Pros and cons of buying fixer-upper real estate

Cashing in not always so easy
By: Robert J. Bruss: Inman News
"All my husband and I can afford to buy is a fixer-upper house" the lady sitting next to me on a flight to Minneapolis last month shared after I revealed I write about real estate. Then I gave her my "short version" of how her purchase of a fix-up house can be a very profitable, tax-free, principal-residence investment.

Personally, I've bought many run-down houses with "profit potential." I patiently explained to my new friend that most home buyers want to purchase a brand-new or resale house in near-perfect, "model home," move-in condition. "That's how to profitably sell houses, but not the profitable way to buy them," I explained.

WHAT IS A FIXER-UPPER HOUSE WITH "PROFIT POTENTIAL?" A fixer-upper house is defined as a residence below neighborhood standards. Some of these properties need major rehab work. But most "fixers" with profit potential are not so deteriorated that the best solution is to tear down the house and start over.

The most profitable fix-up homes only need a thorough cleaning, minor repairs, and fresh coat of interior and exterior paint. New carpets, fresh landscaping, and new light fixtures are additional examples of profitable fix-up work that will bring the residence up to neighborhood standards.

These minor home defects are known as "the right things wrong." However, unprofitable fix-up houses include those needing expensive structural work, which adds little or no market value.

To illustrate, a fix-up house needing expensive foundation repairs, a new roof, updated wiring, or new plumbing is usually an unprofitable fix-up house unless it can be bought at a huge discount price from comparable nearby homes. The reason is the necessary work doesn't show so it doesn't add market value.

Slum fix-up property in a high-crime neighborhood is another example of property without "profit potential" (unless there are solid signs of neighborhood improvement). The local police department office can provide crime statistics if you are unfamiliar with the area.

TAX-FREE PROFIT IS A KEY MOTIVE FOR BUYING A FIX-UP HOME. Occasionally, buyers of fixer-upper houses purchase for the charm or location. I've also met some individual developers who purchase to help improve a neighborhood. But most fix-up home buyers purchase for the prospective profit.

Thanks to Internal Revenue Code 121, it is now possible to earn home fix-up profits tax-free when the principal residence is eventually sold. To earn up to $250,000 tax-free profits upon sale, the owner must have owned and lived in the property as their primary residence an "aggregate" 24 of the 60 months before its sale.

A married couple can qualify for up to $500,000 tax-free capital gains if both spouses meet the occupancy test, even if only one spouse's name is on the title. But they must file a joint income tax return in the year of the home sale.

However, if extensive home renovation is contemplated, it is often advisable to move out while the major remodeling takes place. Especially if there are children involved, renting an apartment or another house for a few months can save the marriage.

To illustrate, three years ago my neighbors took a two-month "grand tour" of Europe with their two children while their fix-up home was completely renovated. When they returned, their "new home" was almost completed and they didn't have to endure the unpleasant aspects of having workers in their personal residence almost every day.

HOW TO BECOME A SERIAL FIX-UP HOME RENOVATOR. I have met several couples who actually enjoy buying fix-up houses, renovating and occupying them, and then making profitable tax-free sales after at least 24 months of ownership and occupancy.

But the big, obvious drawback is living in their principal residence while it undergoes fix-up.

Because the big tax savings of Internal Revenue Code 121 can be used over and over again, but only every 24 months, these repeat, tax-free home sellers are known as "serial fix-up home sellers." It's all perfectly legal and very profitable for up to $500,000 tax-free, principal-residence sale profits every 24 months.

One "serial home seller" husband I met is a carpenter foreman by day with a major home builder and a home handyman by night and on weekends. He told me he often recruits his co-worker plumber, electrician, and other construction friends to help him and he assists them on their home fix-up projects, thus keeping costs low.

FOUR KEY REASONS HOUSES BECOME FIXER-UPPERS. Finding fixer-upper houses doesn't take much work in most communities. Just ask a savvy realty agent if she or he knows of any fix-up bargain houses for sale.

Most home buyers don't want fixer-uppers so you probably won't have much competition from other buyers. Here are the four primary reasons houses become fixer-uppers:

1. The seller either can't afford to pay for home repairs or doesn't want the inconvenience. He or she just wants to sell with minimum hassle.

These homes are often advertised for sale "as is." That term means the seller must disclose all known defects in the home but will not pay for any repairs.

2. The seller inherited a shabby property and wants a quick cash sale. These properties are often called "probates" because the sale must go through the local probate court. Heirs can be either very easy or very tough when buying their fix-up property.

3. The home is "tired." That is a term used by real estate agents to describe an out-dated residence which is basically sound but has not been kept up to current standards. But don't confuse this term with a "tired listing" which has been on the market for sale more than 60 to 90 days.

4. The home has a serious structural problem, which can be cured only at a major expense. This type of fix-up home should be avoided, especially if the upgrade won't add more market value than its cost.

SUMMARY: Fixer-upper houses with "the right things wrong," purchased at substantially below-market value, can be superb profit opportunities, especially if you own and occupy them at least 24 of the 60 months before sale.

Then you can qualify for up to $250,000 tax-free principal residence sale profits (up to $500,000 for a qualified married couple filing jointly). This tax-break can be used again every 24 months. More details are my special report, "Pros and Cons of Buying a Fixer-Upper House or Investment Property," available for $4 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet download at www.bobbruss.com.