the property asking the homeowner to contact you.
Adults who are left holding a deceased parent’s or grandparent’s house are often eager to sell. Estate homes are mostly offered in “as is” condition. Since heirs are often seeking the easiest, cheapest way to monetize estate assets, many of these homes are very affordable. Just as is the case with home foreclosures, estate probate cases must be listed in the local newspaper. This is done to alert potential creditors or heirs not listed in the will. The average probate process takes anywhere from a few months to over a year, with the timeframe varying widely by state.
Rehabbers can follow up on a probate notice in the newspaper by contacting the executor of the estate, whose name is usually provided in the notice. Making an offer on the property before the probate process closes may allow rehabbers to negotiate a more attractive price with heirs who are eager to sell. A potential drawback of estate properties is that price negotiations may become difficult if there are multiple heirs holding small stakes.
Fix and flip investors may acquire properties at tax auctions by paying back taxes owed on the property. To ensure a smart purchase and avoid overpaying, rehabbers should attend the auction forearmed with comparable sales data on nearby properties. Upcoming tax auctions are usually listed on county or city websites. Fix- and-flip investors need to register as a bidder beforehand to participate in one of these auctions. Tax auctions resemble foreclosure sales in that bidders usually can’t inspect the interior of the home so buyers should proceed with caution. The two types of tax auctions are tax deed sales, where the property is sold outright, and tax lien sales, where liens on the property are auctioned. At a tax lien sale, the buyer secures the right to collect the existing liens, plus interest from the homeowner, and to foreclose on the property if liens aren’t paid within a specified timeframe.
Partner with Attorneys
Most investors have partnered with a real estate attorney at some point in their career, but rehabbers may also obtain useful leads on fix and flip properties by partnering with attorneys specializing in divorce, bankruptcy and estate law. Divorces often result in the sale of a home. Both the involved parties in the divorce are usually interested in moving on and dividing joint assets. Clients of bankruptcy attorneys are often looking to sell assets to raise some cash. Like foreclosures and probated estates, notices of upcoming bankruptcies must be published in the local paper several weeks prior to the actual bankruptcy filing.
Some fix and flip investors discover affordable properties by paying attention to properties posted with “For Rent” signs and contacting property owners to inquire about an outright sale. Many landlords grow weary of renters, but lack the cash necessary to upgrade the property. For rehabbers, this landlord’s dilemma may create a great fix and flip opportunity.
While picking the right rehab property is critical to success, if your goal is to generate a reasonable profit, rehabbers must also accurately gauge the property’s ‘after repaired value’ (ARV), and the cost of needed repairs. Before making an offer on a property, rehabbers should already know the ARV and repair costs, since working backward from these numbers establishes the maximum price the rehabber can pay for the property while ensuring an adequate return on investment.
The three steps for pricing a fix-and-flip property are:
- Calculate ARV
- Estimate repair costs
- Use these numbers to determine an appropriate offer price.
Step 1: Calculate ARV
Calculating the price homebuyers will be willing to pay is the starting point of any fix-and-flip project. Without knowing the ARV, there’s no way to determine if the financial risks associated with the project are even worth undertaking.
The ARV calculation starts by analyzing sales data for comparable properties, often referred to as ‘comps.’ Comps are homes similar to the rehab property that are located in the same general area. Rehabbers working with a realtor have access to comps data through the Multiple Listing Service (MLS), which provides detailed descriptions of listed or recently sold homes. There are also free web sites such as Zillow and Trulia that provide online access to home sales data.
Comp data should focus on recently sold homes, not listings. This is because an ARV should reflect actual sale prices, not the wishful thinking of homeowners marketing a property. It’s also critical to ensure that you are comparing similar properties. If your rehab property is a single-story ranch, for example, comps on two-story brick homes are not useful. The properties analyzed for comparison purposes should be comparable in size, age and square footage to the rehab property and have the same number of bedrooms/bathrooms. ARV should also take into account features unique to the rehab property, such as in-ground swimming pools, oversized lots, and other amenities that appeal to potential buyers.
The comp data should be recent (i.e. no more than 90 to 120 days old). Real estate values can change rapidly and using outdated comp data to derive ARV can result in significantly underpricing or overpricing a property. Another caveat is that comps should come from homes in the same neighborhood. School districts and commute times can have a big impact on home prices so comps from nearby properties should be weighted more heavily than data from distant neighborhoods.
If the initial search doesn’t yield a sufficient number of comparable properties, rehabbers can always expand the internet search to include home listings and pending sales. Keep in mind, however, that listed or pending prices often differ significantly from actual sales prices.
Step 2: Calculate Renovation Costs
The next step is to correctly estimate repair costs. Upgrades can range from simple cosmetic improvements such as new paint and carpeting to structural work. The riskiest investments are usually properties requiring major structural repairs since these fixes are not only costly, but also invisible to homebuyers. Upgrading kitchens or bathrooms can be smart investments, but rehabbers should heed the warning of the National Association of Home Builders, which cautions against remodeling investments that raise the asking price more than 15% above the median price of surrounding homes.
Many rehabbers use a budget repair sheet to estimate renovation costs. This spreadsheet tracks needed repairs in the different areas of the house. Rehabbers lacking construction experience may want to walk through the property with a general contractor, who can help estimate repair costs and assist in hiring skilled subcontractors to do the actual building, painting, plumbing and electrical work.
Step 3: Calculate Financing, Closing and Other Expenses
The third step in the process is to estimate financing costs, closing costs and monthly expenses for holding the property. Financing costs vary, depending on the lender, prevailing interest rates and the borrower’s creditworthiness, but most rehabbers should expect to pay 11-12% interest on their loan, plus another 2-3% in points and upfront fees.
Commissions and closing costs are usually paid by the seller, although there will be commission costs if the rehabber is working with a buyer’s agent. Those selling a property through a realtor can expect to pay a 5-6% commission on the sale. Closing costs, which typically include attorney’s fees, title and escrow costs, generally amount to 1-2% of the sale price.
