Selling flip in Ohio advice needed

14 Replies

Hi all, this is my first post, been reading tons on BP.  I have a couple rentals and decided to do a flip this year.  Its just finishing up (next couple weeks) and one of my tenants approached me about purchasing the property.  They have the income but poor credit, and the tenant has already started to work with a local company to repair credit.  A 12 month lease with option would work perfect for this situation but reading on BP it just seems like a lot of risk to me (in Ohio). Also I would like to get as much out up front as possible but have read its normally ~5% for option. I would like more around 20% but then I will run into equity limits, so I may as well do a land contract.  I'm looking for any suggestions on how to structure this sale.  Purchased for 24K cash, ~10K rehab (and a ton of my time), recent sales of comps are ~55-60K.  Thanks in advance.  

What risks are you referring to? I would do a separate lease and a separate purchase option. The option is only good if the lease is in good standing. You make sure the lease covers your costs+ and get at least 3-5k for the option. I have done this multiple times in Ohio and never had issues. 

Matt, thanks for the info. Can you refer me to a good real estate lawyer in the area to assist in preparing the paper work?  GD

@Greg DuPan

Yes, specifically what risk are you referring to? One major risk with land contracts or lease / option sales is the chance that you'd have to foreclose (as opposed to evict) a delinquent tenant. @Matt Motil made a good suggestion to keep the lease and the option to buy separate. Matt, have you ever had someone challenge this structure in court? If so, what was the resolution?

Another key point to remember is Ohio's 5 year / 20% rule. If a land contract vendee pays for at least 5 years or pays at least 20% of the total purchase price, your remedy for non-payment is foreclosure and not eviction. Since you want to evict and not foreclose, structure the transaction in such a way so your tenant buyer cannot ever reach either 5 years or 20%, but has to completely cash you out before either of those milestones are reached.

@Greg DuPan I can send you a message for the real estate lawyer I use. Their office deals with multiple types of law and they specialize in business, real estate, tax, and construction law. 

@Timothy Murphy III I have not had it challenged in court (knock on wood), but the legal structure of a separate lease and purchase option protects you as the owner in the case where a tenant would feel they are entitled to anything what-so-ever. They first and foremost are a tenant, and nothing more. They have purchased an option which allows them to buy the property before anyone else in a designated period of time. That's all. They aren't forced to buy, and they do not become the buyer until they close escrow. My option and lease does not allow for any of the rent to be used and/or applied to a purchase down payment. 

The larger amount of risk in these transactions comes when you reach the end of the option and/or lease term and the tenant is not in a position to purchase the property. You now have a tenant who is at risk of losing their option (and their money) and they are living in your house. This can create a difficult situation where you have a pissed off tenant who can create a bad situation. 

My risk mitigation in these situations has to always go into deals with people that actually have a chance of buying the property some day. If you are a sleeze-ball and put people into your properties that will never qualify for a loan, then you're asking for trouble. When someone approaches me about doing a lease/option contract on one of my rentals, I set them up with my mortgage broker and have them work together to determine when they think they will have their credit repaired to the point where they can purchase. I then add a year or 18 months to the option as a buffer to protect the buyer (any myself from an angry tenant going rampant in my house). I explain that the longer term is there to protect them and they always agree and understand. 

My option contract is structured in a way where they have to have a lease that is not in default. This helps to keep the tenant current, and I'm never worrying about collecting rents. I also put an annual renewal required in the option. The homes that I have done this on are typically $200k+ so I'm not interested in holding a property in option for $3000. If I'm going to lock in a sale price 3-5 years down the road, I want to make sure a few things (1) I'm getting paid to lock that price and (2) the people will actually be able to buy it. So my option typically requires that they put more money down to keep the option current at the start of each new lease-year. Some people balk at this, but if you're serious about buying the property, you're going to need more than a $3000 down payment, and this forces them to save the money (in escrow with me). 

Sorry for the long post, but wanted to give all the details. 

