This article discusses the ethical concerns associated with “flipping” a property and the two ways a speculator can structure the transfer of his ownership rights in a flip.
Frequent readers of the first tuesday Journal Online are aware that our stance on single family residential (SFR) speculators is unfavorable. Speculators pull money out of the hands of both the sellers and the buyer-occupants of homes. In the process, they artificially inflate housing prices, typically in a double-escrow arrangement. [For more information on the damage speculators do to the real estate market, see the January 2010 first tuesday article, “Homebuyer beware: the real estate game lacks fair play.”]
first tuesday writers are aware, however, that speculators exist and continue to be a factor in the California real estate market. Therefore, speculators and their real estate agents should know how to properly structure their transactions to avoid causing undue stress to sellers, buyers and the real estate market as a whole. In other words: if you must do it, do it right.
Two different methods to contract a flip
An undercapitalized speculator locates a residence he would like to buy with the intent to fix it up and immediately locate a buyer and resell the property. However, the speculator is not financially able himself to buy, rehabilitate and carry the property until closing the resale.
If the speculator can enter into a written purchase agreement to buy the property, he will sell and transfer his right to own the property to:
- a user who will pay cash to acquire the speculator’s rights to ownership — called flipping — and become a substitute buyer; or
- a group of cash-heavy venture capitalists, formed by the speculator as a limited liability company (LLC) to fund the purchase price and carrying costs of ongoing ownership with the intent to close escrow and later resell the property — called syndication. [See first tuesday’s Forming Real Estate Syndicates book.]
On the resale of the property to a buyer (other than by assignment to his syndicated group), the speculator will either:
- assign his contract right to purchase the real estate to the substitute buyer, then also known as the assignee, by entering into supplemental escrow instructions, and escrow will close in the name of the substitute buyer (as is accomplished in syndication); or
- transfer his ownership interest using a grant deed by entering into a separate purchase agreement and escrow instructions with his buyer and close concurrent with or after closing the speculator’s purchase escrow with the owner, a process called double escrowing if the speculator avoids putting up more money than his good-faith deposit.
Assignment provision and vesting
All purchase rights a speculator holds as a buyer under a purchase agreement entered into with the owner can be assigned unless restricted by a provision in the purchase agreement or escrow instructions. Further, an assignment is barred when any personal performance promised by the original buyer (the speculator) under the purchase agreement will differ if it is to be performed by the substitute buyer (the assignee), such as occurs with carryback financing arrangements which require the buyer to meet the same standards of creditworthiness and care of property. [Calif. Civil Code §1457; Masterson v. Sine (1968) 68 C2d 222]
Nor may an owner refuse to cooperate with an investor’s assignment of his purchase rights to a title warehousing agent so the investor can complete a reverse Internal Revenue Code §1031 transaction, called a parking transaction by the Internal Revenue Service (IRS). The warehousing agent is not a substitute buyer, but a middleman or straw man who will merely hold title and deed the property to the investor at a later date. [Nicholson v. Barab (1991) 233 CA3d 1671]
Further, when the purchase agreement states the speculator’s purchase rights are assignable, the owner cannot require the original buyer — the speculator — to close escrow and take title in his name instead of in the name of a substitute buyer by assignment.
To put the owner on notice of the speculator’s right to assign his purchase rights to a substitute buyer who will close escrow under the purchase agreement, the vesting provisions in the purchase agreement call for the conveyance of title by the owner to be insured in the name of the buyer or assignee.
Having agreed in the purchase agreement that title may be vested by assignment in the name of a substitute buyer, the owner must cooperate in good faith by signing closing instructions and transfer documents so title can be conveyed to and escrow closed in the name of the substitute buyer. [See first tuesday Form 150 §12.4]
Having entered into a purchase agreement with a provision that imposes a duty on the owner to cooperate in an assignment, the speculator then:
- seeks out and locates a substitute buyer;
- negotiates the amount he is to be paid for the sale of his purchase rights; and
- enters into an agreement to sell and assign his right to buy the property under the purchase agreement and escrow instructions he has with the owner.
