DAVID J. WILLIS
Attorney at Law
Copyright © 2009. All rights reserved.
One factor to consider in using “creative” or non-standard methods to convey real estate is whether or not such methods will enable a lender to accelerate the existing loan pursuant to the “due on sale” clause in the deed of trust. There are a variety of contractual and statutory factors that need to be considered. However, if the contemplated transaction involves a title transfer without prior consent of a lender that holds a note and lien on the property, then the risk of acceleration is present if the lender’s deed of trust contains a due-on-sale clause and the lender’s prior written consent is not obtained.
“Due on sale” has become a more important consideration since lease-options, long a bulwark of residential investor portfolios, are now limited in utility as a result of changes to Sec. 5.062 et seq. of the Texas Property Code (effective September 1, 2005) which defined residential lease-options as “executory contracts” subject to burdensome restrictions and requirements. Especially problematic is Sec. 5.085(b)(3)(C) which requires that “the lienholder consents to verify the status of the loan on request of the purchaser and to accept payment directly from the purchaser if the seller defaults on the loan.” This means that the lienholder must be informed of and consent to an executory transaction, which is unlikely to occur as a practical matter. Accordingly, residential executory contracts longer than 6 months in duration are effectively limited to paid-for properties. As a result, residential investors owning property subject to a lien must now look to alternatives to lease-options – wraparound transactions, owner financing, leases with a right of first refusal (rather than an option to purchase), and inter vivos land trusts. Each of these alternatives requires consideration of due-on-sale issues. Historically, due-on-sale clauses are seldom exercised, even if the lender learns of a title transfer, since mortgage lenders are not generally interested in foreclosing upon a performing loan on merely technical grounds. However, some lenders (including Ocwen and Wells Fargo) have begun sending letters demanding that the new owner apply and qualify to assume the loan – or else the property may be posted for foreclosure. Whether or not that threat is real or just a bluff may depend on individual circumstances. It is nonetheless clear that acceleration can happen, as can lawsuits in the event one party to a transaction alleges that he was not properly advised on the implications of due-on-sale and claims to have been damaged as a result.
The Seven-Day Notice Requirement:
Property Code Sec. 5.016 (effective January 1, 2008) attempts to deal with the issue of due on sale by requiring 7 days notice to the buyer before closing that an existing loan is in place; (2) giving the buyer this same 7 day period in which to rescind the contract to purchase; and (3) also requiring that the 7 day notice be sent to the lender, theoretically giving the lender an opportunity to accelerate and call due a loan if the security property is being transferred without its consent. Actual lender consent, however, is not required under this provision.
The purpose of this legislation is to thwart transaction structures that separate title (as shown on a deed) from debt (as shown on a note and deed of trust). There is nothing inherently illegal or even unethical about doing this, however. It happens often, most notably in “subject to” and wraparound transactions. The effect of the new law is to bring this issue out into the light of day and eliminate situations where lenders lose control over their loans and unsophisticated sellers complain they were unaware that they were not being released from an existing loan when title to the property was transferred.
Sec. 5.016(c) lists 11 exceptions to the notice rule:
(c)This section does not apply to a transfer:
- under a court order or foreclosure sale;
- by a trustee in bankruptcy;
- to a mortgagee by a mortgagor or successor in interest or to a beneficiary of a deed of trust by a trustor or successor in interest;
- by a mortgagee or a beneficiary under a deed of trust who has acquired the real property at a sale conducted under a power of sale under a deed of trust or a sale under a court-ordered foreclosure or has acquired the real property by a deed in lieu of foreclosure;
- by a fiduciary in the course of the administration of a decedent’s estate, guardianship, conservatorship, or trust;
- from one co-owner to one or more other co-owners;
- to a spouse or to a person or persons in the lineal line of consanguinity of one or more of the transferors;
- between spouses resulting from a decree of dissolution of marriage or a decree of legal separation or from a property settlement agreement incidental to one of those decrees;
- to or from a governmental entity;
- where the purchaser obtains a title insurance policy insuring the transfer of title to the real property;
- to a person who has purchased, conveyed, or entered into contracts to purchase or convey an interest in real property four or more times in the preceding 12 months.