I don't like land contracts for the 5/20% rule. Stick to lease purchase and make sure your risk is mitigated going in. 

Personally I would skip all the lease option stuff and just put it up on the MLS.

If it's comping at 55-60k and your all in for 34k you will be able to price it aggressively and move it quickly.

@Greg DuPan

Your taxation on your gain (purchase - sales price) is much higher if you sell it quickly.

Own it for 366 days and you pay a lot less.  Rent to own may assist you in keeping more profit.

Also watch out for dealer status.

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If you are a professional, full-time flipper, you may not qualify for that capital gains tax treatment.

Why? Because of a little-understood IRS requirement. If you rely substantially on your flipping profits to generate income to live on, then the IRS no longer considers you to be an investor, but a dealer. And as a dealer, you come under different tax rules. Which means almost everything you read about the general tax treatment of residential real estate investment property is wrong.

Dealers vs. Investors

How? Specifically, if you are classified as a dealer, it’s just like running a retail store: The IRS considers your profits to be ordinary income, rather than investment profits. And that means you get taxed on your profits in the current year. You don’t get to defer them indefinitely, by executing 1035 exchange after 1035 exchange.

The key: Internal Revenue Code Section 1221, defining capital assets. According to the statute, a capital asset is real property used in your trade or business. In a nutshell, if you are making a trade or business out of buying and selling real estate at a profit, and doing so to such an extent that it’s clear that you are a trader rather than an investor, then you will fall under the dealer rules.

The IRS has similar provisions that apply to auto dealers and professional, active stock traders, as well, and for similar reasons: Capital gains tax rates were not designed to apply to retailers – even if you are a retail seller of something very large. Like a house. IRS Publication 544 contains more information (see pages 11 and 12).

Short-Term Capital Gains

For a hard-core flipper, it doesn’t directly affect the tax rate you’d pay. If you hold investment property for less than a year – an eternity to a flipper – then you have to pay the long-term capital gains rate, which is the same as your ordinary marginal income tax bracket. That is, a maximum of 35 percent for the highest earners among us, but more likely 25 to 28 percent for most people. So it’s primarily a wash in that respect.

The major effect on property flippers is that you are disqualified from using a Section 1031 like-kind exchange to defer taxes on that property. Instead, you have to declare any profits from those sales as income that year – even if you buy another property.

Note, too, that if you have real estate profits designated as income at the federal level, that could have state income tax ramifications as well. Make sure you take both state and federal income tax into account during your cash flow projections.

Self-Employment Tax

If the IRS designates you as a real estate dealer, rather than an investor, you get hit with a double whammy: Not only do you lose the option to do a Section 1031 exchange, but you also have to pay self-employment taxes on your profits – a tax hit of up to 13.3 percent as of 2012. That tax is scheduled to increase to 15.3 percent in 2013, unless Congress intervenes to extend the current rate. The self-employment tax comes in addition to the income tax, though self-employment taxes are themselves tax deductible. That’s a far cry from the indefinite capital gains deferral through 1031 like-kind exchanges and the plain vanilla capital gains tax treatment afforded to investors.

Are You a Landlord?

If you invest some of your portfolio to flip, and also own rental property, pay careful attention: If you flip just a couple of properties, and the IRS designates you as a dealer, they will designate you as a dealer across your entire real estate portfolio. This will cost you dearly when you go to sell any of your other properties: You’ll have to pay ordinary income tax on any gains even on properties you’ve held for years.

To avoid the tax sting, consider holding your flipping properties in an entirely separate entity.

For example, you can hold your rental apartments and rental homes in an S-corporation, and collect rental income as a direct pass-through to your individual income tax return. If you buy a couple of properties you’re planning to flip, hold them in a separate S-corporation. If the IRS deems you a dealer, rather than an investor, the negative tax consequences will only apply to the properties within that corporation. In effect, you have shielded your rental portfolio from the undesirable tax effects of your flipping business.

Separating the two practices with entities also has important asset protection benefits – if the corporation gets sued, only properties within that corporation are subject to a judgment, if you conduct yourself properly.

