What is Predatory Remodeling?

Predatory remodeling is the most common type of real estate fraud.¹ It happens when a troubled property is remodeled to conceal its problems. Then the property is sold at a higher value to a victim without disclosing those hidden problems. It is considered theft by swindle, and a Buyer often has little or no chance of recovering the damages from the Seller.

A real estate investor, sometimes called a “flipper”, is someone who buys a property and resells it for profit. On its face, this is perfectly legal. Sometimes the flipper does not change anything about the property before putting it back on the market. Other times they make cosmetic improvements, such as giving it a fresh coat of paint. More ambitious flippers might buy a low value property and try to rehabilitate it with some basic repairs. But a flipper can make the most profit by buying a liquidated property such as a bank-owned foreclosure, finding low-cost solutions to problems, and putting it back on the market at a significantly higher price point. This can become unethical.

Flipping is extremely profitable

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 average profit house flipping profits were $48,893 in 2012, and $54,927 in 2013³.

Flippers who offer to buy properties with cash and without contingencies usually win the sale. Regardless of a property’s condition, a flipper will find a way to resell it at a profit. Some flippers even advertise themselves.

When a Flip becomes a Flop

Home buyers can be exploited by deceptive house flippers. When a property has building code violations, an abusive flipper may intentionally hide the problems behind finished surfaces, such as drywall. This is illegal, but a flipper who practices predatory remodeling uses methods to avoid getting caught.

• Unlicensed contractors are cheap and unregulated. They are often hard to identify and prosecute.
• No building permits are obtained, so the property is never inspected by a building official.

Predatory remodeling conceals very serious problems. Left uncorrected, the problems can become worse and cause further damage to the property. Sometimes, the hidden building code violations can be life-threatening.

• Leaking pipes or other plumbing problems
• Unsafe electrical wiring
• Ventilation and air duct problems
• Mold
• Structural problems, such as damaged or missing load-bearing supports

A real estate inspector only reports problems that can be observed during the inspection. Predatory remodeling keeps problems away from an inspector’s eyes by hiding them behind drywall, flooring, roofing, cabinetry, or even concrete.

After closing, the all of the property’s problems become the legal responsibility of the Buyer.

Covering their tracks

Predatory remodeling is intentional. When a flipper does illegal work on a property, they will try to divorce themselves from any responsibility. They can do this in a number of ways.

• A Seller’s Disclosure Alternatives form keeps the flipper’s knowledge about the property’s condition a secret.
• Starting a new LLC for each property keeps the flipper’s name out of the title paperwork.
• Assigning power of attorney to some other individual at closing keeps the flipper’s signature out of the title paperwork.

A flipper can also hide their money.

• Unlicensed contractors are often paid in cash to avoid a receipts, taxes, and other paper trails.
• Property sale taxes can be deferred during closing by filing a 1031-Exchange. This process uses the proceeds from one property sale to purchase another property with the option to defer taxes. It is common for real estate investors to use a 1031-Exchange in a perpetual series of transactions, deferring their taxes indefinitely. Eventually, taxes may be collected from whatever is left of the flipper’s estate upon their death.
• Some flippers may choose to use offshore accounts and tax havens to hide their money.

Finally, 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.

Laws Against Predatory Remodeling

United States

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.

Federal Laws

At the federal level, 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 holds the flipper accountable to building codes and inspections. If the flipper fails to follow regulations, they lose their license to flip real estate. It also gives victims access to the state’s Contractor Recovery Fund. This fund is only available to those affected by the work of licensed contractors.

Local Ordinances

A popular practice adopted by many municipalities requires Point of Sale Inspections by the city building official prior to every real estate sale.⁷ This can be done in two ways:

1. Building official discovers code violations that the Seller must correct before the property can be certified for sale.
2. Building official discloses code violations to the Buyer while certifying the property for sale. This forces the Seller to lower the price accordingly.

Unenforced Regulations

When none of the above laws or ordinances are used, flippers are able to commit predatory remodeling without consequences. This lack of enforcement allows flippers to deceive and exploit home buyers.

• There is no penalty for doing remodeling work without a permit, even when one is required.
• A building official can issue a Stop Work order when they observe work without a permit or work done against building code. If a flipper is not caught in the act of predatory remodeling, there is no penalty.
• Trades contractor licenses are largely not enforced.

Outside of the United States

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.

Predatory remodeling impacts a community

When a home buyer is swindled into purchasing a house that has experienced predatory remodeling, it sets off a chain of events. In most cases:

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

Recourse for victims

Buying a home is a one-way transaction. Most real estate laws exist only to protect that transaction. In very rare cases, a judge can reverse the sale if there is a problem with the title or mortgage, but not the condition of the house itself.

Unfortunately there are very few protections for 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 after the closing.

Preventing predatory remodeling

Buyers

• Take a first time home buyer class. Never allow yourself to be pressured during the home buying process.
• Investigate a property’s building permit history. Avoid properties that don’t account for additional bedrooms, bathrooms, or other construction projects.
• Investigate a property’s sale history. Avoid properties that have been flipped in a short period of time.
• Hire experienced individual trades inspectors, not a real estate inspectors. Never use any inspector suggested by a realtor.
• Never agree to a Seller’s Disclosure Alternatives waiver.
• Walk away from any property that is owned by an LLC instead of a person.
• Walk away from any transaction that is filing a 1031-Exchange or where the owner gives power of attorney to another signer.
• Require contractor receipts as part of your purchase agreement.
• Require a home warranty as part of your purchase agreement.

Municipalities

• Institute a point of sale inspection program.

States

• Require real estate flippers to be licensed general contractors.

Countries

• Deny flippers access to federal loan programs.
• Establish laws that limit reselling real estate until after a holding period.
• Establish laws that require warranties from real estate Sellers.

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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