We’ve covered a lot of ground in this column over the last two years, so let’s catch our breath and review some principles of successful property flipping. Here’s a review:
1. Don’t let anyone tell you that flipping properties is either illegal or unethical. It is neither. Flippers simply provide a ready market to help motivated sellers solve problems of their own, and then take care of neglected maintenance and make improvements to the housing stock, making homes (and neighborhoods) more valuable after the flip than before. They then capture some of this value as profit. That’s it.
2. Make your money when you buy, not when you sell. The engine that drives your profit potential is the discount from the fair market value that you can get. You can get this discount by being willing and able to close quickly on a house where a motivated seller needs fast cash or the ability to relocate. You might not be a seller’s “Mr. Right.” But there’s a lot to be said for being a seller’s “Mr. Right Now.”
3. Buy at a discount to the intrinsic value of the investment.
4. Be picky. Especially with your first deals. Get a good pitch to hit. Or, as Warren Buffett puts it – stay within your own “circle of competence.”
5. Keep it simple. Most big renovations are net money losers, on average. Don’t count on them for your profits, unless you need to renovate in order to make the property livable or to bring it up to the minimum standards of the neighborhood. But make sure you factor in your renovation costs when you make the offer to the seller.
6. Remember that house flipping is essentially a market-neutral strategy. That means you aren’t relying on a continuing bull market in real estate to make your money. Flipping, if well-executed, can be profitable in up, down or sideways markets. That’s because motivated sellers must sell below market price no matter what the market is doing. Flippers exploit the difference between the discount to market value that a motivated seller will take on one hand, and the full value of a well-shown and presented property on the other. That tension – that dynamic – propels flipping profits no matter what the overall market is doing. You must move faster during a bear market, or when interest rates are rising, and you may have less margin for error. But keep it simple and straightforward, and you can profit in any market environment.
7. Take advantage of every tax deduction you can get.
8. Maintain a sound balance sheet and enough liquid savings to deal with the unexpected. Murphy’s law is alive and well in the Flipping Market, and it will drive you out of business if it strikes at the wrong time, when you are overextended.
9. Don’t neglect contract assignment. This is a great way to get started because it allows novices to hand over deals to more experienced investors who have the cash needed to make a deal profitable. And it’s a great way for experienced investors to leverage the efforts of other smaller investors! A related concept: wholesaling!
10. Serve the masses, eat with the classes. Master the art of selling to the fat part of the bell curve.
11. Understand fraud rules – and keep your integrity intact. No. Matter. What.
12. In the long run, property flipping is a people business. You will run into the same players many times over. Your reputation as one who deals fairly and honestly is a thousand times more important than any given deal.
13. Don’t lose money.
14. Be a great singles hitter. Create and work a system for nailing a modest profit again and again. You don’t have to swing for the fences. Keep it simple – reinvestment and turning over capital many times in a year, doing multiple deals with the same money, will do just fine. You’ll get your share, and four simple deals with steady profits over the year are better for new investors than one big, complex deal with uncertain profitability.
Hello! Yes, you will still be liable for capital gains tax. Well, the LLC will, but since it’s a pass-through entity, that’s going to spill over onto your personal tax return.
However, since you’re dealing with investment properties, you may be able to make use of the Section 1031 Exchange, which allows some investors to defer capital gains if they are exchanging one property for another of ‘like kind.’
Once you have a few deals under your belts, though, then you may begin to fall under dealer rules. At that point, your profits aren’t taxed as capital gains, but as income! I’ve got a couple of columns on that topic if you just search through the archives.
It’s vitally important at this point to have a tax advisor and an attorney in your corner, and to work in close consultation with them. Particularly since you are in the start-up phase. This is when you are most likely to make rookie mistakes that can cost thousands of dollars!
Normally, you’ll have to recognize profits or losses when you sell. Any profits or losses will ‘pass through’ to your individual income tax return and those of the other members at the end of the year. You’ll pay capital gains tax if you don’t do more than a handful of deals – maybe. But if you’re at all active you’ll probably fall under ‘dealer rules.’ When that happens, profits from flipping become treated as ordinary income… like you’re selling inventory from a storefront.
See a couple of columns I wrote and click around from there. You should understand dealer rules pretty well if you’re going to be serious about the flipping business!
A market that is falling as much as this need more
people with good jobs. Especially, if trying yo raise the price, by flipping or improvements.
I have to say I’ve never heard of flippers as being unethical or illegal. Making a home work and look better seems like a pretty great thing to me. Along with perhaps slowly but surely raising the neighborhood value and creating safer areas due to upscaling. I think it’s also great to be able to be more environmentally aware by not tossing the baby out with the bath water. If something has good bones and materials that are able to be saved and given a face lift and think all people should be able to support that.
Question: I a newbie, and will be partnering with 2 other people. We will be forming an LLC. We want to reinvest the profits into our “business” to use for the next flip. We will all have equal shares in the profit, so it will be spit 3 ways, but we all agree to reinvest into the next flip, how do we deal with taxes in that scenerio? If we purchase another property with the profits do we still pay capital gains tax?
The same rules and cautions apply as Jason Van Steenwyk discussed above, plus with an LLC you have the option to let the profit flow through to the members or leave it in the corporation and let the corporation pay the taxes. It can get tricky, so this is where sophisticated planning and good luck are important. Do the planning before you do the business – waiting until later is not a good thing.
If you have elected to let the corporation keep the profits and you lose money, the corporation would have to file for a carryback or would be stuck with a carryover. If you had elected to let the profits flow to the owners, you could use the losses to offset other types of taxable income.
All the other rules about such things as hobby losses, regular income vs capital gains, and being a dealer or not still apply.