A brief summary of the biggest mistakes real estate flippers make and suggestions on steps to take to avoid the problem.
1. Buying property to flip in their own name.
The biggest unnecessary risk happens when flippers buy property using their own name rather than using some business entity such as a corporation or limited liability company. Failing to use an entity exposes the flipper to unlimited personal liability. The flippers entire net worth is at risk from something as unexpected as a contractor getting hurt on the job. Fix it by using an entity.
2. Having *partners* without a written partnership agreement.
Many flippers, especially new flippers have partners. Many of the partnerships are based on a handshake or very limited written agreements. While it may work out ok if, everything turns out exactly as each partner hopes and every deal is highly profitable, problems arise if the partners have different ideas regarding costs, work to be done, what price to sell at etc. A well-drafted partnership agreement will cover the common areas of disagreement and provide a fair way to resolve disagreements in advance. Fix it by having a documented partnership agreement in writing.
3. Not using a Limited Liability Company.
A limited liability company is the preferred entity type for the large majority of flipping operations. The combination of liability protection, pass through tax status, ease of record keeping, and greater flexibility in company structure and operations give it the advantage over other types of entities. Fix it by converting a partnership or corporation to an LLC or forming an LLC from the beginning.
4. Using a single member Limited Liability Company.
In California a single member, LLC provides little true asset protection. A creditor can obtain a charging order against the distributions of the LLC defeating the purpose of the LLC with respect to asset protection. In practice, it is easier to pierce the vail of a typical single member LLC than a properly structured multi member LLC exposing the flipper to liability. Fix it by bringing in an additional member even if on a limited basis.
5. Using improper distribution language in the operating agreement.
Requiring mandatory distributions reduces the liability protection of the LLC. Properly drafted distribution clauses are one of the better ways to keep creditors away. While it may be possible for a very determined creditor to attack, it becomes much more expensive and much less likely to be a successful result for the creditor. The goal is to change the analysis of the creditor and convince them that an attack is just not worth the time, money or risk. Fix it by amending your current LLC operating agreement or drafting the correct language for a new LLC.
6. Using contractor supplied contracts for work performed.
Most contractors will have their own contracts for the flipper to sign. The contracts are written in a way that strongly favors the contractor at the flippers expense. The contract should be modified to provide the flipper with more certainty with respect to costs, completion dates, quality of work performed, warranties on work performed, and protection from liens. Fix it by either creating your own construction contracts or by creating an addendum to the contractor*s version.
7. Using a neutral contract when buying
Most flippers use a preprinted form contract from the California Association of Realtors or other similar group. These contracts are designed by a trade group to protect its members; they are not designed to protect the Flipper. Except for the language required by law, statute or regulation the contract can be modified to favor either the buyer or the seller. For example as a buyer, you would want the deposit to be refunded in full if the transaction fails to close. The standard liquidated damages clause can be modified to provide greater protection to buyer. Fix it by modifying the clauses that give the seller an advantage to suit your objectives.
8. Using a neutral contract when selling
As a seller, your objectives are better accomplished by limiting the buyer advantage clauses. For example you should modify the standard *as is* clause to make it a true *as is* clause. You can modify the language to provide a greater ability to recover the deposit from a defaulting buyer. You can eliminate the right of the buyer to sue for specific performance if the seller defaults. Fix it by modifying the buyer advantage clauses to suit your objectives.
9. Using hard money rather than private money
Most hard money lenders require credit checks, background checks, verifiable experience in rehab, and personal guarantees. If you obtain a hard money loan and do not satisfy all the lender requirements the points, fees and interest rate upcharges can put a serious dent in the profitability. Private lending takes a bit of extra time and some documentation but is typically available at better terms than hard money. Better loan to value, better financing of construction costs, and no points can have a big impact on your profitability. Fix it by securing private financing on your terms.
10. Securities violations when raising money
If you have or want to take the next step in flipping, you may need to raise investor money. This is different from partners that work with you on the project; investors generally just want a return on the investment and are not involved in the work. Raising money from investors requires an understanding of federal and state securities laws. Failing to register or qualify for an exemption from registration can result in substantial liability including civil and even criminal penalties and civil liability to all investors. Several exemptions exist but they must be properly documented. For example, some LLC*s would be exempt from registration while others are required to register. It depends on how they are structured. Fix it by being aware of what the securities rules are and structuring your business to fall within an exception or budgeting for registration.This guide is designed to provide basic information. You should of course consult with an attorney of your choosing for advice regarding your specific situation. You may call my office at (714)627-4556 if you wish to consult regarding the specifics of your business.
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