Real Estate Fraud: Theft by Swindle: Predatory Remodeling

What is Predatory Remodeling?

Home buyers face exploitation from house flippers when the Seller intentionally hides building code violations behind finished surfaces. To maximize profit, the Seller may also neglect to get building permits, hire unlicensed contractors, side-step disclosures in purchase paperwork, and utilize tax loopholes. This type of real estate fraud has been dubbed "predatory remodeling", and leaves the unsuspecting buyer responsible for repairs. In extreme cases, the revealed code violations can draw the attention of city building inspectors who have the authority to condemn unsafe properties and evict the new homeowners. Predatory remodeling is the most-abused type of real estate fraud today.1

Motivation

Home values are on the rise, with a year-over-year price increase of 11.6 percent, according to the National Association of Realtors. The average profit on flipping a house in California was $37,375 in 20122. In Minnesota, the flipping profits were $48,893 in 2012, and $54,927 in 20133.

How Does it Work?

Building code ordinances are in place for two reasons:

  1. To ensure the safety of residents.
  2. To protect the taxable value of the property.

When a property is in violation of building codes, a city building permit is required for all repairs, and those repairs must pass a building code inspection by the city official. However, building permits are often expensive, and a negligent flipper sees them as lost profit. When a predatory individual does not obtain a building permit, the building official is never notified, and an inspection never happens. So long as the flipper is not caught in the act, they usually face no penalties for performing remodeling or repair work without a building permit.

It is recommended that building trades contractors are used for property repairs. These contractors are licensed by the Department of Labor and Industry, and are backed by a Contractor Recovery Fund for any mishandled work. However, licensed contractors are expensive, and once again, a predatory individual can cut costs by hiring unlicensed contractors or "handymen" to do the work. This means that victims of predatory remodeling do not have access to the Contractor Recovery Fund. Additionally, the flipper can pay these unlicensed contractors cash under-the-table so that compensation cannot be tracked.

When selling a property, the Seller is required to disclose all building code violations. However, a predatory individual can simply lie, and not disclose any problems whatsoever, to make the property seem more attractive to the Buyer. The Buyer then becomes responsible for those hidden building code violations after the sale. Additionally, the Seller can utilize the Disclosures Alternatives form that acts as a waiver to any responsibility for the hidden problems.

A home Buyer can approach a Seller about building problems and ask them to address them one by one. If the Seller does not respond, the Buyer can take them to court for each problem found. To limit this possibility, the Seller can ask the Buyer to agree to arbitration during the purchase process. This means that the Buyer and Seller settle disputes out of court, and they become legally binding. However, this can only happen once, and only for a limited period of time after the purchase date. Any additional building problems that are discovered after the arbitration are legally indisputable.

Finally, a predatory individual can hide the profits by using money laundering techniques:

  • Start an LLC for each transaction. This is a front company that is disposable, availing the Seller of any responsibility for the fraud.
  • Defer paying any income taxes to the IRS by closing the sale as a 1031 Exchange. This is a common tactic among many real estate investors which transfers the profits from one property into the purchase of another. These transactions are strung together indefinitely so the investor dodges paying taxes altogether. Later, the taxes are collected from the investor's estate after their death.
  • Keep liquid funds concealed in an off-shore bank account.

Why Does It Work?

Opportunistic real estate investors are able to commit predatory remodeling without consequences because:

  • There is no penalty for doing remodeling work without a permit, even when one is required.
  • Unlicensed contractors and handymen are not bound by law to adhere to building codes.
  • There is no penalty for not disclosing building code violations at the time of the sale. After the closing, the burden of proof is upon the Buyer.

These are legal loopholes that allow predatory individuals to deceive and exploit home buyers.

Recourse

Unfortunately, most real estate laws exist only to protect the execution of the sale, but not the Buyer. Even when there is evidence that fraud has been committed and damages have been incurred, there is little to no precedent for prosecuting a Seller for real estate fraud. Buying a home is a one-way transaction, and there is no clear recourse for a victim of predatory remodeling.

