Shadow-flipping has been the subject of intense media attention over the past few months, and there has been increasing pressure on the B.C. government to address the issue. The government responded on May 9, 2016 by unveiling new regulations aimed at combatting the practice. The regulations, issued pursuant to the Real Estate Services Act, come into effect today.
What is shadow-flipping?
Shadow-flipping a property involves the assignment of a purchase contract by a purchaser to a third party for a fee, often on multiple occasions and for increasingly higher fees. There is, of course, nothing wrong with entering into a purchase contract and deciding to assign it for a fee. Assignments are a common feature of the real estate market, particularly when prices are rising.
The "shady" aspect of an assignment can arise where, for example, the real estate agent and purchaser are working together to flip the property before the sale closes.
A typical shadow-flip might occur as follows:
- A vendor is persuaded by the vendor's own real estate agent to sell his or her property to an initial purchaser for $1,000,000.
- The purchase price recommended by the real estate agent is below market value.
- After entering into the purchase contract, but before closing the deal, the initial purchaser assigns the contract of purchase and sale to a second purchaser for an assignment fee of $200,000, which the purchaser splits with the real estate agent (unbeknownst to the vendor).
- When the sale closes, the second purchaser pays the $1,000,000 price set out in the purchase contract to the vendor.
It is the element of deliberate deceit by the real estate agent and purchaser that converts a typical contractual assignment into something beyond the pale. The breach of duty by the vendor's real estate agent in the above scenario is obvious, but the purchaser and the purchaser's real estate agent can also cross the line by pressuring an unsophisticated vendor to sell at a below market price, while knowing that a second purchaser is waiting in the wings and willing to pay more for the property. In addition to the commission paid to the real estate agent, the agent and the initial purchaser split a significant payment that would have accrued to the vendor had the real estate agent dealt honestly with the vendor and, to add insult to injury, the shadow-flipping purchaser avoids the property transfer tax that would have been payable had the purchaser paid a market price on closing (or closed on the property and then re-sold it to a new purchaser under a new purchase contract).
The new regulations
Under the new regulations, real estate agents are required, unless their client instructs otherwise, to include the following terms in any purchase contract they prepare:
- the purchase contract must not be assigned without the written consent of the vendor; and
- the vendor is entitled to any profit resulting from an assignment of the purchase contract by the purchaser or any subsequent assignee.
If the real estate agent for the purchaser is aware that the purchase contract does not contain the above terms, the agent must provide a written notice to the vendor advising of the missing terms at the time the purchase contract is presented to the vendor. The notice must also advise the vendor to obtain independent professional advice before signing the purchase contract. The Real Estate Council of BC has prepared a form of notice to be used.
If a purchase contract is to be presented to the vendor and does not contain the required terms, the vendor's real estate agent must provide the same notice to the vendor and inform the vendor as to whether and how the purchase contract can be assigned.
Notably, the new regulations do not apply to the sale of "development units" (as defined in the Real Estate Development Marketing Act) presumably because developers do not require the same level of protection against shadow-flipping as ordinary vendors.
The result
The new regulations crack down on real estate agents, making it more difficult for a purchase contract to be assigned without the vendor's knowledge and express approval. The regulations seek to transfer to the original vendor any profits gained on "flips" by real estate agents and assignors. While a vendor can instruct the real estate agent to proceed without inserting the required terms into a purchase contract, the vendor would be doing so with full knowledge that the purchase contract may be flipped to another purchaser for an assignment fee in which the vendor will not share.
Continuing risks
There are many ways to shadow-flip that are not covered by the new regulations. For example, where the original purchaser is a corporation that has a property under contract, the shareholder could sell the shares of the corporation to a third party for a profit. This change in control would effectively result in a "new" purchaser, without the need for any assignment of the purchase contract and without triggering the protections under the new regulations.
In addition, the new regulations only apply to flipping that occurs before the transaction closes. There is nothing to prevent the original purchaser from closing the transaction and then immediately flipping the property to another purchaser for a higher price. As this would require the original purchaser to pay property transfer tax, the flipper might pursue a "skip transfer" transaction (whereby the initial purchaser directs the vendor to transfer title directly to a third party) in order to avoid paying the tax and the requirements of the regulations.
Finally, if there are no real estate agents involved, an enterprising purchaser would still be able to transact with an unsophisticated vendor without advising the vendor of the terms required under the new regulations and, if the purchase contract does not contain such terms, flip the property to another purchaser before closing.
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