DAVID J. WILLIS
Attorney at Law
Copyright © 2010. All rights reserved worldwide
Lease-Options have always been a favorite tool of residential real estate investors. It is easy to get tenant/buyers into such an arrangement (because of the low down payment) and has traditionally been easy to get them out through the forcible detainer (eviction) process if they default (See our companion article, Evictions in Texas). However, changes to the Texas Property Code (Sec. 5.061 et seq.) made in 2005 define lease-options for longer than 6 months as “executory contracts” which (like contracts for deed) are now subject to strict regulation and penalties if not done exactly right. Numerous initial and ongoing requirements must be observed, and the burden is on the landlord/seller to meet these. Failure to do so incurs not only penalties under the Property Code but potential liability for the landlord/seller under the Deceptive Trade Practices – Consumer Protection Act. The latter can involve treble damages and an award of attorney’s fees against the landlord/seller.
The risk to the seller of engaging in executory contracts (lease-options and contracts for deed) has therefore discouraged their use, and investors have moved away from these devices in favor of wraparounds and land trusts. For more information on wraps and trusts, read our articles on these subjects at LoneStarLandLaw.com.
However, lease-options may still have some utility if the term is less than 6 months or if the property is paid for (which means that a lender’s consent will not have to be obtained).
How to Identify an “Executory Contract”
What exactly is an executory contract? Look at Section 5.062(a)(2) of the Property Code: “An option to purchase real property that includes or is combined or executed concurrently with a residential lease agreement, together with the lease, is considered an executory contract for conveyance of real property.”There is an exception for lease-options for six months or less – otherwise, the residential sales contract promulgated by the Texas Real Estate Commission would have violated this provision if combined with a temporary lease. Note that options that are not combined with a residential lease as well as options on commercial property are not affected by Sec. 5.061.
Executory contracts include any transaction that defers some action by either party that pertains to ownership or possession of real property into the future. Think of it this way: an “executed” contract is one that is fully performed today. It is done, finished. An “executory” contract, on the other hand, leaves something dangling. Usually the dangling item is the most important item of all, namely, who owns the property and when do they get the deed?
In Executory Contracts Conveyance of Title is Usually Delayed
Executory contracts can often be recognized by their similar structure. Typically, one party (the seller) holds “legal title” to the property. This usually means he retains a deed to the property in his name. The other party (the buyer) holds “equitable title,” meaning that he has only an equitable right to receive legal title at some time in the future if certain conditions are met. This arrangement gives an advantage to the seller, because enforcement of “equitable rights” by a purchaser generally involves filing suit and asking that one’s equitable rights be recognized by a court and enforced – a lengthy and expensive process at best. Buyers under financial pressure are more likely to abandon their option rights along with their down payments.
In the past, unscrupulous sellers used this situation to their advantage. They disregarded the buyer’s equitable rights, representing to Justices of the Peace that such buyers were ordinary tenants subject to ordinary leases, obtaining evictions for minor or technical defaults, and often confiscating large down payments in the process. The seller was then free to move on to his next “victim” and obtain another down payment. The legislature rightly acted to stop such abuse.
Executory Contracts: Requirements and Penalties
Make no mistake, one can still do a transaction by means of an executory contract – but many requirements now exist that did not apply before the 2005 revisions to the Property Code. Sections 5.069 and 5.070 contain a number of these requirements, which must be met before the executory contract is signed by the purchaser:
5.069(a) (1) requires that the seller provide the purchaser with a survey which is no older than a year, or a current plat.
5.069(a)(2) requires that the seller provide the purchaser with copies of liens, restrictive covenants, and easements affecting the property.
5.069(a)(3) requires that a “Seller’s Disclosure of Property Condition” be provided by the seller.
5.069(b) states that if the property is not located in a recorded subdivision, then the seller is required to provide a separate disclosure form stating utilities may not be available to the property until the subdivision is recorded.
5.069(c) pertains to advertising the availability of an executory contract. It requires that the advertisement disclose information regarding the availability of water, sewer, and electric service.
5.070(a)(1) requires the seller to provide the purchaser with a tax certificate from the collector for each taxing unit that collects taxes due on the property.
5.070(a)(2) requires the seller to provide the purchaser with a copy of any insurance policy, binder, or evidence that indicates the name of the insurer and insured; a description of the insured property; and the policy amount.
Cancellation and Refund
What happens if the foregoing requirements are not met? Firstly, failure to do so is defined as “false, misleading, or deceptive act or practice” under the DTPA (Sec. 17.46, Texas Business & Commerce Code); secondly, the purchaser is entitled under Sec. 5.069(d)(2) to “cancel and rescind the executory contract and receive a full refund of all payments made to the seller.” That would include any down payment plus monthly payments that have been made.
Note that Sec. 5.074(a) entitles a purchaser to cancel an executory contract for any reason within 14 days of signing, even if all of the statutory requirements have been met.
Financial Disclosure Required
An additional pre-closing requirement is imposed by Sec. 5.071, which requires that the seller provide a thorough disclosure of the financial terms of the transaction, including the interest rate, amount of interest charged for the term of the contract, the total amount of principal and interest to be paid, and the non-existence of a pre-payment penalty. There is some slight relief under this section in that violation of it is not defined as a DTPA violation.
The 7 Day Letter
Another, related pre-closing requirement is contained in Sec. 5.016, which states that “A person may not convey an interest in or enter into a contract to convey an interest in residential real property that will be encumbered by a recorded lien” without giving a 7 day notice to both the lender and the purchaser. The section sets out the required content of this notice, which is quite technical. It should be observed, however, that at this time this section provides no real penalties other than to allow the purchaser to back out of the transaction prior to closing if the 7 day notice was not given.
