House Flippers Work With No Net

EDDIE KING no longer has the moves that earned him a spot as a fullback for USC in the mid-1960s. But his ability to spot an opening and capitalize on it has earned him millions in another favorite sport — home flipping.

Over the last 30 years, King has bought, renovated and sold — or “flipped” in real estate parlance — 60 houses in Los Angeles, Hawaii and elsewhere. Most years, he’s sitting on four or five homes worth a total of more than $5 million. It’s the kind of success story that inspires daydreams of quick riches among the rest of us.

But don’t cash in that home equity just yet, warns King. Like most sports, this one isn’t kind to rookies who don’t know the rule book. “Most people who are newcomers to flipping get into it kind of like it’s an art project, and they spend too much money and try to impress their friends,” said King, 61.

Inspired by exuberant real estate pundits and late-night TV pitchmen, many homeowners who have watched prices appreciate by double digits for several years may now be convinced that home flipping is a better investment than the stock market. But advocates of the nothing-down, double-your-money-in-a-year strategy often fail to mention potential pitfalls. There are the obvious downsides — failing to budget properly and overspending on repairs — but the bigger hazards include market volatility and unforeseen tax consequences. As a result, brokers and accountants who work with flippers say that for every smart investor like King, there are dozens who lose their shirts or, worse, their savings.

“If you really know what you’re doing, you’ve got a good chance of making money,” said Mike Teer, an agent to several successful home flippers. “But if you aren’t on top of your game, you can get taken to the cleaners.”

Topping the list of pitfalls is the sheer unpredictability of the market. Bill Brame, a realtor who has flipped homes since 1989 and has several such clients, recalls how the market turned on him when he least expected it.

After starting out with just a couple of homes, the former film editor had created a virtual empire by the early ’90s. He had 14 houses going at once, with three crews of hand-picked renovators working full time to rebuild cracked foundations, repair leaky roofs, paint, plumb and generally transform fixer-uppers into top-dollar properties. Then, in 1993, the market took a dive. Unable to keep up with mortgage payments, Brame was forced to sell most of his homes at a loss and lay off his crews.

“I just overextended myself because I was having so much fun,” said Brame, a hale 78-year-old who edited the original “Star Trek” TV series and several “Star Trek” films before retiring from Hollywood to take up real estate. “Now,” he said, “I never do more than two houses at a time, because there are always things that can happen to a market, or to yourself, and you end up with two incomplete houses and no income coming in.”

Another veteran home flipper who has felt the bite of the market is Herb Rizzardini, 63, a hardware-store owner, who’s completed about 16 projects in the last 20 years. After making “decent” money buying, renovating and selling three homes, Rizzardini bought some rental properties in 1988 and then sat on them for the next 15 years.

“I bought them, and the market dipped and then it didn’t go up for 15 years,” Rizzardini recalled. “I didn’t make a cent.”

Perhaps the second-biggest issue novice flippers fail to factor in is the complicated nature of the tax system. Accountants who work with casual flippers — the weekend warriors who hear about a good deal and quickly mortgage their homes to buy another — say they often are ignorant of the tax implications of owning investment properties.

“I’m always surprised by how many people don’t know the rules,” said Michael Cain, a certified public accountant. For starters, Cain and other CPAs say that most homeowners are far from current on Internal Revenue Service regulations. For instance, in 1997, the IRS ended the so-called rollover provision, which permitted profits from a home sale to be applied to another such purchase without the seller having to pay taxes on the gain. The current law allows a seller to keep, tax-free, gains of up to $250,000 (or $500,000 for married couples filing jointly) on the sale of a primary residence if the seller has lived in it for 24 of the previous 60 months.

For investment homes — and those in which the owner did not live for at least two of the previous five years — the IRS assigns taxes according to the length of time it was owned before a sale. Profits from homes owned for two years or more are taxed as capital gains, at the current rate of 15%, plus state levies — in California, 9%. Profits from homes owned for less than two years are taxed the same as regular income, according to the bracket the seller falls into, anywhere from 25% to 35%.

The upshot is that smart home flippers follow one of three basic strategies to minimize taxes, Cain said. Most commonly, they move into a home for two years, fix it up, then sell it, claim the standard exemption for primary residences of $250,000 or $500,000 and move on to the next one. However, because this strategy only works for one home at a time, most flippers try to simultaneously own other properties long enough to qualify for the capital-gains-tax rate.

A third approach is to move the proceeds of a home sale into another investment property of roughly equal value, a procedure known as a like-kind or 1031 exchange. It could be a chicken farm or a rental house, but the exchange must be from one investment property to another, so a personal home is excluded unless it is rented out.

IRS rules give investors 45 days from the time they sell a property to identify the exchange property and 180 days to make the exchange. Investors can’t receive any cash from the sale, so all money must be held by qualified intermediaries, such as a title company.

“Occasionally, you just have to flip them before two years and pay your taxes,” King said. “But my philosophy is, you’re never going to go broke paying taxes. You do everything you can think of to not pay, but in the end you just pay them because you’ve done well and made money.”

The scenario that every savvy home flipper hopes to avoid is being labeled a “trader business” by the IRS. That title applies to those investors whom the IRS identifies as making their living off the buying and selling of homes. In that case, a flipper will not only have to pay the higher income tax rates, but he or she will also have to pay 15.3% in self-employment taxes.

“I always caution my clients about letting this become their trader business, but the truth is, there’s no rule of thumb that says: Buy three houses, you pay capital gains; buy five and you’re a trader business,” Cain said. “What’s happening is, people fall through the cracks. And every now and then someone else doing the same thing gets unlucky.”

In the end, flippers who thrive despite market fluctuations and tax rules are those who have a passion for homes and an eye for a bargain.

“I love houses and I always have,” said Brame, who paid $400,000 in 2004 for his current home and plans to put it on the market soon for $1.2 million. “I’ve always remodeled every house I’ve ever lived in because I just love remodeling. So I get to do what I love and get paid handsomely for it. What more could you ask of life?”