An expense item frequently overlooked by rehabbers that can add up quickly is property carrying costs. These will include utilities, insurance, yard maintenance and property taxes. Depending on the type of property, rehabbers may also be on the hook for Home Owner’s Association or Condo fees.
The best way to control carrying expenses is to create a work schedule and make sure you’re your subcontractors stick to it. A subcontractor falling behind by a few days can create a cascade effect that delays the project by weeks and increases holding costs exponentially.
Once ARV, renovation, and financing/closing/holding costs are known, an offer price can be calculated that incorporates the rehabber’s targeted return on investment.
A simple formula for calculating offer price is:
ARV – (Renovation Costs + Financing, Closing and Holding Costs + Profit Target) = Offer Price
For example, if the property ARV is $210,000, repair costs are estimated at $30,000, closing, financing and holding costs will be $15,000 and the profit target is 12% of ARV ($25,200), the calculation is:
$210,000 – ($30,000 + $15,000 + $25,200) = $139,800
This means that the maximum price offered for the property should be $139,800.
Note that rehabbers usually calculate the target return on investment as a percentage of ARV. A 10% to 15% profit margin target is typical for most rehab projects.
When you’re first evaluating a property, how do you determine whether it’s better suited as a rental or a fix and flip project?
When deciding between fix and flip or holding a property as a rental, investors need to evaluate:
- Their financial position;
- The condition of the property;
- Local real estate market trends; and
- Their individual preferences.
Factor 1: Your Financial Situation Impacts the Decision
A big advantage of owning a rental property is that it may begin generating income right away. Of course, whether the property produces profits immediately or not will depend on your ability to find and retain tenants. If rent is set too high, the property could sit vacant for months, negatively impacting your bottom line. Investors should plan to have a sizable cash cushion available that can be used to cover mortgage payments and other costs during months when the property is not earning income.
Another benefit of renting versus flipping is that the income stream from the property tends to be predictable and also more stable over time. This is not the case with fix and flip properties, whose value can fluctuate with supply and demand. A downside of rental properties is that managing them can be time-consuming. The alternative, hiring a property manager, can be expensive.
An advantage of flipping over renting is that capital usually isn’t tied up in the property for as long. Most fix and flips sell within a few months, allowing capital to be redeployed quickly into new investments. Fix and flips often require large amounts of capital upfront, however, to cover costs for needed repairs, carrying costs and other upfront expenses. Investors who run out of cash mid-renovation may find themselves forced to sell at a loss. In addition fix and flips require closing costs to be paid twice. There are closing costs for both the purchase and sale of the property.
Factor 2: Evaluate the Condition of the Property
Buy and hold rental properties may deliver better returns in the long run if home values are rising in your area. If home prices are falling, fix and flips may produce better results since the investment is monetized more quickly. The National Association of Realtors provides good online sources for researching local real estate market trends.
The age of the property should be factored into the equation. Older properties generally have higher maintenance and upkeep costs, so fix and flip may be the more profitable option. The location of the property must also be considered. If the property is located hours away, managing a rental could involve frequent long commutes. Distance is less of an issue for fix and flip strategies since the property is usually re-sold within a few months.
The local real estate market should help guide your fix and flip or rent decision. If the local market is depressed, acquiring the property may be much easier than selling even after renovations are done. If there are more rental units than renters in your area, rents may drop to levels that barely cover mortgage and other property expenses.
Factor 3: Assess Regional Market Trends
A recent survey by Auction.com shows a national trend favoring buy and hold strategies over fix and flip tactics. The trend varies widely across regions, however. Investments in rental properties are most popular in the Midwest and South, whereas fix and flips are preferred in the Northeast. In the West, rentals are slightly more popular than fix and flips. In regions where home prices are high, fix-an-flips are prevalent whereas modestly priced markets tend to generate better long-term returns from rentals.
The trend nationwide shows the population of renters expanding faster than home buyers. According to the National Association of Realtors, four million new renter households have been created since 2010, while homeowner numbers have declined by one million. Experts attribute the increase in renter households to tighter lending standards since the recession, which keep some otherwise qualified individuals from obtaining mortgages and expectations of rising interest rates.
Roughly 29 percent of suburbanites living outside the nation’s eleven largest cities were renters in 2015, up from 23 percent in 2006, according to a report by New York University’s Furman Center and Capital One bank. The report examined rental trends in Atlanta, Boston, Chicago, Dallas, Houston, Los Angeles, Miami, New York, Philadelphia, San Francisco, Washington and their suburbs.
Regarding trends in fix and flips, RealtyTrac reported that flips accounted for 5.5 percent of all home sales during 2015. Average gross profits on flipped homes hit a ten-year high of $55,000 last year, but hold times for flipped properties also increased. During the second quarter of 2015, average hold times rose to 179 days, the longest since 2007, presenting liquidity challenges for some house flippers.
The regional market with the greatest number of flipped homes in 2015 was Miami, where flips accounted for 8.6 percent of overall home sales, States with the highest percentage of flipped houses included Nevada (8.8 percent of home sales); Florida (8.0 percent); Alabama (7.4 percent); Arizona (7.1 percent); and Tennessee (6.9 percent).
The good news for both house flippers and landlords were low vacancy rates in most markets. RealtyTrac’s most recent residential property vacancy analysis showed only 1.6 percent of residential properties vacant at the beginning of February 2016, which was down 9.3 percent from their vacancy analysis in late 2015. Unusually tight vacancy rates in many markets help both fix and flip strategists and buy and hold investors by putting upward pressure on rents and home prices.
Factor 4: Which Strategy Do You Prefer?
