If you aim to be a professional property flipper, it pays to acquire a professional’s understanding of the law. Property flipping is, of course, totally legal. There’s nothing wrong, ethically, morally or legally, with finding a motivated seller, fixing up a property, and quickly selling at a higher price to someone who wants the house. Indeed, adding value for the end user and benefiting everyone on both ends of the transaction is exactly what commerce is all about!
You’ll run into trouble, though, if you attempt to use deception to trick a seller, financer, or buyer into the deal. Yes, real estate markets in some areas have taken on some “wild west” qualities. But state DAs are still rigorously enforcing applicable laws – especially laws against various forms of fraud.
What is Fraud?
Let’s begin at the beginning: At common law – the vast legal tradition of court rulings and precedents we inherited from antiquity – fraud has three basic elements:
1. A false statement
2. Reliance on that false statement
3. Damages
Basically, for someone to commit fraud against you, they must tell you something that is intentionally false or misleading. As the plaintiff, you must demonstrate that the information was false, that the false statement was material to the decision (that is, not irrelevant), and that you depended on that information to make a decision. And then that decision must have harmed you in some way.
Note that this is just from British common law. Each state sets its own specific definitions. For example, some states, like Arizona, Montana, Oregon and Washington, define as many as nine separate elements of fraud. And some states treat omissions of relevant, material information differently from others. So it’s important that you also seek the services of an attorney licensed in your particular jurisdiction to answer questions specific to your case.
Special Real Estate Considerations – Duty to Disclose
In addition to the above elements of the crime of fraud, real estate brokers and sellers also have, in most jurisdictions, a duty to disclose all known property defects. There’s generally no obligation to conduct a full and detailed inspection of the property, but some states do impose a checklist of features that the seller is expected to be familiar with prior to the sale. If you deliberately omit material information concerning property defects, the buyer may come after you with a lawsuit later – and possibly have a case.
Burden of Proof and Available Defenses
The burden of establishing all three elements of fraud falls on the plaintiff. That means if you want to accuse someone of fraud in court, you need to be able to prove all three elements beyond reasonable doubt with evidence and testimony.
Likewise, if someone accuses you of fraud, your defense will be to destroy at least one or more of the elements of fraud, in the eyes of the jury.
Note: Remember our mail campaigns in earlier columns? If you use the mail to perpetuate a fraud, you don’t just have a problem under state statutes. You could get hit with a federal offense. That carries a potential sentence of 30 years in prison, or up to a $1 million fine. So be careful what you put in the mail – and make sure you can back up any claims that go in a direct mail campaign. The same applies to wire fraud. If you use interstate phone calls, or the Internet, to defraud people, you could likewise face up to 30 years in prison and a $1 million fine, per offense.
Fraud in Action
This isn’t just theoretical: The Department of Justice recently filed wire fraud charges against six individuals for using the Internet and telephone lines to perpetuate a property-flipping scam.
Their target: flippers. That’s you.
Specifically, the DOJ accused this group of people of selling REO property (bank-owned real estate) that could be quickly turned around for a profit. The problem: These properties did not have clear title, were uninhabitable or “simply worthless,” according to the DOJ.
This wasn’t just a bunch of local yokels. The DOJ arrested or arraigned individuals in Southern California, Tennessee and Florida in just this one case.
Never Skimp on Due Diligence
There’s a saying among old-school newspaper editors and reporters: “If your mother says she loves you, check it out.” The same goes for any counterparty in a real estate transaction: Don’t rely on what people tell you voluntarily. Check out the information for yourself. The stakes are too high for you to do anything else. A closer look at the details of this case underscores the importance of being disciplined about your due diligence procedures and safeguard mechanisms like escrow before you commit to a property. From the Department of Justice:
In some cases, victims did not receive the properties because they simply did not exist. In other cases, the properties were condemned or other issues with the titles meant victims were not able to take control of the properties. Of those victims who did receive titles, some found that the titles were encumbered by tax liens, fines or building code violations. Furthermore, the indictment alleges that investor funds were immediately disbursed upon receipt, rather than being held in escrow. [Emphasis added – Ed.]
If the DOJ’s characterization of the facts of the case is accurate, the flippers who got conned had an opportunity to head the danger off at the pass. Escrow could have protected the buyers. A drive-by would establish a property that doesn’t exist. And the encumbrances for tax liens, fines and code violations are a matter of public record – easily obtained by checking with the office of the county recorder, or simply checking with a title insurance company.