The most obvious available exception between non-family members is a transaction where title insurance is issued (an odd exception, actually, since it was never the purchaser’s title that was in doubt).
Transfers into a trust do not constitute an exception, although transfers by an existing trustee are excepted. So creating a land trust is not a means around the notice requirement.
No time period is specified during which a lender must act on the notice, if at all.
The actual effect of this legislation remains to be seen, particularly since the only sanction is to allow a prospective purchaser to back out of a contract. Many sellers are sending the seven-day notice to the servicing agent, technically meeting the statutory requirement; but servicing agents apparently do not know what to do with these notices (yet) and no action is generally taken.
Effect of the Mortgage Fraud Act:
The Residential Mortgage Fraud Act (effective September 1, 2007) requires virtually anyone connected with a real estate transaction (including real estate brokers, mortgage brokers, escrow officers, attorneys, etc.) to report to an authorized government agency suspicious activity that may involve real estate fraud (Government Code Sec. 402.031). Question: Is failure to give the 7 day notice required by Sec. 5.016 “suspicious?” Future cases are likely to answer this question in the affirmative. So . . . there is no way around it. While Sec. 5.016 may be largely toothless, fraud sanctions can be severe. The notice must be given unless there is a specific exception available under Sec. 5.016(c).
A Look at the Wording of the Due-on-Sale Clause:
Even if notice of a transfer must be given under Sec. 5.016 of the Property Code, it is not necessarily true that a lender will accelerate and foreclose; nor is true that a lender always may take such action. There are exceptions.
Take a close look at the language of the Fannie Mae/Freddie Mac Uniform Deed of Trust, which is nearly universally used to secure institutional residential loans. It contains the following due-on-sale clause:
18. Transfer of the Property or a Beneficial Interest in Borrower. As used in this Section 18, “Interest in the Property” means any legal or beneficial interest in the Property, including, but not limited to, those beneficial interests transferred in a bond for deed, contract for deed, installment sales contract or escrow agreement, the intent of which is the transfer of title by Borrower at a future date to a purchaser.
If all or any part of the Property or any Interest in the Property is sold or transferred (or if Borrower is not a natural person and a beneficial interest in Borrower is sold or transferred) without Lender’s prior written consent, Lender may require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if such exercise is prohibited by Applicable Law.
First, it should be apparent that there is no such thing as “breaching” or “violating” this clause. It is merely an enabling clause – if the borrower takes certain action, then the lender may require immediate payment in full. A person who transfers title without the lender’s prior consent commits no offense, civil or criminal. Secondly, the clause expressly states that a lender may not act if such action is “prohibited by Applicable Law.” It is here that we get into the exceptions to due-on-sale.
Exceptions Provided by “Applicable Law:”
Federal law. The Garn-St. Germain Depository Institutions Act (U.S.C. Title 12, Chapter 13, Sec.1701j-3(d) is among the “applicable law” that limits lenders’ discretion in matters of due-on-sale:
1701j-3(d) Exemption of specified transfers or dispositions:
With respect to a real property loan secured by a lien on residential real property containing less than five dwelling units, including a lien on the stock allocated to a dwelling unit in a cooperative housing corporation, or on a residential manufactured home, a lender may not exercise its option pursuant to a due-on-sale clause upon– (1) the creation of a lien or other encumbrance subordinate to the lender’s security instrument which does not relate to a transfer of rights of occupancy in the property; (2) the creation of a purchase money security interest for household appliances; (3) a transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety; (4) the granting of a leasehold interest of three years or less not containing an option to purchase; (5) a transfer to a relative resulting from the death of a borrower; (6) a transfer where the spouse or children of the borrower become an owner of the property; (7) a transfer resulting from a decree of a dissolution of marriage, legal separation agreement, or from an incidental property settlement agreement, by which the spouse of the borrower becomes an owner of the property; (8) a transfer into an inter vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property; or (9) any other transfer or disposition described in regulations prescribed by the Federal Home Loan Bank Board.
