Flipping Houses

With House-Flipping Profits Down, Here Are 4 Alternative Investing Strategies to Consider

Expertise:
9 Articles Written
Business desk with a keyboard, report graph chart, pen and tablet on white table

Overall, home flips dropped 12.9 percent during the third quarter of 2019, according to the latest report on fix and flips from ATTOM Data Solutions. Among other trends, data show seasonal slowing in this sector, in addition to reported near-seven-year-low returns.

And as most home flippers can tell you, profits are down. Recognizing and preparing for this less profitable phase in the fix and flip market are the best ways to protect yourself. Keep reading and we’ll talk more about the latest report, what it means for you, and what your options are.

Home-Flipping Profits May Be Down… But Here’s What Investors REALLY Need to Know

When reading this year’s “Home Flipping Report,” many are focused on the slump in actual flips. To be sure, the number of single family homes and condos purchased and sold within one year were down from the second quarter of 2019. However, that appears to be an annual phenomenon. And they were actually up slightly year over year.

Related: 6 Essential Considerations When Looking at Real Estate Statistics & Data

What I found most significant was that home-flipping return on investment (ROI) has hit its second lowest point since 2011. The lowest point was in the first quarter of this year. Housing costs are up and the inventory of distressed properties continues to shrink, with foreclosures down 6 percent year over year.

Of those, “zombie properties" (abandoned pre-foreclosure properties) now account for less than 3 percent of the country's inventory.

flip-houses-no-money

More Information From the Report

The report by ATTOM Data Solutions is compiled from sales deed data. It calculates the difference between the purchase price and sales price of single family homes and condos bought and sold in less than 12 months (gross ROI).

The report indicates their analysis of sales deed data found ROI slightly over 40 percent. However, the data available only includes purchase and sale prices. For the purposes of this report, ROI (their “average gross flipping profit”) is the difference between the purchase price and the flipped price.

This report does not factor in rehab costs and other expenses incurred. According to flipping veterans, they estimate such costs typically run between 20 to 33 percent of the property's after repair value (ARV). This means that net returns for veteran flippers were actually significantly lower than the stated 40 percent.

Other Important Housing Data From ATTOM

If you don’t have time to read ATTOM’s report, here are some other important highlights:

  • Distressed sales as a share of all transactions drop to the lowest point in nearly 13 years.
  • Total distressed sales—bank-owned (REO) sales, third-party foreclosure auction sales, and short sales—accounted for 10.5% of all single family and condo sales in Q3 2019. This is down from 11.3% in the previous quarter and from 11.6% from the same time last year.
  • Distressed sales as a portion of all sales now stands at its lowest point since the fourth quarter of 2006.
  • Higher home prices have a slower turnaround time.
  • Home prices rose across the country by 9% year over year in the fourth quarter of 2019. This means the typical home remains a financial stretch for most average wage earners.
  • Even as mortgage rates remain low, the shortage of affordable housing puts a downward pressure on sales.

Related: How Data Analysis Can Make You Rich in Real Estate Investments

While Flipping Profits May Be Down, You Still Have Options

With a shrinking inventory of distressed properties, if you are an investor with a home-flipping business model, it would be wise to adjust now. While the acquisition and rehab costs are escalating, a change in strategy and timing can significantly reduce the taxes you pay on this activity.

In his ultimate guide to flipping, Brandon Turner acknowledged that, “[Flipping profits] are not all yours to keep. Instead, any profit you make needs to be shared with the government when tax time comes. House flipping is generally considered ‘active’ income and therefore taxed at the highest levels.”

Want more articles like this?

Create an account today to get BiggerPocket's best blog articles delivered to your inbox

Sign up for free

Flipping is taxed at the highest rates, corresponding to ordinary income tax brackets. This can be reduced to the capital gains tax rate while still allowing you to benefit from the upside potential of distressed properties. Keep reading below for more about this and a list of other potential options you can use.

home appraisal

1. Hold onto the property for 1 year and 1 day, and change your intent.

As you likely know, capital gains are the profits from the sale of an asset (like a home or property). Such profits are considered taxable income.

When you sell your property in less than a year, you are subject to capital gains tax (short-term capital gain) that is based on ordinary income tax brackets, which can be quite high. However, if you hold onto your property for at least one year and one day, you will pay a much lower capital gains tax rate (long-term capital gain)—as long as you can also demonstrate that it was your intent to hold the property for productive investment use (similar to a 1031 exchange).

