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
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.
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.