Calculating the ROI on a Flipping Project
Posted on April 8, 2008 - Filed Under Business |
Last week a discussion was started about Project #2. With the background laid down I’m going to talk about how I screwed up the ROI calculation.
When watching the house flipping shows, the show always end with with the aspiring flipper running down their numbers. Each number flies onto the screen with a whoosh sound.
“We bought the house for $150,000. Whoosh! We spent $50,000 in renovations. Whoosh! We’re going to sell it for $300,000 (whoosh!) which gives us a potential profit of $100,000 (Cha-ching!)”
Making $100,000 for 6 weeks worth of work? Not bad.
But that’s television land. Not reality.
When running the numbers for my project, I used the same technique. Selling Price - Purchase Price = Profit. The Return on Investment (ROI) = (Profit - Investment)/Investment. Lord Google verified the ROI calculation to be correct.
So from the mount on high, I declared “Yeah I made 30% ROI on my investment. That’s pretty good!”
It would be even better if it were true.
My calculation for ROI was correct however that little thing called “Profit” wasn’t calculated correctly. There are two hidden values that directly impact the Profit Calculation: taxes and Realtor fees.
Funny how those numbers are never mentioned on television.
In the above example, let’s assume the house was sold for $300,000. First hit: Realtor fees. Depending on market, this number fluctuates between 3 and 6% of the selling price. So between $9,000 and $18,000 will walk right out the door. If super-conservative is your game, then figure 7% which is $21,000. The second hit: Capital Gains tax. 30% of $150,000? Sure, the upgrade costs can be deducted etc etc but figuring conservatively, the taxes on this project would be $45,000.
That $100,000 profit the excited flippers talked about?
| ITEM | Percentage | Dollar |
| Profit | $100,000 | |
| Realtor Fees | 7% of Sales Price | -$21,000 |
| Taxes | 30% of Property Value Increase | -$45,000 |
| Real Profit | +$33,000 | |
Now is $33,000 anything to sneeze at? Not at all. ROI is 34%.
This is where I made my mistake.
Using the appraised value of the property, that number was used to calculate the ROI. Realtors fees and taxes were ignored in the ROI calculation.
Big mistake.
It is possible that if the Realtor fees were reduced to say 2%, which is possible, that a small profit could be made. It doesn’t hurt to open this to negotiation.
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6 Responses to “Calculating the ROI on a Flipping Project”
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Did you include interest, loan fees etc. in costs?
Cliff,
I’m a little confused at some of your numbers. You mention factoring in the upgrade costs, but that doesn’t seem to have been done when you’re calculating the taxes of $45,000.
And I believe the realtors fees (and other associated selling costs) should also be subtracted from the gain before you start calculating any capital gains taxes.
Also not sure about the 7% in commmissions assumption, either, as 6% is the max I’ve heard of anyone getting hit for. And 30% capital gains tax is much higher than what most investors will be hit for, as far as the actual capital gains assessed.
Here’s what the calculator located here (http://www.spectrusgroup.com/Capital-Gains-Calculator.aspx) spits out, using your numbers:
Results
Original Purchase Price $150,000.00
Plus: Capital Improvements $50,000.00
Less: Accumulated Depreciation $0.00
Total Net Adjusted Basis $200,000.00
Sales Price $300,000.00
Less: Net Adjusted Basis $200,000.00
Less: Selling Expenses $18,000.00
Total Capital Gain $82,000.00
Depreciation Recapture @ 25% $0.00
Federal Capital Gains @ 15% $12,300.00
State Capital Gains @ 0% $0.00
Total Taxes Due $12,300.00
Granted, the actual capital gains tax paid will likely be between 15% and 30%($12,300-$24,600), but that’s a good ways off $45,000.
Not at all arguing with your premise that taxes and commissions need to be accounted for when you’re calculating your profit from the sale of a property, it just looks like you’re overstating the case a bit as far as inflating the “bad” numbers.
But I ain’t an accountant and don’t play one on TV so I may be completely and utterly wrong here. If so, feel free to ignore.
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Moom, when I reran my numbers I used the total amount that was due. Any interest or loan fees, etc. are included in that amount.
Seth, thanks for the detailed breakdown of the actual costs. I looked at the website and I’m always skeptical of black-box programs without seeing the formulas.
But with that being said, the point of the article is the flippers on tv never take into account taxes or realtor fees when they do their little summary at the end of the show. My quick and dirty calculations were just to provide an example of how these costs have a huge impact on what they call “profit”.
This was where I made my mistake.
You may not like 7% for selling costs and 30% capital gains tax may not be applicable in Texas. Each investor in their own state has to base their calculations on what their specific state does. When writing this article, I based mine on California numbers.
Decidedly I am not an accountant. This is why I refrain from providing examples of detailed calculations. People, a lot smarter than me, would tear the article to shreds. For my numbers, I’ll continue using the 30% capital gains tax along with the 7% selling costs. Ultra-conservative numbers is what I need to plan with.
If you flipped within a year you’d pay your Federal marginal tax rate + the California one on the net profit - which could easily be 34-37% in total depending on income. If you hold for more than a year you’re looking at around 21-24%. Vermont is the only state I know of that taxes long-term capital gains at a lower rate than ordinary income (MA taxes short-term gains higher than ordinary income). Of course, Texas, Wyoming, Washington, New Hampshire, Tennessee, Florida, and Nevada won’t tax the capital gain.
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Actually Moom, you bring up a valid point. It didn’t occur to be that June 1 would be the one year anniversary. If the houses don’t sell before that date then I’ll be put into a different tax category. Because “short term” is one year or less . . . .
I also have something to add…. You don’t want to cut your Realtor’s fees to the bone, or they won’t work very hard for you! In fact, what they’ll probably do is stick your listing on the MLS and forget about it. They’ll think, “well, if it sells it sells, but at least I didn’t waste a lot of time on that one.”
Lots of sellers here try to edge the commissions down to 5% from 6% and are never aware that their properties don’t even get shown. As a newbie Realtor, I was “educated” by another, more experienced Realtor, “Don’t show the property if they’re only offering 2.5% to the buyer’s agent. Why should you work every bit as hard for less money? Just take it out of your list of properties to show that buyer.”
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