Some quick facts about capital gains tax:

  • Capital gains tax is assessed on the positive difference between the original purchase price and the sale price.
  • When you take the total of the capital gains then subtract any capital losses, that is known as the net capital gains.
  • Long-term capital gains tax rates can be either 0%, 15%, or 20%.
  • Short-term capital gains tax rates can go as high as 37%, since they are based on your ordinary income tax bracket.

2. Consider live-in flipping for a couple of years.

Living in the home you’re flipping can arguably be difficult. Usually, there is a lot of construction going on, and it can be tough to keep things organized. Mindy Jensen’s article addresses exactly that.

But Mindy and many other investors—myself included—have figured out that this a great way to avoid paying taxes on their flips through the Taxpayer Relief Act passed in 1997. All you have to do is own the home and live there (it must be your primary residence) for two of the five years preceding the sale.

If you can live in your property for two years while you’re flipping it, you can then write off up to $500,000 in capital gains ($250,000 for single folks).

3. Change to the BRRRR method.

Brandon Turner first coined the term BRRRR some years back, and it's been popular ever since. If you're unfamiliar, the BRRRR method describes the process of Buy, Rehab, Rent, Refinance, and Repeat.

landlord, rental, homeowner, realtor

It involves:

  • Buying a property: Specifically, one that you intend to hold—not flip.
  • Rehabbing the property: You have to make it livable and functional while also adding value.
  • Renting the property out.
  • Refinancing the property: Try to look for a bank that will offer cash out instead of paying off debt. Also, you need to borrow on the appraised value. So, look for a bank that is prepared to lend on the appraised value as soon as a property has been rehabilitated and rented out.
  • Repeating this process again for a steady stream of cash flow.

4. Use 1031 exchanges to defer taxes on sales.

Instead of looking to flip a house quickly, you can hold onto it and increase your buying power with a 1031 exchange. With a 1031 exchange, you follow certain steps to defer paying any capital gains tax when selling one rehabilitated house to purchase more investment properties.

When using a 1031 exchange, you must have had the intention of holding the property for productive use at the time of your purchase—although the rules and regulations do allow for a change of intent after purchase when necessary.

Renting out your rehab property for a period of time in order to take advantage of a 1031 exchange is a great idea and definitely one that you should consider.

Bottom Line: Learn How to Adapt to Remain Profitable

If you are an investor who has been flipping homes for profit, the diminishing returns may have you worried. However, you have options.

You can change your business model just a bit and adjust your activity. This can help you reduce your tax burden and maximize your  profit.

As Ashley Wilson cautioned in her recent article: “As deals become more scarce, it is more important than ever to continue learning from our past so that we are still in business in the future!”

Are you a fix and flipper? Does data included in this report concern you?

Weigh in with a comment below.