… And Speaking of Your Mother …
The FBI recently obtained an indictment of an Oklahoma man on four counts of wire fraud involving a property flipping scheme. His modus operandi? He would buy properties, own them for a couple of months, and then sell them to his mother and stepfather – without their knowledge or consent. He just worked the transactions out on paper. The Justice Department alleges that between 2005 and 2007, this 39-year old signed fraudulent mortgage applications on as many as 20 properties. The motive: He could obtain the mortgages himself and profit from their sale.
The stakes: This man faces up to 20 years in prison and up to $250,000 in fines, plus mandatory restitution … on each count.
Don’t even think about trying these schemes. They leave a paper trail, nearly by definition – and they are just plain wrong.
Self-Defense
As a property-flipping professional, you need to defend yourself against two possibilities:
1. Getting defrauded
2. Being accused (and convicted) of fraud
The best things to do on the first count seem obvious: Conduct a thorough due diligence at every step. People who take shortcuts and fly by the seat of their pants eventually get burned. Also, protect yourself through escrow – especially if you don’t know the counterparty well.
Defending against an accusation is trickier – because anyone can accuse anyone of anything. The best defenses are to conduct your business on the up and up, and document your moves – including any material disclosures. If you do disclose defects, do so in writing – and get the buyer to initial or sign off on the document.
Get Professional Advice
One of the differences between a hobby investor and a real estate professional is that the professional has a team of experts: One of those experts that you should be forming a relationship with – before the crisis – is an attorney. Arrange a meeting, and talk about preventing fraud and your responsibilities in your jurisdiction. And once you have that relationship established, you should have his or her number on speed-dial. Don’t wait for the FBI to come knocking on your door, though, or to get served by a processor with notification of a lawsuit against you. An ounce of prevention is far better than a pound of cure.
Jason Van Steenwyk is a veteran financial industry journalist who has been fighting to make the world safe for the retail investor since 1999. He lives at Ground Zero of the real estate bubble in Fort Lauderdale, Florida.
{ 6 comments… read them below or add one }
My family just purchased a house in WI from flipers. The did not disclose many problems with the house that were disclosed in the past. The flipers covered up the problems with the house. They made a good profit from the sale of the house. They told us they know their is many issues with the house. They know the laws and their is not a thing we can do. The flipers purchase new house to flip 10 miles away.
What do you do when you realize you bought a house in which all of the issues were masked by the flipper? And in which the inspector didn’t find these major issues? My husband and I are young but we managed to save enough to buy our first home just over a year ago. We are now having to pay an extra 30% of what we purchased our house for to fix/replace things that seemed to be in perfect condition when the house was sold to us. These issues were just bandaged and then we discovered them after being in the home for a short time. Do you know of any agencies/organizations that help people in our situation. Our insurance won’t cover us because they are proving to be pre-existing problems.
Hello, Amie,
Thanks very much for writing!
That kind of issue would be very specific to state law, so there wouldn’t be a single answer I can give you other than to consult an attorney for specifics in your case.
Broadly, you MAY have a claim if you can 1.) Show that a reasonable inspector executing routine due diligence normally expected would have uncovered the issues, or 2.) The previous owner failed to make the required disclosures mandatory in your jurisdiction. Some jurisdictions actually have a checklist of specific items the seller has to address. So your case might be stronger if the issue you’re having was on the checklist. 3.) You need to establish that the failures of either the previous owner, the inspector or both contributed to you suffering economic harm, and 4.) you can peg a reasonable dollar amount on it.
Which brings us to 5.) Whether anything you might win in a judgment is actually collectible. If it’s not collectible, then you might not want to bother with it, because litigation is expensive, even for the winners, if the assets just aren’t there to collect against.
Now, most established inspectors would carry a special form of insurance called Errors and Omissions. This is sort of a type of malpractice insurance, which protects the inspector as well as the client. Anyone can make a mistake, and you don’t seem to be accusing deliberate fraud. So if you do have a case, the E&O company may be willing to come to a favorable settlement that works for both sides. If it goes to a trial, there should be assets on the table sufficient to make you whole.