Certain Punitive Fees and Clauses
Sec. 5.073 prohibits these. Excessive late fees are banned, as a pre-payment penalties and any clause that “prohibits the purchaser from pledging the purchaser’s interest in the property as security to obtain a loan or place improvements. . . .”
In the past, lease-options did not need to be recorded in the real property records. No longer. Sec. 5.076 states that “the seller shall record the executory contract, including the attached disclosure statement . . . on or before the 30th day after the date the contract is executed. Additionally, any instrument that “terminates the contract” must also be recorded.
Annual Accounting Statement
Sec. 5.077 requires that the seller provide an annual accounting statement every January, which must include the amounts paid, the remaining amount owed, the number of payments remaining, the amount paid in taxes, the amount paid for insurance, an accounting for any insurance monies paid by the insurer, and a copy of the current insurance policy.
Buyer’s Right to Convert to a Deed
The buyer has an absolute right “at any time and without paying penalties or charges of any kind” to convert an executory contract to “recorded, legal title” under Sec. 5.081. The seller has no choice in the matter so long as the buyer tenders the balance owed under the contract.
Buyer’s Rights upon Default
It is not permissible to simply evict a tenant/buyer under one of these contracts if there is a default. Sections 5.063 and 5.064 specify the content of a notice of default, which must be followed to the letter if it is to be valid. The tenant/buyer is allowed 30 days unconditional right to cure the default. Moreover, if the tenant/buyer has paid in 40% or more of the purchase price, then a 60 day notice is required and, if the default is not cured, then a traditional foreclosure (not an eviction) must be used to regain possession and title (Sec. 5.066).
The Reality of the Courtroom
Why not just ignore the executory contract rules and march merrily forward? The reason is that courts and juries generally do not favor investors and landlords, who are often perceived as profiteers preying upon the weak and helpless. It often does not matter how clever your legal argument is. If a transaction does not pass the “smell test” a seller/landlord will likely lose. Underestimate a jury of 6 or 12 of your peers at your peril. Even if the executory contract rules are found not to apply, remember that the court can look to the “laundry list” of offenses under the Deceptive Trade Practices-Consumer Protection Act. Section 17.50(a)(3) of the Act prohibits “any unconscionable action or course of action by any person” – an exceptionally broad statement.
Forfeiture remains a hot-button area. Section 5.073(a)(4) prohibits a forfeiture of a buyer’s down payment or option fee if a monthly payment is late. This is an important change, because it codifies what judges and juries have been telling lawyers for quite some time. They hate forfeitures. The trend in the law is to view any substantial forfeiture as unreasonable and unconscionable, whether within the context of an executory contract or not, if it results in a buyer losing either a large down payment or the home itself.
Executory Contract Distinguished from Other Preferential Rights
Right of First Refusal (ROFR)
An option to purchase, in a technical sense, is a unilateral contract which gives the holder of the option the right to compel sale of the property at certain price. It must be in writing, exercisable within a specific term, and either recite a price or a formula to compute a price.
A ROFR merely requires the owner, when and if he or she decides to sell, to first offer the property to the holder (ie., the buyer). ROFR’s generally do not specify a price. Depending on how the ROFR is worded, the seller may be required to first negotiate a specific deal with a third-party buyer and then freeze that transaction momentarily while the holder of the ROFR is given a chance, for a specified time, to buy the property at the same price and terms. Often the price is to be determined by what fair market value is at the time of sale. Careful: As soon as you include a specific price, it is likely that an ROFR will be interpreted as an option. ROFR’s are therefore not an effective substitute for an investor seller who wants to pre-set an above-market price in order to lock in a long-term profit.
Right of First Offer (ROFO) and Right of First Negotiation (ROFN)
There are two lesser forms of preferential or pre-emptive right:
- a right of first offer (ROFO) which obligates the seller to notify a buyer of his intention to sell, and the buyer will then have the right to make an offer, the terms of which are not specified in advance; and
- a right of first negotiation (ROFN), which obligates the seller to negotiate exclusively with the buyer for a prescribed period of time. Price and terms of sale are open.
ROFR’s, ROFO’s, and ROFN’s are all potentially useful substitutes for a lease-option, but they must be carefully structured and worded so as not to fall into the executory conveyance “trap.”
Landlords and sellers should generally avoid lease-options because of the numerous requirements and potential liability for doing them improperly. In addition to stiff penalties contained in the Property Code, certain violations are defined to be DTPA violations, which can result in treble damages plus attorney’s fees. Such contracts are no longer advisable or even feasible for property in Texas unless the property is paid for or used exclusively for commercial purposes.
Another caution: Beware of “seminar forms” or lease-option forms off the internet, never much good since they were not designed specifically for Texas. These can now get you in real trouble. If you have such 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, they are toxic waste in the State of Texas. Throw them away. One can call a cat a dog but that does not change the nature of the beast. Courts look to substance over form. Moreover, a judge and jury will likely be angry with a seller who tries to pull a fast one with overly-clever verbage – and more inclined to consider a finding of fraud.
Find a good real estate lawyer, one with courtroom experience, and consult him regularly. His fees are cheap insurance. Pay attention to what he says about how a judge or jury will react to your proposed deal. A good lawyer knows that documents should be drafted as if you will one day have to defend them in court.
Information in this article is proved for general educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. 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 retained and expressly retained in writing to do so.
Copyright © 2010 by David J. Willis. All rights reserved worldwide. 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