Is Flipping Illegal?

by 17 Apr 2012

A Brief History of Flipping and Title Seasoning

Flipping, the technique of buying properties and quickly reselling them for a profit, is one of the oldest and most widely used real estate investing techniques. Yet, people unfamiliar with flipping often ask, isn't flipping properties illegal? The answer is - it depends. If you do it legally, it's legal. If you do it illegally, it's illegal.

Let's examine one of the many perfectly legal ways to flip a property. An investor buys a fixer upper at a bargain price. Then, he improves the property and makes it marketable to retail buyers. Finally, he finds a buyer who is willing to pay fair market value for the property. The buyer qualifies and obtains financing from a retail lender. The buyer gets a nice renovated property and the investor makes a profit for his time and investment. There is nothing illegal about this method. It's a perfectly legal and ethical form of flipping.

Now let's examine how illegal flipping usually works. An investor buys a fixer upper. They usually do not buy it at an appropriate discount. They also typically do a subpar rehab to the property. Then, the investor lines up a naive buyer (although oftentimes the buyer is in on the scheme too), an appraiser, a mortgage broker, and a closing agent. The investor conspires with the appraiser to artificially inflate the value of the home and the closing agent facilitates the transaction, oftentimes giving the buyer a "kickback" for his cooperation in the scheme. In fact, all parties usually get a piece of the fraudulent gains.

In these schemes, the buyer obtains financing through a lender who is unaware of any manipulation in the appraisal or misinformation provided during the loan application process. Since important facts were misrepresented to the lender, the parties have committed bank fraud. As a result, this type of flipping is illegal. The result of this situation is that the buyer paid too much for the house and is stuck with a mortgage he cannot afford. The bank is ultimately forced to foreclose on the house and incur a sizeable loss when they sell it.

So now that we have shown that flipping properties can either be done legally or illegally, we have illustrated that flipping, in and of itself, is perfectly legal. Flipping is only illegal when bank fraud is involved. Otherwise, buying low and selling high is perfectly legal and ethical. In fact, taking on substantial risk and being rewarded with a profit for your efforts is the American way. So don't let an uninformed person tell you that flipping is illegal or unethical.

When fraudulent flipping schemes began taking place, the media began loosely referring to these deals as "property flipping schemes," when in reality these deals were simply bank fraud as illustrated above. Over time, as the public became repeatedly exposed to these stories, it associated flipping properties with being illegal. In the absence of these schemes, flipping properties is neither illegal nor unethical.

However, it is important to understand that due to these fraudulent schemes committed by a small number of individuals, lenders were forced to initiate ways to protect themselves from fraudulent transactions. One of the ways they did this was to require what is called "seasoning of title" before they would consider lending money on a property. Title seasoning is the length of time a particular lender will require for a seller to have been on title to a property before the lender will fund the transaction for the buyer. The extent of "seasoning" required by a particular lender varies, but is usually between three and twelve months. As a result, many conventional retail lenders have strict requirements regarding how long a seller must have "seasoned" a title.

While there are benefits to the lender (and to the entire marketplace) for requiring title seasoning, it also places limitations on legitimate real estate investors when buying, fixing, and reselling a property for a profit. If a real estate investor attempts to sell his property to a buyer who is using a lender with seasoning requirements, the lender may feel there is something wrong if the investor is selling a property for double what they paid for it, even though the investor may have put $50,000-$70,000 worth of work into the property.

This is why it is important for real estate investors to keep accurate records that document the transaction. A smart investor will be able to show proof that he bought the property at a discount from a motivated seller and that the property needed work (evidenced by a listing sheet and before photos). He should also have proof that a legitimate rehab was performed (evidenced by receipts and invoices). When armed with this documentation, investors are able to support the increased sales price in such a short amount of time. In some cases, the lender may decide this documentation is enough to waive its seasoning requirement, and may require a second appraisal to be sure. In other cases, lenders may not bend on their seasoning requirements no matter how much documentation is provided. In that case, it may be necessary for the investor to bring the buyer to a lender who has no seasoning issues.

[caption id="attachment_8398" align="alignleft" width="115" caption="Alex Everest"]Alex Everest[/caption]

Alex Everest, Founder and President of Deal Maker Library, is a nationally known real estate investor, author, speaker, and advisor from Minneapolis, Minnesota. He specializes in the areas of wholesaling, rehabbing, owner financing, and land trusts for residential real estate.



Is TILA-RESPA a good or bad thing long term?