Installment Sales Prohibited

While investors can do installment sales, and only pay taxes on the money as they receive it, a dealer has to pay taxes up front on any income due from an installment sale. This can cause a real cash crunch if a flipper gets caught unawares: You may have a $35,000 tax bill due on capital gains of $100,000, for example, but only be receiving a fraction of that amount in the first year in an installment sale.

To avoid the problem, consider a rent-to-own deal, in which title is transferred at the end of the process, and not at the beginning.

Avoiding an Unwanted Designation as a Dealer

There’s no set-in-stone criteria the IRS uses to designate just who is a dealer and who is a real estate investor. They look at the overall facts and circumstances, and in many cases it comes down to a judgment call. Here are some criteria the IRS may use to assign you dealer status:

  • How many properties do you buy and sell per year?
  • How long do you usually hold the properties?
  • Do you make major capital improvements?
  • Do you obtain favorable zoning law changes while you hold the property?
  • Did you subdivide the property?
  • Do you maintain a “sales office”?
  • Do you maintain a sales staff?
  • Do you collect significant rental income?
  • Is real estate your full-time job? Or do you receive a full-time income doing something else and real estate is clearly a sideline?
  • Are you actively involved in the rehab, renovation and sale of properties you buy?
  • How do you advertise?

If the overall pattern indicates you are a property flipper, then you will be designated a dealer, not an investor, and subject to the same tax rules any other retail seller has to abide by.

That’s not the end of the world. Indeed, there are some advantages to being classified as a dealer, as well. Specifically, any losses get treated as ordinary losses, as opposed to capital losses. Ordinary losses can offset a lot more ordinary income than a capital loss, which is limited to offsetting $3,000 of ordinary income per year. If you’re a dealer, these losses are business losses, and deductible against business income on a schedule C, if you don’t hold the property within a corporation.

Exception

The exception to the above rules comes when you hold your properties in a self-directed retirement account. If you do, and you stay within the rules, there is no income tax nor capital gains tax due on anything you do – as long as it stays within your retirement account, which could be a self-directed IRA, Solo 401(k), SEP IRA, SIMPLE IRA, or even a health savings account! However, if you use leverage within your self-directed account, the account could be liable for unrelated debt income tax.

@Dmitriy Fomichenko

@Brian Eastman

@Steven Hamilton II

@C. @Timothy Murphy III

@Greg DuPan

Welcome to Bigger Pockets. Consider sending messages to other members for specific guidance.

risk vs reward

My inclinations are similar to @James Wise if the comps are there and you can make 20-25k, and sell it quick with minimal headache, and I can get my money back to invest in something else, I would do that in a heartbeat.

I have done lease options, some worked but many of them ended poorly.  Maybe you can sell the property for a few thousand more by doing lease option,  but it is also very likely your buyer won't be able to get financed in a year, its very possible he will walk at that point and you have to sink money into the house again to sell it to another buyer. 

In regard to making more money by not paying taxes as earned income.

Capital gains rates at 15% if in  25% tax bracket, on 20,000 profit gain is 2,000, while significant, to me the hassle, the delay, tying up my money, and the potential for greater loss if the buyer destroys the property... would not be worth the potential increase profit. 

We all have different risk reward tolerances, cash needs, consider them then you can devide what's best for you. 

Congratulations on completing a successful profitable flip! 

@Matt Motil

Thanks for the detailed explanation. I hope I didn't come across as criticizing your structure; it's exactly how I recommend that such a transaction is done. Like you, I've never had it attacked in court so I'm always curious to hear if someone else has had the opportunity to battle test one of these strategies. (How much protection an LLC provides and how easily can its corporate veil be pierced is another similarly interesting question I see from time to time.)

As to the 5 year / 20% rule, I believe it would also apply to a transaction that was structured as a lease with option to purchase all in the same document, though I've never had to test this in court yet either. I am picturing how the eviction hearing would go down using the separate lease and option strategy you've described and I imagine the landlord would fare quite well with that setup.