Aftermath

When a residential property is riddled with hidden problems:

  • the victim usually chooses to abandon the residence, let it fall into foreclosure, and damage their credit.4
  • The bank devalues the property, and tries to get rid of it in a short sale.
  • The taxable value of the property drops, affecting the city, county, and state.
  • The values of the surrounding properties drop.
  • The city is stuck with a problem property in their housing stock.
  • The flipper gets away with a large profit.

Laws Against Predatory Remodeling

In the United States, there are several laws designed to prevent this type of fraud. However, many of them are relaxed or simply not adopted by most cities or states.

Federal Laws
The main catalyst for house flipping fraud is the easy availability of loans. On May 1, 2003, the Department of Housing and Urban Development (HUD) issued FR-46155, an anti-flipping rule that:
  • Prohibits federally-insured mortgages (conventional, FHA, and VA) on properties sold within 90 days of acquisition.
  • Investors need to hold title before resale.
  • Property that is being sold for more than 20 percent more than the seller's acquisition cost must include a second appraisal or provide documentation of the improvements to the home to justify the price increase.
  • An inspection must be completed by the lender if the home is being resold within 90 days for a price that is 20 percent more than its previous sales price.
  • Any flipping event in the previous 12 months is prohibited.

Unfortunately, the FHA waived this law in 2010 in an effort to accelerate the resale of homes and to stimulate the economy. That waiver has been extended year-over-year4, and is still in place today.

State Laws
Washington State law SBH 1843 / RCW 18.276 states that any person or entity must be a licensed and bonded general contractor if they:
  • Purchase a property and intend to rehab it and sell it for a profit
  • AND intend to resell that particular property within 12 months
  • AND plan to spend more than $500 on rehabbing the property

This simple law means that flippers MUST adhere to the building codes if they wish to maintain their general contractor license. Additionally, it means that victims have recourse through the Contractor Recovery Fund.

Unfortunately, similar laws have not been adopted by other states at this time.

Local Ordinances

Cities and municipalities can prevent predatory remodeling and protect the quality of their housing stock through a Property Maintenance Inspection Program. This program can require properties to undergo Point of Sale Inspections by the city building official prior to every sale.7

This type of program is gaining traction and has been adopted by many cities. Unfortunately, unscrupulous real estate flippers choose to exploit properties in cities without property maintenance inspections.

Alternatives

Outside of the U.S., there are examples of common laws to prevent real estate fraud.

  • Many countries in Europe require homesteading of a residential property for a minimum of 2 years before it can be resold.
  • Some countries require a home warranty with all residential property sales. As an example, home owners in Finland must include an 8 year warranty when selling their residence.

Both of these practices make real estate flipping rather impractical, greatly reducing any chance of predatory remodeling.


References

  1. Flipping is Illegal by Ron LeGrand, REIClub.com
  2. The New Rules of House Flipping by Chris Taylor, Reuters, New York
  3. Minneapolis House Flippers Become Holders - High Profits In Rental Homes by Jenna Thuening, prweb.com
  4. House-flipping waiver extended by Steve Kilar, The Baltimore Sun
  5. 2010 Press Release 10-011 - U.S. Department of Housing and Urban Development
  6. SBH 1843 / RCW 18.27 - Washington State Legislature
  7. Property Maintenance Inspection Program - St. Louis Park, MN
  8. VIDEO: Selling Your Home in St. Louis Park - St. Louis Park, MN

About the Author

Frost Simula purchased his first house in Columbia Heights, Minnesota in May of 2013. When it became clear that the Seller had committed real estate fraud, Frost began documenting the nightmare of hidden building code violations, the struggle to save the property from condemnation, and the ongoing ordeal to find justice. An active citizen in his community, Frost is currently working with local, county, and state lawmakers to ensure that nobody becomes a victim of predatory remodeling again. Frost is frequently featured in the media, and maintains his Hoodwinked House website to educate the public about real estate fraud.