So you’re ready to get into the real estate game and are wondering how to start house flipping. Congratulations on exploring your 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.
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.
Mistakes of Novice House Flippers
The reason that experienced flippers tend to do better than novice flippers it 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 obsessed with them. It may be worth mentioning that I was raised by a Certified Public Accountant (CPA) who also happened be an IRS Tax Agent for 30+ years, so I started studying the tax code very young and still do today, even though it is now a dreaded 74,608-pages long.
With short term flipping, any profit you make will get treated as active income, and therefore, 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:
- You will owe federal taxes at a rate of 10% to 37%.
- 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%.)
- Depending on your jurisdiction, you may owe local income taxes.
- You will usually owe self-employment tax as well (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. Seriously, with a 1031 exchange 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.
If you can’t find anyone else who will talk to you about taxes, then message me. While I legally can’t give you tax advice, I can definitely direct you to the important sections of the IRS Tax Code.
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 had better be prepared.
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 repairs 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.
How to Start House Flipping: 5 Simple Steps
If you’re new to the flipping scene, how do you make sure you’re a success and not a sucker? Use these tips to master your first flip.
- Find Hidden Value
- Start with Cash
- Know How Much to Pay
- Do Serious Background Checks for Contractors
- Make It Universally Appealing
1. Find Hidden Value (Spot an “Ugly Duckling”)
Finding a flip-worthy house is often the most challenging part of any real estate investment. Not all inexpensive homes have hidden value you can bring out with a renovation.
There are two aspects of a house that you cannot change:
- The location
- The lot
The key is to find a shabby home in a strong location with enough space to have value.
This is why it’s so important to know your local real estate market. You need to know how a house’s value compares to the value of the homes around it.
You also need to know the trends. Which neighborhoods are on their way up and which are on their way down? Understanding which neighborhoods to watch will help you snag a great deal as soon as it hits the market.
2. Start with Cash
Make no mistake: buying a great flip house is a competition.
One of the best ways to be a top competitor is to have cash on hand. Paying cash for a house can save you thousands. For one, you won’t shell out money for interest or other financing fees.
You may even be able to get a lower purchase price on a home if you pay cash. Buyers with financing make sellers nervous because that financing can fall through at any time or can be associated with delays. If that happens, the sale falls through and the seller is back to square one.
If you’re prepared to pay with cold, hard cash, sellers may accept a lower amount from you to avoid the hassle of a buyer with financing.
How to House Flip with No Cash?
Paying cash doesn’t mean that it has to be actual cash, as in your money from your bank account.
Instead, your cash could come from:
- Money Borrowed Against Your Assets – If you own a valuable asset, a great option is to borrow against its value or equity. The best known example of this is a Home Equity Line of Credit (HELOC), in which you can take out a line of credit to access the equity in your home. This is what the wealthy are frequently doing when you hear that they have bought properties for “cash”.
- Cash You Borrow from Friends or Family – Under the right circumstances and because you have relationships with these people, friends and family may give you short term loans with only repayment or a low rate of interest expected in return.
- Cash You Borrow from Investors – Investors are people who expect to be paid a return on their money, either as a flat percent (known as a “Debt Partner”) or if you give them a share of the deal, based on how the deal performs (known as an “Equity Partner”).
- Cash from Hard Money Lenders – This is a loan from a lender who is not a bank, usually an individual or a company. They typically expect to be paid higher rates of return than a bank, sometimes as high as 6-15%. If you use them, you’d better have a lot of upside present within your flip, because they will charge you high interest rates.
Another creative option you could consider is seller financing, in which the seller acts as your lender.
In this case, you pay cash (yes, actual cash) for a small portion of the deal, say 20%. Then, you ask the seller to finance the rest of the sale, paying them the remaining money owned (80%) plus interest over a defined period of time. For example, if you were purchasing a house for $200K, you might pay 20% up-front ($40K) and then repay $160K to the seller over a 5-year time period at an interest rate of 6%.
In short, with seller financing you buy the property from the seller in installments over time. If you ever default on these payments, then they can take the property back from you.
Because you are intending to flip the property we’re discussing, you would make installment payments to the seller during the renovation period and then pay them back in full at the time of sale.
3. Know How Much to Pay
Negotiating a great deal on an investment property is far more difficult if you don’t how what a fair price is.
A good guide is to use the 70% rule. This rule says you should never pay over 70% of a home’s after-renovation value minus the cost of all the repairs.
For example, let’s say you spot a home in a hot neighborhood. Your real estate expertise tells you that with the right renovations, the home could be worth $400,000.
70% of $400,000 is $280,000. After inspecting the home, you estimate it would cost $50,000 to get the house into prime selling condition. This means you should pay $230,000 or less for the home as-is.
Of course, this involves some knowledge and research. You need to be able to see a home’s potential and know what that potential is worth. You also need a basic understanding of how much you’ll pay for various renovation jobs.
4. Do Serious Background Checking for Contractors
We all know the stereotype that contractors will try to scam you out of money. While there are plenty of honest contractors, you have too much to lose to risk hiring a dishonest one.
After you’ve found and purchased the perfect home to flip, you need to be cautious with your contractor choices.
Do research into each person on your team, from your general contractor to your plumber. It takes extra work, but it will be worth it when you receive quality work for a fair cost.
As you flip house after house, your goal should be to develop relationships with go-to contractors. You want to build trust with each person on your crew.
Not only will they be less likely to overcharge you, but you won’t need to research contractors for every new job.
In addition to these pointers, don’t forget the golden rule when it comes to paying the right price. Don’t have contractors purchase materials and bill you for them. Ask the contractors what you need and buy the materials yourself.
The only exception is when you need rare items you can only get through a contractor’s professional connections.
5. Make It Universally Appealing
We all have our own cosmetic styles when it comes to interior design. Flipping a house may feel like an opportunity for you to exercise your creative chops and try something new.
Seasoned house flipper Jeff Lewis suggests otherwise.
For paint colors, countertops, and other major elements of the home, go neutral. You want something that will appeal to as many people as possible.
When you stage the home, use temporary accessories to bring color into each room. These include pillows, rugs, and decorative pieces. Those items will brighten the house without making potential buyers worry about converting the style to their own.
Even in those pops of color, don’t follow the impulse of matching your own style. You need to think about what will appeal to buyers in the neighborhood.
For example, don’t use trendy colors that are popular with millennials if your flip house is in a neighborhood of retirees.
Start House Flipping, Today
There’s something undeniably satisfying about flipping a house. Through your own hard work and investment, you see a shabby shack transform into a proud, elegant home. Done right, the quick gains can be rewarding too.
The tricky part is that every decision you make in your flip contributes to your success or your loss. A Jeff Lewis Flipping Out marathon is a start, but it won’t give you all the knowledge you need to rake in revenue.
The tips above can help you start on the road to success. For more life skills that your parents and teachers probably didn’t teach you, explore the blog.