Dave Foster, real estate investor and qualified intermediary, has 20 years of experience working in all phases of real estate investing, from large scale development to single family homes and vaca...
Read more
    Clint Bolton Real Estate Broker from Hernando, MS
    Replied 9 months ago
    We've definitely seen downward pressure on profits from flipping in our market due to two main reasons: 1. More competition in the market (everyone wants to flip houses now thanks to HGTV and biggerpockets 😁) 2. Less distressed deals in our market. We've had to get more creative on finding deals and we've ramped up the number of flips we do in a year since profit margins are less on each. Still a great business to be in though if you're patient and know your numbers well!
    Paul Compton Harris
    Replied 9 months ago
    Clint, I live here in MS on the coast. There are still many opportunities here. Even though Katrina was 15 years ago I think we are just passing the 60% mark in rebuilding property between the beach and railroad tracks. There are some great opportunities still around.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    absolutely agree Clint. There's nothing like the adrenaline rush of putting together a short hold flip from trash to treasure. Unfortunately it comes with a steep price tag tax wise and the HGTVs and BPs of the world make us victims of our success. Keep on keeping on!
    Dev Horn Flipper/Rehabber from Arlington, TX
    Replied 9 months ago
    Good article. I like your proposed strategies - all very reasonable. It's interesting that we're at a point in the market where it is more competitive than it's ever been, yet there are more GURUS now than ever, producing literally thousands of "wholesalers" in the past year. I've often felt that when you see the MOST HOTEL SEMINARS, we're are the TOP OF THE MARKET. I think the "good news" for 2020 is: (1) Still very strong demand for affordable houses, and (2) Prices will hold up at the lower end of the price curve, so (3) Anything (distressed property) you can buy right is going to sell quickly at a decent price (once renovated). ROI will go to the investors that know what they're doing - those who have sophisticated marketing, significant funding, and established teams and crews. I think the "bad news" is that this is probably the worst time to start as a "wholesaler". Cost per deal acquisition will remain very high in 2020 and that leaves little or no margin for a wholesaler's fee. I think high prices, high marketing cost, and high competition all make 2020 a very tough time to wholesale.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Good thoughts Dev. For the experienced flipper there will always be a market. It just becomes more competitive and expensive. Pressure from too many entries into a market doesn't kill the market. It just disrupts while Darwin runs his course and leaves the fittest. But meanwhile everyone feels the pinch.
    Benny Cash
    Replied 9 months ago
    From what I understand, BRRRRing generally carries the same challenges as flipping in terms of finding distressed properties that can be acquired at below market value to rehab. The main difference between flipping and BRRRRing is what happens after the rehabbing. I'm not sure I understand why BRRRRing is considered an alternative strategy, as one is basically short game and the other is long game.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Benny, I like your description of a long and short game. You can finish 18 using one or the other. But you'll score better using both and knowing when to use each. The BRRRR strategy gives you flexibility when those distressed properties are more difficult to come by. You can play the long game waiting for the next opportunity to chip one in from the fringe. That's why I present it as an alternative. A died in the wool flipper buys fixes and sells. The Brrrr disciple will add the flexitility of time and reduced taxes so they can maintain margins more easily. Good thoughts - Thanks for responding
    Michael P. Lindekugel Real Estate Broker from Seattle, WA
    Replied 9 months ago
    Regarding capital gains tax treatment and the one year there is nothing in the IRC that specifies one year. the IRC does mention intent. while one year is the generally accepted minimum time it possible to sell real property with less than one year of ownership and qualify for long term capital gains tax treatment when the taxpayer document's intent to hold the property long term and there is an unexpected reason that necessitates a sale prior to one year.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Publication topic # 409 speaks pretty clearly to the one year hold for capital gains treatment - https://www.irs.gov/taxtopics/tc409. The statue is pretty clear that a hold of one year or less is going to be ordinary income (outside of a very few exceptions). But I agree with you Michael. it can be pretty subjective when it's looked at from the opposite direction. The IRS reserves the right to examine your intent. And if they determine that your intent was primarily to resell your transaction will be subject to ordinary income tax even if you have held it more than one year - significantly more than one year. So if you have held the property a year or less You'll always pay ordinary income outside of those few exceptions (intent is not one of them). If you've held the property for more than a year you'll almost always pay capital gains. In the world where I live - the 1031 exchange - holding periods get tacked together so it's almost exclusively capital gain. And it's always deferred so everyone's happy ! Thanks for responding
    Mark JOhnson Investor
    Replied 9 months ago
    This the time you should be networking. MLS and Zillow deals are becoming rare. Deals are there but you need to look elsewhere so get connected. This means get out and meet real people. Your cell phone and keyboard are not going to get you that same level of relationship!
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Nothing ever beats boots on the ground and building a personal network. Sometimes the best deals late are right under you nose but take some digging to get you. Great comment Mark!
    Wouter Krusemann New to Real Estate from Eindhoven, Netherlands
    Replied 9 months ago
    Interesting read! What does this imply for the general market conditions and would this trend continue in 2020?
    Paul Compton Harris
    Replied 9 months ago