Ultimately, the choice to fix and flip a property or buy and hold a rental may come down to individual preference. Some investors thrive on the challenges and uncertainties of fix and flips while others find the uncertainty too stressful. Some individuals don’t mind managing tenants and properties, while others lack the patience to deal with day-to-day complaints. The bottom line is that the strategy you choose should be the one that you are most comfortable with.
Pros and Cons of Fix and Flips:
Pro: Potential for High ROI. Fix and flip strategies involve purchasing a property at a discounted price, making upgrades and re-selling the property at market price. A flipper who is skilled at figuring out what buyers want and keeping renovation projects on-track and within budget can often generate 50-60% returns on investment.
Pro: Quick turnaround for capital: Another appeal of buy-and-flip is short hold times. Most flips are completed within a few months and profits are realized immediately when the property is sold. Investor capital is not tied up for extended periods of time. A downside of the fix and flip approach, however, is that large amounts of money may be required upfront. Investors pay closing costs, commissions, inspection and permitting fees, interest on loans and labor and material costs.
Pro: Less risk exposure: Since a buy-and-flip investor doesn’t hold an asset for long, exposure to market risks such as rising interest rates or downturns in the local real estate market are minimal.
Con: Many outsiders involved. The typical fix and flip investor relies on a hard money lender, private investor or business partner to provide financing. These lending professionals have their own interests to safeguard, which may not always align 100% with those of the borrower.
Con: Unplanned repairs. It’s not unusual to encounter unforeseen problems during a renovation that require additional repair work and extra expense. Big problems can quickly blow through a budget and eliminate any chance of making a profit. Although unexpected problems are also encountered with buy and hold strategies, risks are spread over a longer period of time. As a result, cost overruns are more easily absorbed and the damage to profits is more controllable.
Pros and Cons of Buy and Holds:
Pro: Predictable income. A major appeal of buy and hold is the ability to generate monthly income. Owning multiple properties that are all producing rental income can quickly build a solid income stream. While an income stream can also be generated from buy-and-flip, a nearly continuous flow of deals would be required.
Pro: Increased potential for capital gains. Buy and hold typically offers greater opportunities for capital appreciation than buy-and-flip. In most circumstances, a well-maintained property will continue to appreciate in value, potentially yielding sizable gains when the property is sold after several years. Owning a property long-term also means that the investor is less affected by the whims of the market. Buy-and-flip investors sometimes must sell properties regardless of market conditions whereas buy-and- hold investors can wait for the optimal moment to sell.
Pro: More flexibility on purchase price. Buy and hold strategies may be successful even if the property is not acquired at a distressed price. If monthly rental income covers expenses, the investor has the luxury of allowing equity to build over time.
Pro: Better access to financing. Financing is generally easier to obtain for rental properties than for flips. One reason for this is that FHA loans are usually not available for buy-and-flip properties. A requirement for FHA financing is that the borrower has owned the property for at least 90 days.
Con: Cash drain from vacancies. A major downside of buy and hold is properties that aren’t generating income while the property owner remains on the hook for monthly maintenance costs, utilities, mortgage payments and other expenses. A property that stands vacant for several months can create a significant drain on investor resources.
Con: Dealing with tenants. Finding good tenants takes time, patience and initiative. Keeping good tenants requires constant property maintenance and quick responses to tenant complaints. Collecting back rent and/or evicting problem tenants can be both difficult and unpleasant.
All other things being equal, tax issues may sometimes make one strategy more attractive than the other. The tax implications of the two approaches are very different. Buy and hold investors pay taxes on rental income and capital gains taxes when properties are sold. Most rental properties are held for several years. As a result, profits on the property sale are treated as a long-term capital gain and taxed at a 15-20% rate. Buy-and-flip investors also pay capital gains taxes on property sales. However, because most flip properties are held for only a few months, profits on the sale are considered a short-term capital gain, which is taxed at the same rate as ordinary income. For some investors, this tax rate can be higher than 35%. Buy-and-flip investors who do many transactions may also run the risk of being classified as dealers by the IRS. In addition to dealer profits being taxed at the higher ordinary income, dealers may be required to pay a self-employment tax.
The difference between profit and loss may come down to a few key decisions made while the renovation is underway. Here are nine tips to help ensure your fix and flip remains profitable.
Plan for time on the market.
Comps from neighboring properties should help you estimate how many weeks your property will be on the market. You can also talk with other local rehabbers about their experience with flipping timeframes. On average, most rehabbers expect to complete repair work in eight to ten weeks. Knowing the repair timeline and how many weeks comparable homes are on the market is key information for calculating the project’s cash flow requirements. For example, if neighboring houses are selling within four months, and repair work requires eight weeks, you should plan on six months of cash flow to carry the project from purchase through sale. There are also factors specific to each project to consider. For example, if most home buyers in your area seek FHA financing, deals are likely to take longer to close.
In general, city and suburban properties sell faster than rural properties. This is because most home buyers prefer to live near schools and shopping. Another advantage of more urban properties is that better comps are available since home sales occur more frequently. If you plan to bid on a property in the city or suburbs, however, take the time to learn about the neighborhood. Most home buyers won’t even look at a property in a high crime area or where there is significant traffic noise and congestion.
Have an exit strategy.
You should never purchase a property without having a Plan B ready if the house doesn’t sell. Even a great home can be difficult to sell if market conditions erode, and rehabbers may find themselves trapped into paying many months of mortgage costs, maintenance, taxes, insurance, and home owner fees. Exit strategies may include selling the house to a wholesaler or renting. If renting is your backup plan, decide ahead of time whether you want to manage the property yourself or hire a property management firm.
Don’t assume every project is alike.
Most rehabbers rely on past experience when estimating repair costs, but there are hazards to that approach since no two properties are exactly alike. Your current project may have a larger kitchen or more rooms than your last project, adding significantly to renovation costs. A detailed inspection and fresh estimate of repairs is required for each new project. Buyer preferences can also impact repair budgets. For example, if French doors suddenly become popular in your area, installing French doors in the property will increase your budget but ultimately pay off by attracting more buyers. Rising material prices can also throw off budgets and require a fresh set of calculations for every new property.
