News Bankrate.com Flipping houses for a living is a real trick February 30, 2006 by Pat Curry You come home from a long day at work and while channel surfing, you come across a show in which guys are buying run-down houses, fixing them up and reselling them for huge profits before the first mortgage payment is due. Wow. What's more, they claim they make as much money on this one house as you have in the last year. They don't look or sound any smarter than you are and they're raking in the cash. You start crunching numbers and before you know it, you're thinking about a career change. Before you quit your day job, can we talk? It's not as easy as it looks on TV. The price run-up of the past few years led thousands of people to reach the same conclusion you have. There is a boatload of competition out there, which means that the obvious deals are gone in a heartbeat. The pros will tell you that they make their money on the front end by buying properties for at least 30 percent below market value. Finding those houses takes time and once you find them, you'll need to move fast. And no matter what the late-night gurus say about doing this with no money down, it hardly ever works that way. That means you'll need access to cash to do the deal, not to mention the rehab. Dream catchers "The masses believe in the dream that's been promised to them, that they'll be making a fortune in the next six months," says Manuel Iraola, president of Miami-based Homekeys.net, an online real estate company. "They don't have the basic know-how. If it were as easy as they make it seem, 286 million people would be flipping real estate." Richard C. Davis, owner of Charleston-based Trademark Properties, and creator and star of A&E's reality show, "Flip This House" says no one can watch his show and get the impression that this is an easy way to make a living. "In our original video, we had a warning," Davis says. "'Do not try this at home. It's for trained professionals. You will lose money.' I got two guys following me around with a camera. There are no scripts. If I lose $100,000, you see it." While he understands the desire of people to get in on the action, he doesn't have a lot of sympathy for people who don't want to invest the time that's needed to learn the business. "Right now, you have people jumping in on frenzy and it will bankrupt a lot of Joes and Susies who have no business doing this," he says. "I mean, my wife is a doctor, you don't see me going out doing heart surgery." Here's the catch What's there to learn? Atlanta-based financial adviser Bill Kring wishes people understood that they need to have adequate savings in place to pay the bills while money is flying out the door for cabinetry, plumbers and plants. "In a business with zero income until liquidation, what are your resources?" Kring says. "What are your abilities to borrow? Without that, you'll never make it." Access to large amounts of cash is the hardest part -- and one of the biggest misconceptions -- of the business, says Raphael Isaac, who has been rehabbing and reselling houses in the metro New York market for 14 years. For most of his deals, he puts at least 10 percent down and then has a month to close. "If you don't close in 30 days, they keep your money," he says. "Then you need more cash to carry the house, the insurance, the utilities and the maintenance. You won't get a contractor to renovate a house for no money. People go to trade shows and buy these books and tapes on how to buy a house with no money down. I've never seen someone actually do that." Working against you Another reason that access to cash is so important is that you'll probably need to hold on to the house for at least three months because of Federal Housing Administration (FHA) anti-flipping regulations. Houses sold less than 90 days after they were purchased aren't eligible for FHA mortgage insurance; those sold between 91 and 180 days are okay but require an additional, independent appraisal to make sure the sales price is justified. What that means for you as the owner is additional carrying costs. Every day you own the house costs you money in interest, utilities, taxes and insurance. If you're taking out a mortgage to buy the house, talk to your banker about pre-payment penalties. "We make money when people hold loans; we lose money when they pre-pay," says St. Petersburg, Fla.-based banker Mark Dannenmiller. A typical pre-payment penalty, he says, is 80 percent of the balance of the first mortgage, times the interest rate, divided by 2. So, if you borrow $100,000 and get a mortgage for 5.75 percent, your pre-payment penalty would be $2,300 ($80,000 times 5.75 percent, divided by 2). Dannenmiller's advice to individuals who are considering going full-time is to keep your job, make a little bit of money and pay yourself back, building up your cash reserves. "Hopefully, by the fifth or sixth house, you don't need me anymore and you're buying houses for cash. That's important because as soon as you (quit) your job, you can't get a loan." To Joseph Patton, getting cash is the easy part. The hard part is finding the properties to buy. "These properties are not for sale through Realtors and they're barely available through auctions," says Patton, who buys primarily in Philadelphia. "(Finding them) is very time-intensive. You have to be out there on the street. It's almost banging on doors ... It's not an insider's game but you need to put in time to build the network." The taxman cometh One other point to consider: As far as the IRS is concerned, buying and selling real estate as an investment strategy and doing it as a business are two very different things. If you buy a house, fix it up, and resell it while you're working another full-time job that provides the bulk of your income, that's an investment and the proceeds will be taxed as short-term capital gain (if you own it for a year or less) or long term capital gain (if you own it for more than a year. A short term capital gain is taxed at the same rate as your ordinary income. A long-term capital gain currently is taxed at 15 percent of the gain. But if you're doing it year-round and it pretty much pays all your bills, that's a business and the IRS might consider you a dealer-trader, says Los Angeles-based CPA and tax attorney Bill Abrams. Then your gain will be taxed as ordinary income no matter how long you own it, the real estate taxes and interest will be regarded as an expense and you'll have to pay self-employment tax of 15.3 percent. Plus, you won't be able to take advantage of IRS section 1031 like-kind exchanges, which can help with taxes when you have a property that sells for substantially more than you paid for it. Only property that's held as an investment qualifies for this tax break; while the tax code doesn't specify a time frame, the rule of thumb supported by case law is that you need to hold it for at least a year to qualify. Right place, right time So, does it make any sense at all to do this? For the right people and the right reasons, sure. Detroit-based real estate broker and investor Ralph R. Roberts tells people to learn everything they can about the industry and don't consider making it a career until they've made double the amount of money in a year that they do in their current job. "One person I went to high school with bought a house every year for 30 years," Roberts says. "He's flipped about 10 of them. Now he's building a mammoth house. But he never did it to get rich; he did it to have financial independence. You can't go into it for the hype. You do it for financial security down the road." If that's your plan, maybe you don't need to quit your day job after all. It's possible, although often exhausting, to moonlight as a flipper, says New York-based real estate attorney Neil Garfinkel. "I know plenty of guys who do two, three, four houses a year, keep their health insurance and do this on the side," he says. "Many times, they can double their salary." And that's all you really wanted to hear, isn't it?