    Trends are what we make them, thats why they are called trends. With a small group like this forum we could easily start a trend or give a current trend a serious thrust.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    I wish I had a crystal ball Wouter. But compression of returns and fewer value add propositions is a pretty normal event in a mature market cycle. Buyers will continue to accept smaller and smaller returns until they either get caught in a correction event. Or buyers stop buying and prices stabilize or retreat to a point where buyers will buy again. Casual investors start moving to the sidelines. professional investors just look harder for opportunities and take more time to find them. This feels like a very normal cycle. Where it goes tomorrow - who knows!
    Account Closed
    Replied 9 months ago
    Thanks Dave! Good article. I forgot about the 1031 exchange.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Yep. The 1031 is another one of those tools that can help you boost returns while repositioning your assets. Thanks Bob!
    Michael Casile
    Replied 9 months ago
    Great article. HGTV is not the only enemy of the flipper. Now that Zillow, OpenDoor, etc are in that market and looking to make money based on volume ... those high ROIs may be a thing of the past. We were selling one of our rentals (capitalizing on a good market) and OpenDoor provided an offer that was so close to what a realtor would have gotten us ... that we went forward w/it (we also got a good estimate from Zillow, but they saw one breaker in our box was aluminum wiring and balked). I'm guessing most folks out there are like me getting 3 to 10 offers a week on property we hold. I know it's just folks trying to make money, but I know that they are looking for big ROI so they are looking to pay pennies on the dollar. It was a market ripe for a big player to come in with lower margins and more volume. As it is, in central NC, it has become hard to get homes. We do the auctions ... but even when we win (and that is not often), it is often upset with later bids. At this point, we're actually selling some to take advantage of the market ... and we'll likely hold some cash out looking for that elusive good deal ... or we'll wait for the market to take a down-turn. In most of my life, we've had more buyer's markets than sellers. This sellers market has been running for a while (like the stock market). I believe a change in leadership could turn both markets south for a while, and then I hope to be in a good position to capitalize. It's just not a market to buy at all at least here in NC.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Strong strategy Michael. Thanks for sharing it with us.
    Curt Smith Rental Property Investor from Clarkston, GA
    Replied 9 months ago
    I'm pretty certain a flip property is "inventory" and will always be inventory meaning holding for 12 mo + 1 day will NOT get you long term cap gains. Only investment property has cap gains availble. To be an investment you need to rent or Airbnb etc the property. Please correct your taxable statements and inferances.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    You're exactly right Curt. No matter how long you hold a property. If your intent was, is, and remains primarily to resell then you will always pay ordinary income. However actual income production is not a statutory requirement either. The standard is your intent. So in order to get capital gains treatment you must have held the property more than a year and you must be able to demonstrate that your intent was to hold for productive investment use. Most folks feel that it is possible to demonstrate an intent to hold by their actions and the act of actually holding the property more than a year. But there are some outlier exceptions to that (not so much with flippers but with developers especially). I can see where I could have caused some confusion with the phrasing of the article. There's a ton of nuance surrounding application of intent as it relates to capital gains treatment. Writing so people don't nod off to sleep with a topic like this is like trying to stuff 10 lbs of potatoes in a 5 lb sack :). Thanks for point this out.
    Tim Wade
    Replied 9 months ago
    BRRRR has advantages over flipping in that you don't have to factor in selling costs if you're going to keep the property. One potential advantage or disadvantage (depending on market conditions) is that while your profitability isn't as dependent on ARV of the property, it is critically dependent on rental rates and their relationship to cost of acquiring the property in your market.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    That's right Tim. Another huge variable is the cost of that refi money. A rising interest rate environment can wreak havoc with your BRRRR returns. Conversely, an environment of lowering rates can give you that juicy cash and increase your NOI all at the same time. I vote for that!! Thanks for sharing
    John Akolt Investor from Chicago, Illinois
    Replied 9 months ago
    Thanks for the article. I think some earleir posts are confusing capital gains with sec 1031 exchange rules. For capital gains IRC 1222 is pretty clear--You don't have to hold it for a year and a day, just a year. Whether it qualifies as capital asset depends on amounts of income and the value, volume, and frequency of the taxpayer’s real estate transactions. Depending on structure, even the taxpayer can be a dealer in some transactions and investor in others. 1031 exchanges generally assume a year requirement prior to exchange and a year requirement after but there is nothing set in stone. Some 1031 exchanges will qualify if not held for the 1 year period. I am not aware of any 1031 exchanges held for more than a year that didn't qualify--are you? IRC 1222 (1) Short-term capital gain The term “short-term capital gain” means gain from the sale or exchange of a capital asset held for not more than 1 year, if and to the extent such gain is taken into account in computing gross income. (3) Long-term capital gain The term “long-term capital gain” means gain from the sale or exchange of a capital asset held for more than 1 year, if and to the extent such gain is taken into account in computing gross income.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Interestingly enough John there are a few significant cases where the asset was held over multiple years and the 1031 exchange was denied. In once case it was a 10 year hold by a developer who forgot to take down the for sale signs and take the property off the MLS. The IRS determined that he had been attempting to sell the lots for the entire time (though the crash) and so the property and lots were inventory and not a capital asset - yikes! So once again intent becomes the rule with 1031s. Most folks feel good at anything more than a year but there could always be instances where a hold period of less (or more) might be appropriate. With the determination of capital gain there is no wiggle room. In order to get favorable long term capital gains treatment you must hold the property more than a year (some would phrase this as a full year and some might say a year and a day I can see where they're intending the same thing). And your intent must have been to hold. Good thoughts. Thanks for sharing