Don’t overlook these expenses.
Home purchase and repair costs consume the lion’s share of a fix and flip budget, but there are also other expenses that rehabbers must consider. During the pre-purchase phase of the project, there are closing costs, realtor commissions, appraisal and inspection fees to consider. During construction, in addition to costs for contractors, materials and work permits, there are property taxes, loan payments, insurance, utilities and sometimes home owner association dues that must be paid. Selling the property entails listing fees, cost for staging, more closing costs and realtor commissions. In addition, every renovation budget should set aside funds for unexpected repairs. Most rehabbers recommend setting aside 15%-20% as a contingency fund.
Keep a centralized planning calendar.
If you are managing multiple fix and flip projects at the same time, keep organized by creating a central calendar that tracks timelines and progress for each property. Different colors are used for the different properties. This calendar is updated at least weekly, either by an on-site visit to the property or speaking with the site manager. Regular check-ins will help you keep track of the past week’s accomplishments and know what is planned for the following week.
Track expenses for each property separately.
For tax planning and budgeting purposes, each property’s expenses should be tracked separately. The budget spreadsheet should track estimated renovation and material costs, actual costs and keep a running tally of accrued expenses. By tracking accrued expenses, rehabbers can compare that amount to the property’s estimated After Repair Value (ARV) and update estimates for Return on Investment (ROI).
One of the biggest hazards associated with managing multiple fix and flips is an exponential effect that can cause small mistakes to mushroom into costly headaches. For that reason, careful due diligence is particularly important. Studying the local market, compiling relevant comps, investing in a pre-purchase home inspection and understanding the loan covenants are necessary steps for avoiding bigger challenges down the road.
Keep detailed records.
In addition to tracking the progress of each property, your central calendar should also track scheduled versus actual completion dates and note the reasons for any discrepancies. Keeping detailed records will assist you in creating future timelines and help you build a team of professionals who can be trusted to meet deadlines.
If you are just beginning to assemble your team, you can vet potential contractors by checking their rating with the Better Business Bureau. You can also seek referrals from other rehabbers and/or inspect the contractor’s work at other job sites.
Rehab in fall or winter, then list in the spring.
In many parts of the US, the best times of year to sell a property are spring/summer so schedule your renovation work during fall/winter. Seasonal planning is especially important in areas where winters are severe since home buyers are reluctant to venture out on icy and/or snow-covered roads.
In areas with severe winters, schedule exterior repairs for during the fall, leaving the winter months for interior work such as hanging drywall, installing cabinets, carpeting and painting. Landscaping should be done in the early spring so that the yard is in top-notch shape for the summer and maximizes the property’s curb appeal.
Successful real estate businesses need to flip properties quickly to maximize income. The downsides of holding properties too long, which include mounting maintenance costs and taxes, can gradually eat away at profits. These five tips for marketing properties can help investors accelerate flip times and boost profits.
Invest in professional real estate photography.
A recent analysis by Redfin shows that homes showcased using professional grade photography sell up to three weeks faster. High quality photos not only spotlight special features such as crown molding and granite countertops, but also add depth to small spaces like closets and baths.
For rehabbers with the skills and equipment necessary to take photographs themselves, they should try to create photo sequences that mimic walking through the house, and use a wide-angle lens to make rooms appear larger.
Drone photography can also be useful in marketing properties. Aerial drone views provide a broader overview of the property and can be used to draw attention to features such as nearby nature areas.
Create a video walkthrough.
Even six years ago, the residential real estate market saw the value of video marketing: Back in 2012, the National Association of Realtors conducted a study that found that 85% of buyers and sellers preferred real estate agents who made use of video marketing. Nowadays, buyers expect to have access to video, rather than treating it as a bonus.
The best way to showcase a home’s unique features is with a video walkthrough of the property. Attention spans are limited, so video walkthroughs should take less than three minutes, although slightly longer videos may be necessary for luxury homes. The best times of day to shoot video is just after sunrise and before sunset. During these periods, the soft lighting allows visitors to easily see indoors as well as out through windows. Videos shot during other times of the day usually require investing in artificial lighting to get the right amount of brightness.
In addition to showcasing home interiors, video walkthroughs can be used to explore the yards and neighborhood features like playgrounds and walking trails. While the initial investment is more, videos walkthroughs help rehabbers save time by pre-qualifying buyers and eliminating some of the need for personal tours. Videos also reach a wider audience, including potential buyers who may live the next town over.
Leverage social media platforms.
The best realtors are social media savvy. A strong online presence is desirable, since the vast majority of today’s home buyers find properties through online searches. A recent National Association of Realtors report showed 90% of realtors use social media. Before hiring a realtor, check that he or she has a great website and a wide following on social media.
Flippers can leverage their own online presence by tapping into social media platforms like Twitter, Instagram, Facebook, and Houzz to grow networks and target a broad audience. Use your social media networks of choice to expand on-line relationships, share useful content, and create hashtags that reference markets where your properties are located. Each social media site has a unique strength that can be tapped into in different various ways. For example, Facebook and Instagram are great for spreading listing information, while Pinterest is the premier site for image-sharing.
Build a blog for property listings.
Blogs allow for more detailed property descriptions than the MLS. In addition, blogs can share links to additional pictures, videos, and information about the neighborhood.
Another blogging benefit is the ability to capture email addresses of buyers shopping for homes in a particular neighborhood. A sign-up button on the blog asking visitors to join an email list is a great way to obtain leads and build a list of pre-qualified prospects who can be contacted when properties are ready to sell. Email lists can also be leveraged to advertise the business, extend your reach, and build familiarity with prospective buyers.
