In the past several years, many would be investors have been attracted to this marketplace, primarily because of shows like Flip This House, Flip That House, Property Ladder and others. And of course, the bookstore shelves are filled with a variety of books that teach you how to rehab a house.

The TV shows are very exciting because in every instance, they show the rehabbers making a spectacular profit no matter what unexpected problems crop up during the rehab process. And that gets naive investors very excited and prone to believe they can do this without any education. After all, it is so easy to make 20K, 30K or more even when mistakes are made.

Unfortunately, this is not a case of TV reflecting reality. What a surprise, right.

Let’s look at a real scenario in a real market. We will break it down into its components.

We purchased a fixer upper fo 43K. We estimated it needed 20K in repair work and would be work 100K when finished.

Lets start with the purchase costs. First the financing. We went to a hard money lender. The costs were 4 points plus 13.75% interest for 6 months, renewable for another 6 months at no additional points. They financed 100% of the purchase price plus 100% of the rehab costs. That represents a loan of $63,000.

Closing costs were 4 points to the lender and other closing fees totaling around $2500 (including one year prepaid property insurance), for a total acquistion cost of about $5000 in fees. The $43K was paid to the seller and the other 20K was put into a draw account that we could access as we hit specific milestones in the project.

Holding costs – Every month, we had to make an interest only payment to the hard money lender of approximately $700/mo. There were costs for electricity, water and sewer during the ownership period of about $100/mo. There was also the cost of money borrowed against a credit card to pay the contractors in between draws. For the total renovation time – about 2 months – this ran about $500.

Rehab costs – Total rehab costs ran $22K – $2K more than was calculated in the loan. So that came out of our pockets.

Selling costs – The selling costs include time on market to sell, real estate commission (at 6%) and closing fees – including property taxes.

The total time the property was owned was 7 months before the sale to the end buyer was finalized. It sold for 97K.

Lets run down the expenses and profits.

All in all, not a bad profit for finding and managing a small rehab project. But it is a far cry from the $35,000 that would have been reported on one of the Flip This House type of TV shows because they never include all these extra costs. I guess financial reality makes for too much complexity for the viewing audience.

So, is it worth a new investor’s time and energy to learn how to do rehabs? Absolutely. Can a new investor, or even an experienced investor, get burned when doing a rehab? Absolutely.

Numbers are absolutely critical when you make a rehab purchase. Be sure you understand all your numbers and make sure there is enough of a cushion there to ensure a profit when you finally close with the person who buys your house. Do this, get good at it, and you can make a very serious income year after year in any real estate market.

Now comes the tough part – what to offer?

The best way to arrive at an offer is to work backwards from your estimated final retail sales price. Until you get an actual appraisal, this is going to have to be a best guess estimate – perhaps by pulling comps in the MLS or other online service that you may have access to. Once you have a feel for what you will be able to sell the repaired house for, you can now work backwards from that point to get to your highest offering price to make this deal work for you.

Let’s take a look at all the elements that you will need to subtract from this number to reach your highest offering price.

• Estimated repair costs – You will need to estimate how much you will be investing in this property to repair and beautify it for sale. This will have to be a best guess estimate unless the seller will let you bring in a general contractor before you make an offer.
• Closing costs on the purchase of the property AND on the later sale of the property.
• Holding costs – This includes any payments you make on the money you borrowed for the property, the money you pay for insurance, for taxes, utilities, etc. Basically holding costs include all expenses that are generated just because the property is sitting there.
• Contingency fees – Stuff happens. You should plan on the project taking longer than you estimate. And you should expect unexpected repair work to pop up. You never know what could be found behind the sheetrock or under the floorboards once you start that rehab. This also gives you a buffer in case the market is a bit softer than expected and you have to take a slightly smaller final selling price than you originally planned. A good guess of contingency fees is 10% of the purchase price.
• Desired gross profit – This is the amount of money you want to put in your pocked for this rehab before paying taxes on it. A good rule of thumb is a solid 10-15% of the purchase price.

By examining all these costs, you will get a maximum offering price on the property. As some of the numbers are based on the purchase price rather than the final value, you may need to do a few iterations to reach your exact numbers. It helps if you have a ballpark offer price in mind before starting the calculations.

This calculation is good for several things. First, it allows you to calculate a fair price to offer on the property to ensure that there will be a profit for you in all but the most disastrous situations. Second, it gives you ammunition to talk with the seller. When you have a seller that is reluctant to sell at that low price, you can show exactly how you arrived at those values. It might not change the seller’s mind at that moment but it shows you are working based on real numbers rather than just someone out to "steal" their property. But when the house is still not sold a month later, you can come back and make the same offer. That gives the seller a month to think about what you said and sometimes come around to where they are happy to do the deal to get out of their situation.