The resale by assignment
Documentation of the speculator’s assignment of his contract right to purchase a property is best handled through escrow as supplemental escrow instructions. [See first tuesday Form 401-2]
A speculator, by an assignment, transfers all of his purchase rights to the substitute buyer, called the assignee, in exchange for a promise to pay the speculator a sum of money due on entering into the assignment or at the time escrow closes. [See Form 401-2 §2]
The substitute buyer accepting the assignment agrees to fully perform all of the speculator’s obligations under the purchase agreement and escrow instructions. By the assignment, the substitute buyer takes legal responsibility for the speculator’s contract obligations delegated to the substitute buyer, an activity called an assumption. [See Form 401-2 §4]
On the speculator’s assignment of his purchase rights, the substitute buyer “steps into the shoes” of the speculator as the buyer in escrow. Having been assigned all the rights to purchase the property, the substitute buyer may enforce the purchase agreement in his name and require the owner to close escrow by conveying the property to the substitute buyer. [San Francisco Hotel Co. v. Baior (1961) 189 CA2d 206]
Also, the substitute buyer, on accepting the assignment in escrow, assumes all of the speculator’s obligations under the purchase agreement and escrow instructions. On elimination of all contingencies, approval of disclosures and waiver of other rights to cancel, the substitute buyer must perform by paying the purchase price and closing escrow on the transaction. If not, he is liable to the owner for wrongfully failing to close escrow. [Fanning v. Yoland Productions, Inc. (1957) 150 CA2d 444; CC §1589]
The substitute buyer who fails to close escrow without legal excuse or justification, called a breach, is also liable to the speculator under the assumption provisions in the assignment for losses the speculator may incur due to the breach. This speculator may incur money losses if the owner pursues the speculator for money losses or specific performance on the breach, unless a release of liability, or novation, was entered into by the owner and the speculator at the time of the assignment. This release and substitution agreement requires the owner to look solely to the substitute buyer for performance of the purchase agreement and escrow, an arrangement called a novation. [Bank of America National Trust and Savings Association v. McLaughlin (1957) 152 CA2d Supp. 911; Gates v. Quong (1906) 3 CA 443; see Form 401-2 §7 and 8]
To comply with escrow instructions after the assignment of the speculator’s purchase rights, escrow prepares all closing documents in the name of the substitute buyer. Closing documents include:
- carryback notes and trust deeds;
- closing instructions and statements;
- approvals and assumptions of any existing loans;
- title insurance; and
- clearance of any other items necessary for escrow to close.
A separate resale by grant deed
A speculator flipping a property may not want to disclose to a substitute buyer the purchase price the speculator is paying for the property and thus his earnings on the flip. Also, the owner might refuse (wrongfully) to cooperate and allow escrow to close in the name of the substitute buyer when asked to comply with the speculator’s assignment of his purchase rights. The owner may feel he is entitled to the speculator’s quick profit.
Instead of assigning his purchase rights under the purchase agreement and escrow instructions to a substitute buyer the speculator has located, the speculator can simply resell the real estate, whether or not the speculator has acquired title in his name. In some counties, the resale will be additionally taxed on recording the second grant deed, a tax the assignment avoids. Also, there is the issue of the Franchise Tax Board (FTB) withholding 3% of the price on the resale, which causes speculators to incorporate and report as an “S” corporation to avoid FTB withholding on the resale.
On the speculator’s resale of the property, the speculator and his perspective buyer will enter into an entirely new purchase agreement and set of escrow instructions, separate from the speculator’s contracts with the owner.
In the context of a resale, the speculator undertakes the duties an owner owes a buyer to make all the disclosures required of a seller of real estate. The speculator may use the disclosures he received from the owner, noting any additional or contrary information known to him. [Shapiro v. Sutherland (1998) CA4th 1534]
A separate escrow will be opened for the resale that will be funded by the resale buyer and any purchase-assist mortgage lender. The escrow company handling the speculator’s purchase is typically used on the resale for convenience and reduced escrow charges, and if a concurrent closing, the transfer of funds.
The speculator’s purchase escrow with the owner and the separate resale escrow opened with the substitute buyer may close concurrently, or the closings may be separated in time. The closing of the resale escrow should be contingent on the close of the speculator’s purchase escrow with the owner. The speculator’s net sales proceeds from his resale escrow will be the source of the funds he will use if he closes concurrently with his purchase escrow with the owner.
Through this legitimate double-escrow process, two grant deeds will be recorded — one from the owner to the speculator who, in turn, will further convey the property by grant deed to the resale buyer in this variety of a flip.