Flippers who don’t have a blog should consider creating a dedicated website for each property listing. Incorporating key search terms in the copy will help drive traffic to the site. Most website visitors won’t click through multiple pages, so be sure that all essential information about the property, including description, amenities and location, is summarized on the home page.
Establish a following on YouTube.
Posting videos or slide shows on YouTube is a great way to spread the word about a property listing. Rehabbers obtain the best YouTube results by crafting titles that incorporates key search words and phrases. YouTube sorts videos and matches them to search queries based on “metadata” (i.e. title, description and tags), so take the time to fill out all the fields when uploading videos.
Descriptions created for YouTube should be concise, include relevant search terms, and be linked back to your website. Since only the first 125 words of the description appear in YouTube search results, make every word count.
The best results are obtained by frequently adding new and varied content, since YouTube gives preference to active posters. Varied content can include narrated video walkthroughs of the neighborhood and discussion of general real estate topics. Expert commentary helps position you as a professional, and makes it easier for home buyers to find you online.
Questioning conventional wisdom: Should you host an open house?
Opinions vary regarding the effectiveness of open houses in the digital age. Some realtors believe open houses draw out buyers who are in the early stages of looking for a home and driving around the neighborhood. Others argue that most buyers begin their search online, eliminating much of the need for personal tours.
When deciding whether or not to host an open house, local practice should be a consideration. In some areas, open houses are still popular and customary. Some criticize that open houses attract neighbors, not buyers, but neighbors often share information with friends and family who may be looking for a home to buy.
The wisest approach may be to experiment with holding open houses, see how many sales they generate, and then make a final determination.
A sure way to increase traffic, entice more homebuyers and accelerate flip times is to make your listing stand out. By leveraging powerful digital tools and social media platforms, rehabbers can capture more views that may eventually culminate in more bids and a higher sale price.
Being successful in the house flipping business requires preparation, attention to detail and executing on a well-thought-out plan. Sometimes the best option is to walk away from a potentially problematic house, as even the simplest of mistakes can cost tens of thousands of dollars and destroy your long-term profits.
Anticipating setbacks before they become major challenges greatly improves the likelihood of success. “Caveat emptor” (“let the buyer beware”) should be the guiding principle of every fix and flip investor.
Investors can maximize their odds for successful flips by avoiding these costly and all-too-common fix and flip mishaps.
Poor Property Location
You’ve found a nice house at an affordable price, and you’re preparing to close the deal. This is the moment to take a step back and avoid a common investor pitfall, namely, failing to consider the character of the surrounding neighborhood. An undesirable location erodes property values and makes it harder to find buyers. Even a great house generates sub-par returns if it’s surrounded by run-down shacks or located far away from basic amenities. Investors can avoid this real estate pitfall by investigating neighborhoods on websites such as Zillow, Trulia and PropertyShark.
Pre-purchase due diligence should focus not only on comparable home values, but also on how long houses in the neighborhood have sat on the market. A sure way to increase holding costs is to buy in areas where homes take many months to sell. In addition to examining comparable sales data, investors should walk around the neighborhood assessing the condition of streets and sidewalks. Rehabbers should know the distance to the nearest grocery store and what the police blotter says about neighborhood crime statistics. If you are reluctant to walk around the neighborhood yourself, prospective buyers will hesitate as well, so think twice before purchasing in sketchy areas.
If a neighborhood is in the early stages of gentrifying and you’re willing to hold the asset for several months, it sometimes makes sense to buy while prices are low in anticipation of rising values. However, if your goal is a quick profit, you should limit your fix and flip projects to neighborhoods that already attract plenty of buyers.
Overpaying for a Property
Regardless of whether the property’s selling price seems reasonable, if the purchase exceeds your budget or if the needed repairs are outside your comfort zone, the best advice may be to walk away. In a rising market, the damage from over-paying can sometimes be mitigated by the home’s appreciating value, but over-paying guarantees lesser profits even in a seller’s market.
If you over-paid, avoid the temptation of ratcheting up the scope of the remodel and asking price. It’s a mistake to believe increasing the list price automatically results in greater profits. A home’s selling prices must be determined by market conditions and the prices paid for similar houses in the neighborhood. Hoping to offset over-paying by over-pricing is more likely to result in no buyers and a house that sits on the market. In the end, the price must be dropped anyway to entice buyers. It’s smarter to price correctly from the get-go and minimize holding time.
Underestimating Renovation Costs
Underestimating the cost of rehabbing is a common mistake. The best way to create a realistic renovation budget is to walk through the property with a general contractor who can help you identify necessary repairs and estimate costs. The budget repair spreadsheet created during the walk through can be used to keep track of the various repair items.
Even before the walk through, if the property is an older house it’s often advisable to invest in a pre-purchase inspection. A professional home inspection more than pays for itself by uncovering hidden defects such as termite damage or a leaky foundation that can cost thousands of dollars to remedy and blow up your repair budget. If the uncovered defects are not enough to sour you on the deal, you can often use the home inspection as a bargaining chip for negotiating a lower purchase price.
A rehab budget should set aside some funds for unanticipated costs. A sudden sharp rise in material prices or a contractor who quits mid-job can quickly put your rehab project off-schedule and over-budget. Experienced rehabbers typically set aside 10% to 15% of the overall budget for unexpected problems encountered while work is underway.
Over-Improving the Property
A common pitfall for fix and flip investors is over-improving properties by adding high-end flourishes that overrun budgets or are inappropriate given the nature of the neighborhood. An investment in remodeling a McMansion, for example, is unlikely to pay off if other neighborhood homes are two-bedroom bungalows. Your main priority when remodeling should be a finished product that appeals to most buyers and blends into the neighborhood.
Unusual designs and amenities can make a property difficult to sell, so it’s best to confer with local realtors before rehabbing to find out what options local buyers want. Your plan should be to spend just enough on upgrades to meet or slightly exceed market demand without overspending. In neighborhoods where Home Depot finishes are the norm, buyers are unlikely to pay up for custom countertops and tilework.