If you take the time to do this analysis before you make an offer on every deal, you may miss a few deals but when you get one, you will be able to sleep at night knowing that the numbers are working in your favor.

And if you are a new investor and unsure of things like repair costs, etc., just remember that you can write your contracts subject to an acceptable inspection and acceptable appraisal. And if either report finds things that you didn’t expect, you have an opportunity to walk from the deal or renegotiate with the seller for a lower price. After all, the buy price is where you make your profit and if it doesn’t work for any reason, it is time to move on to another deal. You never want to be in a situation where you are working for the house. You want the house to be working for you and knowing your numbers will ensure that this happens.

The challenge in this situation is that unless creative tax strategies – like a 1031 exchange – are followed, you will pay taxes on the gains at the highest rate allowed in the tax codes.

Let’s take a few minutes to examine the three levels of taxation that can affect a flip type house situation and then talk about strategies that may be appropriate to maximize your after tax return on investment.(And as always, it is best to discuss any scenario with your accountant to be appraised of the most current tax laws as they affect your particular situation.)

When it comes to taxes and real estate investments, time is your friend. As more time passes, you become eligible for more preferential treatment of your profit. Unfortunately, in real estate investments, time is your enemy if you are keeping a property empty.

There are three tax scenarios for buying and then selling a property in a specified period of time.

The first scenario is for a buy/sell cycle that runs for less than one year. If you purchase a house and then resell it before one year passes, your profits will be assessed at the short term capital gains rate. Short term capital gains rates are the highest amount you will pay in taxes on your profits.

The second scenario is where you have owned the property for more than one year. In this instance, you will pay taxes based on the current long term capital gains rate. This rate is generally significantly less than the short terms capital gains rate.

The third scenario is the best. If you are dealing with an owner occupied property – such as a flip where you live in it and make the repairs – you can keep all your profit tax free. It is required that you own and live in the property for at least two years out of any five year period. (This means that if you live in it during the first 24 months of ownership, you are elibible.) If you can meet this scenario, you can keep up to $500,000 in profit if you are married or $250,000 in profit if you are single. And this money is tax free.

After reviewing these three scenarios, you can tell that the best scenario from a direct profit standpoint is the last scenario. And if you are the type who wants to live in the house you are fixing and wait two years before selling, it is certainly a powerful tax benefit. If you choose the right house in an area of rising property values and add value to the property, you can earn a significant amount of profit in two years and enjoy it tax free when you sell the property. It certainly makes a huge nest egg for your next property purchase(s).

The only problem is that you can do this on only one house at a time. So if you plan on flipping more than one house every two years, chances are very high that you will be encountering one of the first two scenarios on every deal.

If you are wholesaling properties – just flipping to another investor for some fast cash – you will always fall into the first category. And in this instance, that is ok. Your goal as a wholesaler is constantly making your money work for you. If it sits in a house too long, it costs you momentum and profits. You are earning your profits on the volume of properties you are flipping and while you certainly care about the tax consequences, you view them as a cost of doing business.

People who rehab houses to sell at retail have a more difficult decision to make. If you can rehab and resell a house for very quickly to get your money working for you again, it probably makes sense to take the hit on taxes that you encounter when you pay short term capital gains because you have your money back and working for you again. Again the tax on the profits is just a cost of doing business.

But some rehabs take longer. Or the profit in the house is very large. In these instances, you need to calculate the cost of holding the house until one year has passed vs the additional tax liability that is created from selling it before one year passes. In this instance, you may choose to just hold the house empty until you can sell it for maximum profit. Or you may choose to do something creative in the sales process and either rent it out for a while (knowing that you will have to polish up the house before final sale) or offer it for sale via a lease option. Either technique will stretch the length of time that you hold the house, help cover the costs of that holding period (or even put profit in your pocket) and let you get that preferential tax rate when you finally sell the property.

Understanding and applying the current tax laws to your real estate transactions is an essential piece to understanding the total profit picture of a deal. If you don’t understand them and plan for them, you could be in for a very large surprise tax bill at the end of the year – one large enough to cripple your real estate investment activities for a long time. Your best resource for understanding the tax ramifications of any investment is your real estate savvy accountant. You should have a person like this on your investment team to be sure you are maximizing your cash flow. If you don’t you could be losing $1000’s of dollars you didn’t have to lose.