Only one title insurance policy will be issued if the closings are concurrent, and one set of loan assumptions or loan origination documents will be completed — all in the name of the substitute buyer. If the speculator’s purchase escrow closes first, a binder form title policy will need to be purchased at a 10% premium. Under a binder, a policy of title insurance will be issued in the name of the substitute buyer when the resale escrow on the flip is closed.
Editor’s note — Normally, property insured by the Federal Housing Administration (FHA) may not be flipped within 90 days of sale, however, the US Department of Housing and Urban Development (HUD) instituted a temporary moratorium on that anti-flipping rule in an effort to combat the purported illiquidity of real estate owned (REO) properties during the foreclosure crisis. Beginning February 1, 2010, and effective for one year, a property may be flipped by a speculator within the 90-day post-sale period, subject to requirements relating to the sales price, lender specifications and the arms-length status of the transaction. [For more information on the relaxation of the anti-flipping rule for speculators (and their brokers), see HUD’s January 15, 2010 Press Release.]
Disclosures on a resale
The speculator offering to sell a one-to-four unit residential property must make a full disclosure of the physical, operating and title conditions as well as the natural and environmental hazards affecting the property. The substitute buyer on an assignment of the speculator’s right to buy the property receives copies of the purchase agreement, escrow instructions and all disclosures received by the speculator from the owner.
On agreeing to the assignment, the substitute buyer acknowledges receipt of the documents delivered to him by the speculator. [See Form 401-2 §5]
When the speculator involved is a real estate licensee acting on behalf of the owner of the property looking to sell (usually acting under a listing or property management agreement), the situation is complicated by the fiduciary duties owed the owner/seller by the speculator.
Consider a broker who, while employed to locate a buyer for the listed property, prepares a purchase agreement naming himself as the buyer and submits it to the seller. The purchase agreement calls for the broker to be paid a fee for acting as the seller’s agent.
Prior to the close of escrow opened for the purchase, the broker locates a substitute buyer who agrees to acquire the broker’s rights to buy the property under the purchase agreement through an assignment and to substitute himself into escrow as the substitute buyer. The substitute buyer pays the broker a transfer fee for the assignment.
The seller agrees to the assignment of the broker’s rights to the substitute buyer after the broker reiterates that the property’s value does not exceed the price set in his purchase agreement with the seller.
At closing, the broker tells the seller he is to receive an assignment fee for the transfer of his right to buy, but does not disclose the dollar amount of the fee. After escrow closes, the seller discovers that, in addition to the fee he paid the broker, the substitute buyer paid the broker 10% of the purchase price for the assignment.
The seller makes a demand on the broker for the assignment fee and the return of the brokerage fee he paid, claiming the broker breached his fiduciary duty owed the seller and did so deceptively since the broker failed to disclose the amount of the benefits he received while acting as the listing agent, and deprived the seller of his ability to sell his property for its highest possible value.
The broker claimed he had no duty to disclose the price paid by the substitute buyer for the assignment since the broker’s status under the purchase agreement as a buyer was that of a principal with an interest in the property he could sell.
Did the broker breach his fiduciary duty owed to the seller as the listing agent (or property manager) by failing to disclose the dollar amount of the benefits he received on his flip of the property to the substitute buyer?
Yes! A broker’s fiduciary duty created by the listing agreement was never terminated, requiring the broker to disclose all earnings. The broker did not extinguish his agency duties before entering into the purchase agreement to buy the listed property as a principal. [Roberts v. Lomanto (2003) 112 CA4th 1553]
A broker must disclose the full extent of all benefits received which resulted from his or his agent’s involvement in a transaction they were negotiating or arranging on behalf of a client. [See first tuesday Form 119]
Special rules for EP speculators
When purchasing a residential property from a seller-in-foreclosure, the speculator is further regulated by the equity purchase (EP) laws designed to protect vulnerable sellers. A seller-in-foreclosure has a two-year right of rescission when speculator misconduct exists under the EP statutes. On an assignment of the speculator’s purchase rights, the seller retains his rescission rights against the substitute buyer since the right to rescind arose under the contract taken over by the substitute buyer.
However, if the speculator conveys the real estate to a third-party buyer flipping it in a separate arms-length resale, the buyer is a bona fide purchaser (BFP) exempt from the seller’s two-year right of rescission under EP law — even if the resale buyer knows the property is in foreclosure.
Keywords: Assignment, flipping, speculators