Excessive flourishes should be avoided, but upgrading badly outdated systems and appliances is a necessity. Few home owners are willing to settle for a decrepit AC system or avocado-colored appliances left over from the 1970s. Updating basic systems and appliances pays for itself in the long run by making the house more marketable.
Rehabbers also need to pay attention to outdoor spaces. Most families expect a multi-bedroom home to be surrounded by a good-sized yard. If the yard is already tiny, think again before adding an extension to the house. A lack of sufficient outdoor space can be a deal breaker for many buyers.
The biggest issue that fix and flip rookies run into is that they aren’t sufficiently focused on return on investment (ROI), and just don’t research which home improvements buyers are willing to pay extra for.
Do your homework. In deciding on upgrades to a property, the most important factors to consider are the current real estate market, the neighborhood and the features that home buyers value most. Your goal should be getting the biggest bang for your investment without over-spending. The local real estate market is evaluated since you will need to do more to make your property stand out in a buyer’s market. The neighborhood must also be considered. If your rehab is located in an older neighborhood, you don’t want to make the property too expensive or look out-of-place when compared to surrounding homes. According to Zillow, a useful rule of thumb is to aim for a post-renovation home value that is within 10% of the average cost of other homes in the neighborhood.
Choosing the Wrong Contractor
Successful rehabs begin with the hiring of an experienced, reliable contractor. The right contractor can be invaluable in avoiding cost overruns, keeping projects on schedule, and advising on best construction practices. The scope of the project should help guide the contractor hiring decision. A solo operator working alone may be able to handle small jobs, but major renovations are likely to require the combined capabilities of a larger crew.
You can find a reliable contractor by asking for recommendations from other fix and flip investors and networking at REIA (Real Estate Investors Association) events. Rehabbers should plan on interviewing multiple candidates, checking references, and visiting previous worksites to gauge the quality of work firsthand. Once you have narrowed your initial list, ask each candidate to provide a line-by-line quote on the job so that you can compare estimates for hours and cost involved in each stage of the rehab.
When you hire a contractor, be specific about assigning responsibilities. An experienced contractor will know what permits are necessary, but it’s ultimately the responsibility of the fix and flip investor to make sure permits are obtained. Beginning a rehab project without the required permits can be a costly mistake that results in fines, pushback from the lender, and a house that can’t be offered for sale.
Not Sticking to a Schedule
Taking too much time on a rehab project is a sure way to erode profits. If you are like most fix and flippers, you borrowed money to finance the project and committed to monthly loan payments. Rehabbers wrack up extra months of interest payments when they allow projects to fall behind schedule. Interest payments are only one of the expenses that accumulate. Other costs such as insurance, real estate taxes, and utilities also begin to pile up when the property sits for too long.
Every rehab project needs a timeline, which should be determined during the walk through and at the same time the budget repair spread sheet is being created. The rehab timeline should consider every aspect of the project, from closing through repair work and the final sales contract. Once work begins, plan on re-visiting the timeline at least weekly and making the necessary adjustments to keep the project on-track.
Rehabbers increase their chances of successful flips when they stick to bargain-priced properties, stay within a budget, make only those renovations that add value and close deals quickly so that capital is continually being reinvested.
Not Having a Contingency Plan or Exit Strategy for Getting Out of an Unprofitable Flip
Real estate ties up large amounts of capital so you should always have a Plan B ready for properties that are slow to sell. A natural disaster or sudden downturn in the economy can make even the most appealing home temporarily unsellable. Plan B strategies may include wholesaling the property, bringing in a partner, or converting it to be a rental. If you choose the rental route, you should decide ahead of time whether you want to hire a property manager or take on the landlord responsibilities yourself.
By following these simple guidelines, investors can increase their likelihood of consistently profitable flips, and avoid costly mistakes.
Successful fix and flips deliver profits, but even veteran home rehabbers occasionally encounter challenges that result in money-losing deals. A recent analysis shows that roughly 12% of flips either sell at break-even or worse. In addition, 28% of flips produce gross profits below 20%. That is well below the 30% profit many rehabbers require when taking on a new project.
Losses sometimes occur because properties take too long to flip, causing carrying costs to accumulate over many months—the average time to flip a house is about six months. Utilities, taxes and other expenses quickly add up over extended holding periods. In addition, extra marketing costs, on top of realtor commissions and closing costs, can easily subtract another 7% or so from profits.
When flips turn unprofitable, rehabbers should consider approaching the next project with more caution, and consider avoiding complex rehabs that require extensive structural repairs. When in doubt, it’s better to hit a few singles and make small profits than swing for the fences and potentially strike out.
Here are five suggestions for making your next flip more successful:
Reassess the Market
Rehabbers should verify that their assumptions regarding local markets are still valid. Markets can shift practically overnight, so talk with local realtors to find out what trends they are seeing in demand, selling prices, and days on the market. When interest rates are rising, home pricing trends should be closely monitored, as higher rates may discourage buyers or cause them to reduce their budgets.
In addition, the time of year a home is listed impacts buyer interest, so plan renovation timelines whenever possible for spring or summer completion dates. Home sales typically slump to a 12-month low during January and February, and rise during the spring to peak levels in mid-summer.
Avoid Overpaying for Properties
Many deals are doomed from the start because the buyer overpaid for the property. Profitable deals inevitably begin with accurate assumptions regarding ARV (After Repair Value). Rehabbers should work backward from ARV, and deduct project expenses to determine a pre-renovation purchase price that ensures a profitable sale.
A good starting point for calculating ARV is gathering MLS data on comparable properties. The best comps will be recently updated homes similar to what you envision for your property. If there are only a few direct comps, the search can be extended to include similar homes in adjacent neighborhoods, as well as recent listings and sale pending properties. If there are no direct comps, consider requesting a broker price opinion (BPO) or hiring an appraiser. Multiple opinions on ARV should be obtained, since opportunities for profits quickly diminish if a property isn’t purchased for the right price.
