Are Rentals Better Than Flipping?

After repairing a house, you can flip or rent it.

Jupiterimages/ Images

Many real estate investors that focus on single family residences tend to fall into two camps. Flippers look to buy houses at a discount and quickly resell them. Longer-term investors look to buy houses and rent them out to collect cash flow for a while before eventually reselling them. Both strategies have benefits and drawbacks, and neither is globally better than the other. However, some investors are better suited to flipping, while others make better landlords.

Flipping Properties

Flipping properties is the process of rapidly reselling a property for profit. The process starts with buying the property at a discounted price. Some flip properties are discounted because they're in bad physical shape, while others are in fine shape but are marked down because the seller is looking for a quick all-cash purchase or has other terms that make it hard for a traditional buyer to acquire it. Once the flipper buys the property, he fixes the problems that made the property inexpensive in the first place, then resells it at a market price. With good leverage, it's not too hard for a flipper to make a 50 percent to 100 percent return on his investment.

Renting Properties

An investor looking to rent a property out has a different strategy. While she probably wants to get a good deal when she buys -- since she'll be holding it for a while -- it's less important to buy at a highly distressed price. Instead, she's looking for a property that she can rent out at a monthly price that will more than cover her monthly mortgage payments and ownership expenses. While she rents it out, she's gradually paying her mortgage down and building up equity. At some point in the future, she can sell the house and make a nice profit in addition to the profit she's made by renting it out.

Work vs. Management

The two types of investing require different types of work. When you're a flipper, you constantly have to be looking for another property to buy or selling a property that you have. If you do work to rehab properties, you're also either doing the construction labor or managing the people that do it for you. On the other hand, if you have rentals, you have to deal with the day-to-day responsibilities of collecting rents, paying bills and managing the properties. Both are different sets of tasks that appeal to different people.

Cash Flow Vs. Equity

Renting out properties is very much a "get rich slowly" business. While you can make good returns, you're getting them by a percent or two every month. When you flip, you collect money much less frequently, but when you do, the hope is that you collect a lot. Furthermore, your income in flipping comes in the form of creating equity, while rentals are primarily about ongoing cash flow.

Tax Considerations

When you're in the rental business, you are subject to two different types of taxes. The net profit that you collect from renting out your properties is taxed as investment income. When you sell properties, it's taxed as a capital gain unless you use the proceeds to buy more property in a 1031 exchange, in which case the taxes are deferred. If you flip properties, your primary income will be from the capital gains when you sell them. However, if you hold the property for less than one year, your capital gains will be considered short-term and you'll have to pay taxes at regular income tax rates. If you do too many flip transactions, the Internal Revenue Service will consider you a dealer. At that point, your profits get treated as regular income, you will have to pay self-employment tax on them, and you won't be able to do 1031 exchanges.