Q: I have heard that a considerable profit can be made by buying a sales contract on a new house that has not yet been built, and then selling the contract before settlement. Assuming that the house appreciates and the builder does not go bankrupt, how does this work and what are some of the risks involved?
A: In real estate jargon, you are describing a concept known as "flipping a contract." It can be applied to both new and older houses.
There is money to be made when you "flip" your contract. For example, you enter into a contract to buy a house from Mr. Smith for $30,000.00. Settlement will not take place for about 90 days. Unless your sales contract prohibits transfer, it is perfectly legal for you to sell the contract for any price you can get, so long as the terms of the original contract remain in full force. Thus, if Mrs. Brown buys the contract for $35,000.00, Brown will settle on the house, Smith will get the original contract price, and you will gain a clear profit of $5,000.
There are many risks and problems involved in flipping contracts, however. It is important to determine whether the contract permits a flip. Most new home contracts specifically prohibit a buyer from selling - or assigning - the contract to anyone else prior to settlement. Thus, if you intend to flip your contract, make sure that the basic contract provides that if can be "sold or assigned."
Perhaps the most serious risk in flipping a contract is the possibility that your buyer (Brown) will default prior to settlement. This leaves you with the choice of either defaulting yourself, thus, rising any deposit you put down on the original contract, or having to come up with enough money to buy the house. It is very important to determine the qualifications of your buyer, and to get a large deposit to ensure against any such default.
If you "flip" a new house contract, what warranties will you be required togive your buyer? Will you guarantee the house to be structurally sound for at least one year? Obviously, you do not want to give such warranties.
Your contract with Brown should specially state that she will not hold you responsible for any warranties but will look to the original developer - Smith - for any such protection. Again, before you enter the first contract with Smith make sure that the warranties are freely transferable to subsequent purchasers. Many warranties only extend to the original purchaser.
Finally, there are tax implications to consider. If you have flipped your contract and made a profit within a year, this will be considered a short-term capital gain, taxable as ordinary income.
If you are in a high tax bracket, the net profit will not be as large as you thought. And, local taxes should also be considered. For example, the recently enacted "anti-speculator" tax law in the District was aimed at curbing speculators who "flip" contracts. You might find that yet another heavy tax will be imposed on you.
Flipping contracts can be profitable. But, there are serious legal and social implications to be considered, and you should not treat this matter lightly.
Benny L. Kass is a Washington attorney. Write to him in care of the Real Estate section, The Washington Post, 1150 15th St. NW, Washington.