Subsection (8) was generally intended to allow individuals to create family trusts for estate planning purposes, especially probate-avoidance. This is the exception relied upon by land trusts which seek to avoid the applicability and enforceability of due-on-sale clauses.
Land trusts have become popular alternatives to lease-options. However, there are two major pitfalls: first, many land trusts rely upon immediate possession coupled with a future intention to convey real property at a specified price (ie., an option), which likely makes them executory contracts subject to restrictions contained in the Texas Property Code, and therefore quite problematic; and (2) secondly, since such trusts may make use of a lease or lease-option (which clearly “relate to a transfer of rights of occupancy” under Garn-St. Germain), most such trusts will fail to avoid the impact of due-on-sale. Only a land trust that carefully avoids these two pitfalls will have practical benefit in Texas.
As an additional complication, the FDIC has promulgated an even more restrictive rule than Garn-St.Germain. It requires that in order for a land trust to avoid enforcement of a due-on-sale clause, the property must continue to be owner-occupied – something which is almost never true in your typical land trust transaction where a “buyer” takes immediate possession.
8000-FDIC Miscellaneous Statutes and Regulations PART 591—PREEMPTION OF STATE DUE-ON-SALE LAWS
Limitation on exercise of due-on-sale clauses. § 591.5 (b)(1) provides:
A lender shall not (except with regard to a reverse mortgage) exercise its option pursuant to a due-on-sale clause upon (vi) a transfer into an inter vivos trust in which the borrower is and remains the beneficiary and occupant of the property, unless, as a condition precedent to such transfer, the borrower refuses to provide the lender with reasonable means acceptable to the lender by which the lender will be assured of timely notice of any subsequent transfer of the beneficial interest or change in occupancy.
Investor and seminar “gurus” often provide extravagant claims that their forms – which are complicated and expensive – provide sure-fire immunity from due-on-sale issues, ironclad asset protection, expedited eviction in event of default, and otherwise lead the investor down the gold brick road to prosperity. Few of these packages are customized for Texas, nor do they usually take into account changes in the Property Code concerning executory contracts. Since violations of the executory contract provisions are defined to be deceptive trade practices (Sec. 17.46, Business & Commerce Code), these off-the-shelf forms can now get investors in real trouble. If you have forms entitled Purchase Option Agreement, Option Cancellation and Release Agreement, Option to Purchase Real Estate, Performance Mortgage to Secure Option, Secured Reverse Assignment Agreement, Slick Tricks to Get What I Want Without Telling Anyone What I’m Doing, and the like, these are real estate “snake oil” and should be avoided.
Note on Drafting Earnest Money Contracts:
Consideration of the ramifications of due-on-sale begins with the earnest money contract. The TREC promulgated forms are less than adequate in dealing with due-on-sale issues, and there is no promulgated addendum for wraparounds. For agents and brokers, inserting anything other than business points is likely to constitute the unauthorized practice of law. It is therefore a good idea for agents and brokers to consult a real estate attorney to obtain a suitable addendum that addresses the non-standard nature of wraparound transactions.
Information in this article is proved for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
THIS DOCUMENT IS NOT INTENDED TO BE USED, NOR CAN IT BE RELIED UPON, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES IMPOSED UNDER UNITED STATE FEDERAL TAX LAWS. THIS DOCUMENT DOES NOT CONSTITUTE DOES NOT CONSTITUTE A TAX OPINION OR OTHER ADVICE TO WHICH CIRCULAR 230 IS RELATED.
Copyright 8 2008 by David J. Willis. All rights reserved. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, http://www.LoneStarLandLaw.com.