Don't Cut Corners - Three Pitfalls to Avoid during your Rehab
When under the pressure of an active rehab project, its natural to seek out cost-cutting measures to stay within your rehab budget. Its always a good idea to seek cost savings. After all, every dollar you save on your rehab is a dollar added to your bottom line (assuming your overall scope remains constant). The pressure of sticking to your improvement budget will tempt any investor to find means of reducing costs. On the surface, the act of reducing rehab costs is a novel idea with the goal of a larger check at the closing table.
However, you must tread lightly when seeking creative ways to reduce rehab costs. Investors are often tempted to cut corners in order to minimize a number that is so influential to your project’s success.
Pitfall #1 – Hiring Uninsured Contractors
The fixed cost of a contractor to carry his/her liability insurance will surely add to the cost of the bid. This makes it a tempting to find contractors who are able to offer lower prices because they are not paying for their insurance. You should make liability insurance a requirement for any contractor who works on your properties; there is no compromising here.
Liability insurance protects your business in the unfortunate event that a contractor gets injured while working on your property. If properly insured, the contractor’s liability insurance will cover the cost of medical expenses and/or time missed from work as a result of the injury. If a contractor does not have this insurance, guess who their lawyer will come after? That’s right, you and your business!
Its common knowledge that uninsured contractors can get the job done cheaper. This doesn’t mean that it will save you money in the long run. If you have a consistent habit of hiring uninsured workers, it will come back to bite you at some point in your investing career. Starting today, make the commitment to screen all contractors to be absolutely positive they have the right insurance.
Pitfall #2 – Paying Cash
Related to hiring uninsured contractors is the habit of paying workers in cash or “under the table” This is a pitfall that is way to common for new investors. In the midst of obtaining contractor bids, you encounter a contractor who is willing to do the work at a steep discount. The contractor has only one stipulation: You agree to pay cash! I’m not talking about cash as opposed to a credit card. I’m talking about cold, hard, 20’s and 50s…physical cash!
On the surface, you may think: “Wow! What a great chance to score a discount! I have to pay the guy anyway…what do I care whether its cash or check?!”. The truth is that it makes a huge difference whether or not you pay your workers “on or off the books”. The major problem with paying in cash is that there is no paper trail as to what the money was used for. This is precisely why contractors may offer incentives to be paid in cash. If there is no record of where the funds came from, the money is untraceable from a tax perspective. They are able to limit their annual earnings because any subsequent audit would present no way of tracing this missing income.
The reason why a contractor would want to be paid in cash is the exact reason why you should not agree to do it! If you pay a contractor in cash, you have no way of accounting for this amount as an expense related to improvements on your property. If you were ever audited, the only thing the IRS would see is a cash withdrawal. What do you think the initial suspicion is of the IRS? They will of course assume that you withdrew cash to put in your own pocket. Even if this is not the case, you have no paper trail to prove that the money was spent on legitimate expenses related to your rehab. Instead of this amount being treated as a capital improvement, the IRS will require that you treat it as a taxable distribution from your investment business.
Don’t count on the off chance that you may not get audited. If you are in business long enough, its not a question of “if” but a question of “when” you will get audited. When this happens, you want to be able to prove that all your expenses and deductions are legitimate. Failure to do so will lead to additional taxes and interest for the time you “skirted around the IRS”.
In addition to paying by check or credit card, you should also prepare 1099 forms for any non-corporation performing work for over $600. 1099s provide a solid record for you and the contractor of the work performed. The 1099 will be used by the contractor when he prepares his taxes at the end of the year. You will also keep these forms for your records. Think of the 1099 as an official receipt between you and the contractor. Issuing 1099s ensures that all your ducks are in a row and that the IRS can trace all funds related to your rehab project.
Pitfall #3 – Skipping out on Permits
One of the silliest mistakes newbie investors often make is trying to skip out on required permits. Permits are required from a wide range of common improvements: Framing, Structural Changes, New Plumbing, Electrical Work, Fences etc.
As one would expect, obtaining permits costs time and money. Your contractor or GC must communicate with the local building authority to explain the project and obtain the necessary permits. All permits will cost some money and require some form of inspection from the building authority. To many, this seems like a huge hassle that they will try to avoid at all costs.
You will learn very quickly not to ignore the necessity of obtaining permits for your rehab projects. Below are some key reasons why you should always obtain the necessary permits for all your rehab work.
Get on the “Good Side” of the Town Inspector
It pays to be up front with the building inspector as to the scope and complexity of your rehab project. Inspectors are used to homeowners and rehabbers trying to cut corners when it comes to permits. If you are proactive in seeking out your permits and show a commitment to doing a solid job on your rehab, you are bound to fall into the good graces of the building inspector. He will see you as an exception to the countless other homeowners who try to avoid him at all costs.
Being on the good side of the building inspector will pay dividends down the road. Not only will the inspector offer what ever leniency possible during his inspections, but he will be prepared to help you out on future rehab projects as well. If you fall to the bad side of the property inspector, the opposite is bound to be true. The inspector will be relentless during his inspections and he will certainly give you a hard time on any future rehab done within the same jurisdiction.
Be Sure your Job is Done Right
There is a 90% chance that your end buyer will perform a home inspection before closing on the property. These home inspections are extremely rigorous and can bring to the surface countless tedious issues. These issues, while potentially minor, can blow up a deal. There is nothing more frustrating than having a sale under contract and having the potential buyer walk away because of an adverse home inspection.
Obtaining the proper permits throughout the project will drastically limit the number of issues that come up during a home inspection. After all, if you have the proper permits, you will have had to pass several inspections from the town building inspector. The eventual home inspector will have a record of all the permits pulled and the resulting inspections. If he sees that the rehab was done in accordance with local building code, the number of potential issues that may come up is limited.
Think of permits and building inspections as checking your work throughout the project. Instead of crossing your fingers and hoping for a positive home inspection from the buyer, you will be confident that the home will pass inspection because the town has checked your work along the way.
They’re not that Expensive
Seriously, permits are rarely more than $100. Budget for these permits and expect to pay them. This low cost pays for the permit as well as the inspection performed by the town building inspection. Sure, on a major rehab you may have several permits that can add up. Consider this an “insurance cost” to avoid any issues with the eventual home inspection. If you are worried about a measly $100 on your rehab, you need to reassess whether you can handle the game of rehabbing houses.
There will come a time in your investing career where you realize that you are the real deal. That is, you run a legitimate business that follows the rules. This is an amazing feeling and one that brings pride and peace of mind. Refuse to cut corners when it comes to your rehab projects. Doing so will put you on the fast past to legitimacy and make you proud to build your business.