Minimize Renovation Surprises
Virtually every rehab project involves some unexpected repairs. Experienced rehabbers anticipate the unexpected by adding a 10-15% cushion to renovation budgets. In addition, rehabbers reduce the odds of expensive surprises by investing in a home inspection.
Another misstep to avoid is over-renovating a property. The finished home should blend in with the neighborhood. For example, if the other properties are two-bedroom ranches, building a McMansion in their midst is unlikely to entice buyers or fetch top dollar.
The basic rehabbing rules are 1) fix what is broken, 2) modernize what is out-of-date, and 3) splurge on a “wow” factor or two that makes the property stand out. Wow factors don’t need to be budget busters. Finishing touches such as new faucets, drawer pulls, or light fixtures create wow factors without adding significant costs.
Avoid Contractor Delays
Unreliable contractors can create delays that waste time and money. The best way to prevent contractor issues is to carefully vet candidates, write a concise, carefully worded contract and build flexibility into renovation timelines.
Effective vetting begins with obtaining referrals from trusted sources, checking references and interviewing multiple candidates. In addition, much can be learned about a contractor’s skills by visiting past job sites and inspecting work performed for other customers.
A well-written contract details every aspect of the contractor’s responsibilities. If a contractor isn’t performing to expectations, work with him to find a solution, but be prepared to terminate the relationship if issues persist. Better to move on immediately than risk more do-overs and delays. This is where a flexible timeline that makes allowances for unforeseen events proves valuable by enabling rehabbers to finish on the project’s original completion date.
Staging a property won’t conceal major flaws, but does helps sell homes by accentuating best features. Staging isn’t cheap, but rehabbers should resist the temptation to cut this item from their budgets. A 2013 study by the Real Estate Staging Association (RESA) of nearly 170 staged properties found that staged homes typically sold within 22 days, versus 125 days for homes that weren’t staged.
Most staging contracts in the California market involve a $250 to $750 initial consulting fee, and costs that range around $4,500 to $5,000 for a typical 3,000 square foot single-family home.
Rehabbers who don’t want to spend that amount may want to instead consider staging just a few rooms, such as the living room and master suite. Another option is to ask the realtor to share some of the staging expenses. According to RESA, over 50% of agents said they sometimes pay a portion of the staging costs, and nearly 80% said they sometimes pay for a staging consultation for their clients.
Profitable flips invariably begin with accurate cost estimates and detailed planning. By anticipating every contingency and having a plan for dealing with the unexpected, rehabbers reduce project risk, and increase their odds of success.
Real estate flippers usually focus on larger markets as major cities like Los Angeles and San Francisco offer significant flip opportunities. Fierce competition for the best properties has driven robust growth in urban property values, and these markets offer access to thousands of potential homebuyers. In recent years, however, an increasing number of young adults have begun abandoning urban centers in favor of smaller markets, where simpler lifestyles and more budget-friendly housing can be found. This migration trend suggests that smaller cities may soon be offering better long-term flip opportunities. Many Generation X homebuyers, for instance, already feel priced-out of urban centers and are looking instead at smaller communities located a short drive from big cities. These communities can generally offer many of the same amenities as larger cities (such as dining and entertainment) without the associated hassles of big city life.
Major advantages of flipping homes in smaller markets include lower cost of entry and less competition from other investors.
Small town properties are typically much less expensive than urban properties. Lower entry costs reduce financial risk for flippers while also enabling attractive returns on investment. Lack of competition keeps these properties more affordable; a small town foreclosure auction may only attract one or two bidders. The disparity between entry costs for small towns versus big cities are evidenced by a recent Realtor.com study that shows median home prices averaging $98,385 for America’s most affordable small towns, versus median home values of $587,090 for the most expensive US cities, according to a Kiplinger survey.
Another advantage of small town flips is less onerous zoning restrictions. Permits are usually easier to obtain and labor costs are typically well below those of big cities. Low crime rates are another small town attraction that make these communities especially appealing for young families.
Flippers should also weigh the disadvantages associated with small town markets as well.
For instance, due to a smaller pool of interested buyers/renters, properties may sit on the market for drawn-out periods of time. In addition, many small towns are overly dependent on one industry or employer. Because of this, the closure of a local plant can have a disastrous effect on real estate values. Much of this risk can be mitigated, however, by targeting small towns within commuting distance of big cities. Flippers should also look for towns that score highly for economic stability and livability. The AARP has an index that scores the overall livability of selected neighborhoods or cities, and Forbes and the Economist regularly rank cities on several different quality of life standards.
As a flip investor, your goal should be identifying smaller cities that have strong growth potential, since these are the communities that are likely to attract new businesses and residents. In a recent national ranking of the 100 fastest growing US cities, 29 California cities made the cut. Here are the California communities identified in the WalletHub study:
|Redwood City||Tustin||Moreno Valley|
|Hayward||Mountain View||San Mateo|
Of these, roughly 20 fit the criteria of a small city, which is typically defined as fewer than 50,000 residents.
In addition to checking crime statistics and other livability factors, flippers should also evaluate the town’s vacancy rates, trends in real estate prices, economic outlook, employment statistics, population growth and other factors. Free online tools for checking these metrics are found on American Factfinder, a free service of the Census Bureau. Mashvisor also works well: they offer analytics for traditional properties, or Airbnb if you’re so inclined.
And when targeting smaller markets, flippers should give preference to cities that have vibrant economies and that are attracting an influx of out-of-town workers. Once you have identified an attractive market, your next step should be to familiarize yourself with major local employers by searching the local newspaper’s business section for hints of layoffs or businesses poised to expand. This will allow you to adjust your property strategy accordingly. The key to smart investing in smaller markets is an understanding of what drives the area’s economy, which gives you the ability to be nimble in responding to economic headwinds or tailwinds.