@Brian Gibbons

Nothing more to add on that. Excellent post.

Welcome to Bigger Pockets, @Greg DuPan ! Some excellent info there from @Brian Gibbons . Regarding the use of self-directed accounts as mentioned in Brians "Exception" paragraph, I will add that the Solo 401k is exempt from most instances of UDFI when leveraging properties. This is a nice benefit over a self-directed IRA.

Thank you all, that's a lot of info. to consider.    I'll post a follow up once the final deal is made.  

@Matt Motil

@C. Timothy Murphy III

@James Wise

@Brian Gibbons

@Mark Nolan

@Dell Schlabach

@Justin Windam

@Matt Motil I see that you have done quite a few lease options in Ohio.  I am curious what price range you have been doing them in.  I have a small rental in Garfield Heights that I am in contract on and considering putting a lease with option to buy on it with the current tenant.  It would retail for about $37500. Needs the basement waterproofed, however that did not come up on POS.  I was wondering what to ask for as an option deposit.  I was going to set the option to buy at $28,500 and rent is $575 per month.  Any suggestions?

Thanks in advance.

@Greg DuPan Welcome to BP and congratulations on your first flip. I am currently working on our first flip (in Cleveland) in South Euclid. What my partner and I decided to do was to put a tenant in it and sell it after the first year with a tenant in it to another investor that is wanting a turn key product. We are putting a tenant in with a 2 year lease. Hopefully they will still be a paying tenant at the time we want to sell. We are all in at $52,000, will rent for $1150 and ARV is about $78,000.

I do like lease options though.  I have not done them on properties under $50,000 though.  It looks like you have a lot of food for thought.  Best of luck.

Originally posted by @Jason Johnson :

@Matt Motil I see that you have done quite a few lease options in Ohio.  I am curious what price range you have been doing them in.  I have a small rental in Garfield Heights that I am in contract on and considering putting a lease with option to buy on it with the current tenant.  It would retail for about $37500. Needs the basement waterproofed, however that did not come up on POS.  I was wondering what to ask for as an option deposit.  I was going to set the option to buy at $28,500 and rent is $575 per month.  Any suggestions?

Thanks in advance.

@Greg DuPan Welcome to BP and congratulations on your first flip. I am currently working on our first flip (in Cleveland) in South Euclid. What my partner and I decided to do was to put a tenant in it and sell it after the first year with a tenant in it to another investor that is wanting a turn key product. We are putting a tenant in with a 2 year lease. Hopefully they will still be a paying tenant at the time we want to sell. We are all in at $52,000, will rent for $1150 and ARV is about $78,000.

I do like lease options though.  I have not done them on properties under $50,000 though.  It looks like you have a lot of food for thought.  Best of luck.

The properties I have done lease options on have been in the $200K+ price point. That being said, no reason you couldn't do it on a lower pricing level, but my first question to you is why set the price 9k below retail? Someone wanting to buy down the road in the future should expect to at least pay retail today pricing. To answer your first question about what the option cost should be would depend on how far in advance they are wanting to complete the purchase. The way I look at it is that you are in essence holding the property off the market for anyone else while they hold a valid option. The longer you allow them that power, the more it should be worth. I also try and keep in mind that I want these people to actually be able to purchase the property (if they want to), and so I try and get them to have at least enough skin in the game at the end that they can use that as a down payment. In your case of a 35k sale, 3.5% for FHA loan would require $1225, so I would use that as a minimum and explain to them why you chose that level. It's to protect you (they will actually have the down payment) and to protect them (they won't lose their option because they don't have the money). When you explain how everyone wins, I never get any pushback. Hope that helps.

Thoughts? 

Update as of Mid-March 2016.  Lease option didn't work out as now I'm in the process of evicting them.  The flip property has been on the market for about 3 months, many lookers, no offers.  I'm thinking to cash out the property and rent it.  Any recommendation on companies to work with locally (NE Ohio) for a mortgage?  Thanks,  GD

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