    Collin Corrinton Investor from San Antonio, TX
    Replied 9 months ago
    You forgot about owner financing!
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    You're right Collin. That is another great strategy - especially given the large % of homes owned with no debt. Most folks think of flip opportunities as depressed properties that the owner can't do their own value add. Sometimes its just convenience the seller is looking for. Great thought. Thanks for reminding us
    Steve Harlow Investor from Irvine, California
    Replied 9 months ago
    Maybe one of the best discussions ever on Big Pockets. All of my flips so far have been in Qualified Retirement Accounts. Beneficial if its a ROTH. The use of 1031s for "fix and flips" can be problematic as has been pointed out and if it blows up can be a big surprise on the tax liablity. I'm not finding acquisition costs going up but rehab costs going up meaning labor and materials. However if your in a major MSA acquisition costs are going up as the big hedge funds are bidding up the prices. Their cost of money is lower and their math models allow then to accept a lower projected return with a greater risk element.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Great comments Steve. Right on the money!
    David Krulac from Mechanicsburg, Pennsylvania
    Replied 9 months ago
    Dave, great post and thanks for all your replies adding and elaborating. The real question is Dealer Status or Not. Some time ago I had the opportunity to do extensive research of the dealer question, which has never been defined in IRC (Internal Revenue Code). Perhaps that what @Michael L. was suggesting. Just heard a presentation for a CPA, where he said if you did 1 flip a year you're probably ok, but when further questioned refused to say ay t what number you were NOT ok. I've heard others, including CPAs and Attorneys say 5 or 6 transactions a year. But again neither number of transactions or any number of transactiosn is supported by the IRC. In my research I looked at Tax Court cases for some guidance, but that was not satisfactory either. There was one case where the taxpayer did one transaction and was labeled a dealer, and another court case where another taxpayer did multiple transactions and was not a dealer. With state and local taxes added on to the Federal tax brackets, the maximum tax on a flip, a short term gain could be approaching 50% of the profit. And on top of that could be subject to FICA (Social Security + Medicare tax) of 15.3 % on top of the income taxes and at the max could be around 65% tax on your short term gain. Despite the other stated reasons for a declining flip market, the tax situation transcends the current economic trends. While I have long advocated long term rentals (having had several tenants staying more than 30 years), there is a very tax saving strategy in the middle of renting maybe to one tenant and when they move out, then polishing the property and then put it up for sale. The act of renting a property clearly demonstrates for the tax man that it is not property held in inventory as a dealer. Or on vacant land renting farm land for agriculture of wood land for timbering might present an argument that the real estate is not dealer property
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    There's an awful lot open to interpretation isn't there David?! The mantra in the 1031 world last cycle was "one year and one day". Everyone said you're absolutely fine with "one year and one day". That was until there were a couple of court cases where it was more than that and the exchanges were denied! Your idea of renting and then selling has a lot of merit. Ultimately it's going to come down to each individual case and what you can demonstrate in that instance if questioned.
    John Murray from Portland, Oregon
    Replied 9 months ago
    I purchased a bunch of Zombies an a few Vampires. Cash to leave the Vampires worked well. Fast forward 6 years and a total of 9 Zombie/Vampires when a tenant moves out I remodel/renovate and sell. This may take 6 months to year and that reno home I take my second home mortgage deduction and taxes and stop deprecation. I keep my AGI down to avoid recapture and capital gains to a minimum. The trick is to take a paper loss and pay near zero taxes. I avoid earned income completely so AGI is pretty easy to manipulate so a 1031 is pretty much superfluous.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Creative thinking John. I'm all about using many strategies to eliminate/mitigate taxes. I'm wondering how you're getting out of depreciation and recapture during the period when it is a rental?
    John Murray from Portland, Oregon
    Replied 9 months ago
    That's a very good question Mr Foster. I take a huge paper loss by cost segregation and keep capital improvements to a minimum and repair to a maximum. The $25K pass through keeps the recapture and capital gains down to a minimum upon closing. The Feds give an $80K pass on capital gains but not the state. Depreciation will stop if any money pays down the principle, bad idea. Safe harbor of depreciation will continue as long as the contract is a pure Lease Option. The Lease Option to Purchase is not a safe harbor to continue depreciation since the IRS defines it as an installment sale. The IRS will disallow the safe harbor. Make 70% of all cash outflow tax deductible this includes medical, SALT taxes, 1st and second mortgage. Combine with paper loss and 5 or 6 income streams the AGI can be throttled to achieve close to zero income tax on both state and federal. It's all in the AGI, that is the key to zero taxes or close to it.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 9 months ago
    Thanks John. I had to ask :) . And now I have to chew on this one! Very interesting!
    John Murray from Portland, Oregon
    Replied 9 months ago
    Another tax question in the Lease Option is how the fee to purchase the right to purchase is treated. The up front money can be treated in 2 ways, declare the funds in that tax year or when the property closes. Iv'e researched this and my CPA advised declared it in the tax year when the funds were acquired. My CPA told me that the funds would have to be treated as a separate escrow account kinda like security deposits for renters. I think the IRS just wants you to be up front about things and if a mistake is made, fall on the sword and beg for forgiveness. No fraud just and ignorant tax payer.