Now that you’ve identified a community poised for growth, your next step is selecting an individual property.
The same acquisition criteria apply for small towns and big cities: flippers should look for houses located near major thoroughfares, close to good schools and quality shopping.
Choose a home that is not too different or unusual, and that is surrounded by other nice homes. You should also check commute times to nearby big cities, as well as the area’s cell phone coverage and high-speed internet access.
Since small towns generally have fewer property listings, finding the right property to flip may require more aggressive search tactics. Hiring a local realtor with access to MLS listings is a good start, as well as checking sites such as Zillow and Realtor.com, and visiting property auctions. For a more direct approach, you might try driving around local neighborhoods looking for “For Sale by Owner” signs. Regardless of how you look for a property, after identifying a likely prospect, search the address at the Assessor and/or Property Tax Records office and find the name of the property taxpayer, who is more than likely also the home owner. Online databases such as Property Shark can be used to obtain information on property ownership for a modest fee. Knocking on doors sometimes also yields positive results, as does talking to neighbors in order to obtain the homeowner’s name. Once you have a name and address, you could send the home owner a postcard expressing interest in the property and asking that he or she contact you.
The bottom line is that small cities are potentially great places for flipping houses. But successfully doing so requires taking the time to identify markets that are attractive to young families, as well as choosing properties that are a good fit for the neighborhood, inexpensive to renovate, and marketable at an affordable price.
Too many house flippers fail to plan for the tax consequences of their transactions and end up sharing too much profit with an uninvited partner – the IRS. House-flipping is governed by complicated tax rules. Here are some of the most common tax questions encountered when flipping real estate.
The tax treatment of flipped houses is partly determined by whether the IRS categorizes the seller as a real estate investor or a dealer-trader, who flips houses as a full-time business. There is no hard rule for differentiating between occasional flippers and flipping pros. However, if you frequently buy and sell homes, are a real estate broker, own multiple properties at the same time or derive most of your income from flipping, the IRS is likely to consider you a dealer-trader and tax your profits accordingly.
The profit an investor generates from the sale of a property is considered a capital gain. The amount of capital gains tax paid depends on how long the property was held. The sale of a property held for one year or less triggers a short-term capital gain, which is taxed at the ordinary income tax rate. If a property is held for more than a year, the profit from its sale qualifies as a long-term capital gain. The tax rate on long-term capital gains is 15-20%.
Investors can reduce their tax rate by selling a money-making property during the same year that a loss is taken on another long-term property. The loss on the losing property may be used to offset gains from the profitable property.
Dealer-traders are not allowed to take advantage of long-term capital gains rates when selling properties, regardless of how long the property was held. Dealer-traders are also not eligible to benefit from installment sales or 1031 Exchanges.
Many fix and flippers think taxes can be deferred by selling one property and immediately reinvesting the sale proceeds in another, but that is possible only under certain circumstances. This tax strategy is available to real estate investors, but not to dealer-traders. Exchanging one property for another similar property is known as a like-kind or 1031 Exchange. The parameters for a 1041 Exchange are fairly broad. A residential rental property can be exchanged for a commercial property, for example, as long as the exchanged property is also an income-generating asset. While a 1031 Exchange can delay taxes, the tax bill comes due when the investment property is sold.
Both investors and dealer-traders can take advantage of an IRS provision that allows the tax-free sale of a property that has been your primary residence. To qualify, you must have lived in the property for at least two of the past five years. If this provision is met, you may be able to exclude up to $250,000 of the sale profits from taxes. However, if you are selling a house where you never lived, the property is considered an investment property, which has entirely different tax considerations.
Active versus Passive Income
The income that dealer-traders generate from house flipping is considered “active income” and subject to ordinary income tax rates, plus another 15% for self-employment taxes. The tax treatment of active income differs from passive income, which is income generated from rental properties.
A benefit that is available to dealer-traders is deducting losses in full in the year of the sale. Investors may be limited in the amount of losses they recognize on a real estate transaction in a given year, depending upon their other capital gains or losses during that year.
Corporation versus LLC
The main advantage of incorporating a fix and flip business is separating business activities from your private life and eliminating any personal liability for the success or failure of the business. Incorporating does not alter the tax status of the business owner and may actually signal to the IRS that you are a dealer-trader.
The IRS allows professional house flippers to write off many of their business expenses. The money spent purchasing a property and making upgrades is considered a capital expenditure, which may be deducted from taxable income after the property’s sale. However, these expenses cannot be deducted prior to the sale.
Office expenses may be deducted, whether the flipper works out of a home office or an off-site office. All office expenses for an offsite office, including rent, utilities, phone and Internet, are deductible. For a home office, a percentage of the house expenses, based on the square footage of your office relative to the entire house, may be deducted. Other direct business expenses such as office supplies and business cards are fully deductible.
Flippers who use their personal vehicle for business travel may also claim travel expenses as a deduction for the business. The IRS allows two methods for calculating vehicle expenses. The first is the standard mileage rate, which is miles traveled for the business multiplied by the standard mileage rate (54 cents a mile in 2016). The second method is deducting actual vehicle expenses, including maintenance, repairs, oil and fuel. If you claim a vehicle deduction, be prepared to maintain a written log tracking mileage and keep receipts for gas purchases and vehicle repairs.
A variety of miscellaneous expenses related to the business may also be claimed such as property taxes on the investment property, building permit costs, real estate commissions and legal and accounting fees
The best way to track deductible expenses is to set up a separate checking account for each property. This avoids commingling expenses from multiple properties which may lead to confusion and tax issues.
Given the complexities of tax laws governing real estate transactions, house flipping start-up businesses should plan on recruiting an experienced accountant to the team who is familiar with real estate investing. Seeking expert tax advice upfront will help ensure maximum tax benefits and minimum payouts for your business.