House flipping risks are a real, as you can definitely lose your shirt. But done right, so are the rewards. Fortunes can be made.
If COVID has you wondering about getting into the house flipping game, you’re not alone. Plunging real estate prices are catching the attention of investors nationwide.
Given that house flipping relies on picking up properties below market value, the coming months may be an opportune time to get started.
Plus, it’s exciting to explore a new career. Make no mistake, it is a career, because you’re going to be involved with every step of the house flipping process, from identifying the asset, to buying it at the right terms, renovating it, paying contractors, and relisting it at a premium price point.
House Flipping Risks and Rewards
Thanks to a slew of reality shows, including Bravo’s Flipping Out which features mogul Jeff Lewis, house flipping is spreading in popularity.
House flipping is when you buy a house with the intention to quickly resell it for a profit.
Frequently, but not always, there is a renovation process involved. This is because it is difficult to purchase a house substantially below market value if it doesn’t require some elbow grease.
Although more and more people are exploring how to start house flipping, not everyone makes money.
If you are going to use dropping real estate prices caused by COVID-19 to get into the house flipping game, make sure you understand the hazards below so you can navigate them gracefully.
Mistakes of Novice House Flippers
The reason that experienced flippers tend to do better than novice flippers is that novice flippers often fall prey to one of the following:
- Tax Implications
- Realtor Fees
- Closing Costs
- Unexpected Complications
- Not Understanding the Full Cost Breakdown
Each of these risks is explored in greater detail below.
1. Tax Implications
Perhaps the very biggest mistake that novice flippers make is that they don’t fully understand the tax implications of house flipping.
I know, taxes really aren’t that fun to talk about. However, they are one of the single biggest expenses associated with house flipping, so it’s worth getting knowledgeable about them.
With short term flipping, any profit you make will get treated as active income, and therefore, will be taxed the at the very highest levels.
If you own a property for less than a year, you will pay the following on any profit from the sale:
- Federal Taxes: You will owe federal taxes at a rate of 10% to 37%.
- State Taxes: Unless you are in one of the seven states have no tax on earned income, you will owe state income tax. (In the state of California, this could be as high as 13.3%.)
- Local Income Taxes: Depending on your jurisdiction, you may owe local income taxes.
- Self-Employment Tax: You will usually owe self-employment tax (currently 15.3%).
In total, those taxes really add up. They could easily easily eat up 40-50% (or more) of your total profit. Yikes, right?
In contrast, if you held a property for the long term (over one year), you would benefit from much lower capital gains tax rate of only 0% to 20%.
You could also do a 1031 exchange at the time of sale, in which you could roll all proceeds from the sale tax-free into a new like-kind investment property of equal or greater value.
With a 1031 exchange you can sell one property and buy another one without paying a single cent in tax. It’s an insane tax loophole and it’s available to anyone who owns an investment property for over a year.
The tax implications related to short term house flipping are huge and you need to understand them.
Given these realities, after finishing renovations, you may want to rent out your properties for a year or two while the economy recovers before relisting it.
In doing so, you’d get taxed at the much lower capital gains tax rate, and potentially, benefit from rebounding real estate markets as we move toward the other side of this pandemic.
2. Realtor Fees
Sometimes novice house flippers don’t realize that 5-6% of the final sale price will need to be paid to the realtors that facilitate the transaction. This can take a serious chunk out of one’s profits.
It’s one of the reasons that in nearly all of the house flipping shows on TV, the featured couple are usually realtors.
They do this to save themselves an average of 6% per transaction. On a $300K house, that could be $18,000 in savings.
3. Closing Costs
Even if you pay cash for the property and therefore avoid lender fees, there will be closing fees, both when you buy the house to flip and when you sell it to a happy buyer.
Closing costs can include appraisal fees, title searches, title insurance, surveys, taxes, deed-recording fees, and more.
In total, they can add up to several thousand dollars, so you’d better plan ahead. Don’t let house flipping risks like unexpected costs catch you unprepared.
4. Unexpected Complications
Novice flippers are also less prepared to deal with major complications, such as zoning issues, the presence of mold, structural issues, or environmental complications, among other potential problems.
More often than not, these issues will add both repair costs and a longer holding period.
5. Not Understanding the Full Cost Breakdown
Many novices don’t understand the full cost run down associated with flipping, such as carrying costs and opportunity costs.
Carrying costs are any expenses that you have to pay while owning a property. They typically include utilities, such as gas, electric, and water, as well as taxes and insurance. They may also include debt service payments.
Opportunity costs are those associated with deployment of your labor and cash into a single asset when it could be used elsewhere.
House Flipping Risks in a Nutshell
There’s something undeniably satisfying about flipping a house. Through your hard work and investment, you see a shabby shack transform into a proud, elegant home. Done right, the gains can be rewarding too.
However, like all high risk activities, house flipping comes with risks and rewards.
Hopefully the tips above have clarified the pitfalls to avoid, so you can lock in your gains. For more life skills that your parents and teachers probably didn’t teach you, explore the blog.
Related: How to Start House Flipping: A Simple 5 Step Guide
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