I wouldn’t retain the services of an inspector or any other licensed professional ANYTHING unless they maintained at least some basic E&O coverage, and this is something you can verify at the outset of your relationship in the future. Not because I’m sue happy. I’ve never filed or threatened to file in my life, thank goodness.
Even assuming the best of everyone, insisting on E&O coverage is just prudent. It’s just a reasonable precaution to take so that I know I’m protected in case a well-meaning but maybe overworked professional makes an honest error. In that case, I know that I can be made whole in case someone messes up, and I won’t be driving a good person into bankruptcy by insisting on being made whole from damages resulting from someone else’s error.
P.S., What state are you in, Christie?
Hello, Christie, and thanks for writing!
I came across this particular misconception just the other day, as I was writing this column in a cafe. Two insurance agents came to share my table, and were making phone calls trying to put deals together.
I’m always anxious to add sources and perspectives, so I asked them if they worked at all with flippers. The younger agent immediately claimed that “house-flipping is illegal.” The older agent corrected him. House-flipping is not at all illegal. There is a such thing, however, as illegal flipping! But that has more to do with fraud law than flips.
I’ll be writing more on this in the future. I’m hesitant to write too deeply into scams, because the more detail I write about it, the more ideas I might give to dishonest people!
The practice mostly referred to as “illegal flipping” works like this: You start negotiating with a buyer. You bring in an appraiser who low-balls the appraisal… because he’s corrupt or on the take. The criminal may pay him off. You then fix up the house. The criminal then brings in an appraiser who comes up with appraisal that’s too high, again because he’s corrupt or on the take. The new buyer goes to the bank which lends him money based on the corrupt appraisal.
Another variant of the scheme is the deliberate inflating of an appraisal to trick the flipper’s bank into overlending. The flipper borrows the money… and then takes off to Brazil with the proceeds at the first whiff of trouble.
Banks may also impose “title seasoning” restrictions, meaning that they won’t lend unless the current owner has held the title for a specific amount of time – say, 3 to 6 months. The FHA won’t guarantee mortgages that haven’t met a title seasoning threshold. So you might have an illegal flip if the flipper committed fraud to hide the fact that the title didn’t meet the title seasoning requirements from a lender.
In each case, it’s the **FRAUD** that makes it illegal, not the flip. It’s not illegal to buy and sell houses at a profit, and even to do so very quickly. It’s done all the time, and it’s no different than your grocer selling produce (and letting you buy it with your credit card.)
I disagree with your instructor’s premise that flipping itself has hurt your state or caused the foreclosure crisis – though this canard is frequently trotted out by populists whenever markets reverse direction for a time and they blame “speculators” over everything from oil prices to stocks to houses.
These “speculators” serve a critical function in capital markets – they provide liquidity. I harp every chance I get on the importance of the flipper finding a “motivated buyer” who needs to sell quickly. Take the flipper out of the community, and it becomes much more difficult to sell when you need to. Well, any economics theory textbook will tell you that liquidity risk – the risk that you won’t be able to sell and convert your investment to cash quickly – depresses the price of assets. (Look up the term “liquidity premium” for more on this idea.) The presence of a healthy number of flippers competing for opportunities to buy houses INCREASES real estate prices, and is good for the community. Provided, of course, they are open and honest and comport themselves within the law.
There is no room in this business for shysters and fraudsters – nor any other industry.
As to your last question, “why do money hungry and scamming people still flip houses?” That reminds me of when someone asked Jesse James why he robbed banks. “Because that’s where the money is!”
Money hungry and scamming people flip houses for the same reason the honest people do: They think they can make money doing it.
Thanks for your question! More on these ideas in future columns. A good amount of information on ‘Title Seasoning’ has already been written and turned in to the good people at RealEstate.com, and will soon be appearing. Check back every tuesday!
Best of luck in all you do.
Jason Van Steenwyk
Fort Lauderdale, Florida
When I was in school for the post salesman’s course (after I passed my real estate state test) we in class asked the instructor if “house flipping” was illegal in our state and his response was “yes it is”. I was never able to find any reason to refute his comment nor could find anything that proved what he said was true, so I always thought flipping was illegal. These days, and especially in my state, foreclosures have abounded and during this abounding we’ve been told again that flipping houses is part of what has hurt our state. If flipping is so bad that it puts people in a bind plus continually raises the cost of living then why do money hungry and scamming people still flip houses?