DAVID J. WILLIS ATTORNEY
Copyright © 2010. All rights reserved worldwide.
OWNER FINANCE IN TEXAS RESIDENTIAL TRANSACTIONS
Owner financing, also referred to as seller financing, is a legitimate and effective way to sell real estate in an economy where conventional financing is scarce. Residential lease-options exceeding 6 months (formerly the favorite of investors) and contracts for deed were both restricted by changes to the Texas Property Code made in 2005. Because these changes impose severe penalties on sellers if strict, burdensome rules are not followed, sellers have moved away from lease-options and contracts for deed. Thus only a few types of owner financing remain practicable:
- the traditional owner finance, used when the property is paid for;
- the wraparound, which involves giving the buyer a deed and arranging for the buyer to make monthly payments to the seller so the seller can in turn pay the existing lender; and
- the land trust, which involves deeding the property into a trust as a “parking place” of sorts until a credit-impaired buyer can obtain financing.
Those interested in wraps or land trusts should read the articles on these subjects available at LoneStarLandLaw.com.
The business of owner financing is now affected by two new laws – the 2009 SAFE Act which requires that sellers of non-homestead property to non-family members have a residential mortgage loan origination license; and Dodd-Frank, known as the Wall Street Reform Act – the Mortgage Reform and Anti Predatory Lending Act. We will look at these new laws first. Then, before moving on to a discussion of the traditional owner finance, the wrap, and the land trust, we will take a quick look at two formerly popular devices, the contract for deed and the lease-option, which have faded way.
A checklist of information needed by the attorney to prepare documents is attached at the end of this article.
The SAFE Act Licensing Requirement
This is new. The SAFE Act places a licensing requirement on certain types of owner financing provided by professional investors. Since traditional owner finance transactions, wraps, and land trusts are all a form of owner finance, the Act applies; however, the seller is required to be licensed only if the property is not the seller’s homestead and/or the sale is not to a family member. If the subject property is an investment rental house being sold to a non-family member, then the seller is required to have a residential mortgage loan origination (rmlo) license from the Texas Department of Savings and Mortgage Lending.
The Commissioner of the TDSML has ruled that the SAFE Act will not be applied to “non-pros” – persons who make five or fewer owner-financed loans in a year, thus preserving the so-called “de minimus exemption” under Finance Code Sec. 156.202(a)(3).
Does the SAFE Act effectively shut the door on non-homestead owner finance for persons who do more than five such deals per year? Not necessarily. The TDSML has expressly approved the role of an “intermediary agent” who, for a fee ranging from half a point to a point (i.e., 1%) of the loan amount, will step in and satisfy the Act’s requirements. The intermediary agent will supply the new 2010 Good Faith Estimate, Truth in Lending disclosures, order an appraisal, give state-specific disclosures, and the like, and insure that all “cooling periods” are observed in the loan process. So, non-homestead OF deals can still be done, but at a higher net cost. The result is better consumer protection in order to avoid the abuses of the past.
Note that the SAFE Act licensing rule applies only to residential owner financing.
Dodd-Frank Law (Mortgage Reform and Anti-Predatory Lending Act)
Dodd-Frank overlaps the SAFE Act in its regulatory effect. It requires that a seller/lender in an owner financed transaction involving a residence to determine at the time credit is extended that the buyer/borrower has the ability to repay the loan. Seller is obligated to investigate Buyer’s credit history, current and expected income, current obligations, debt-to-income ratio, employment status, and the like in order to make this determination. This law provides for a de minimus exception for persons doing not more than three owner financed transactions per year (so long as the seller/lender is not in the building business) – but the loan must be fully amortizing (i.e., there is no balloon); the seller must determine that the buyer has the ability to repay the loan; and the owner financed note must have a fixed rate or, if adjustable, must adjust only after five or more years and be subject to reasonable annual and lifetime limitations on interest rate increases.
The intent of Dodd-Frank is essentially to put an end to the practice of making of loans to people who cannot afford to pay them back.
The Demise of Contracts for Deed
Contracts for deed (sometimes called land sales contracts or just land contracts) are all but dead in Texas residential transactions – a far cry from the old days when these were common, particularly in the country, where it was literally the “wild west” in terms of deals of this type.
However, contracts for deed are now characterized by Property Code Sec. 5.061 et seq. as “executory contracts” (i.e., transactions that are incomplete or unfinished in a material respect, namely the delivery of the deed). The Code was amended in 2005 to remedy what were perceived as abuses by sellers in using contracts for deed – e.g., collecting a large down payment and then, if the buyer fell behind, using the eviction process to repossess the property as if the buyer were no more than a tenant. This approach unfairly confiscated any equity that had been deposited and accumulated by the buyer in the property. Because of this history, burdensome rules and restrictions now apply. Such contracts must be recorded, a through financial disclosure must be given to the buyer at closing, and the seller must provide an accounting statement every January. Buyers also have a right to convert to a deed, note, and deed of trust. Other requirements:
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.
Failing to comply with the above may constitute a deceptive trade practice and result in treble damages. Accordingly, contracts for deed have fallen into disuse – which was exactly the legislature’s intent.
Note that even if a seller is willing to endure the various restrictions and potential liability involved in engaging in a contract for deed, the SAFE Act licensing requirement would still apply.
Sec. 5.061 does not apply to commercial transactions.
Lease Options in Residential Transactions
Although not technically a form of owner finance, lease options were a traditional way for investors to get less-than-qualified buyers into a home. These too are now considered to be “executory contracts” and are subject to Sec. 5.061. Note that there is an exception for lease options shorter than six months and, of course, commercial transactions are not covered.
Some sellers have attempted to continue to use this practice by re-writing the contract to call for a right of first refusal rather than an option – but be careful . . . as soon as a price is named, it becomes an option. Clever draftsmanship will not avoid Sec. 5.061. Courts look to substance over form – they will look at what a transaction actually is, not what the parties (or their lawyers) pretend it to be.
The result? Lease options still have a role in short-term residential transactions and in commercial deals, but are otherwise nearly extinct. For more information on lease options, see our companion article Lease Options in Texas.
Traditional Owner Finance
A traditional owner finance transaction involves conveying paid-for property to a buyer by warranty deed, with the seller taking back a note secured by a deed of trust. There are no worries about an existing lien-holder; therefore the deed of trust put in place by the seller financing becomes a first lien against the property. If the buyer defaults, the seller can foreclose. Traditional owner finance transactions often close in a lawyer’s office without title insurance.
So long as the property is the seller’s homestead or is being sold to a family member, the SAFE Act licensing requirement does not apply.
Wraparound transactions (sometimes referred to as subordinate lien financing) have become more popular since the 2005 changes to the Texas Property Code limited the utility of lease options. A “wrap” is a creative device that leaves the original loan and lien on the property in place when the property is sold. The buyer makes a down payment and signs a new note to the seller (the “wraparound note”) for the balance of the sales price. This wraparound note, secured by a new deed of trust (the “wraparound deed of trust”), becomes a junior lien on the property.
Money flows as follows: the buyer makes monthly payments to the seller on the wraparound note and the seller in turn makes payments to the original lender. The original lender’s note is referred to as the “wrapped note,” and it remains secured by the “wrapped deed of trust.” Note that is possible to wrap more than one prior note (e.g., an “80/20”).
In the usual case, the wraparound note to the seller exceeds the amount of the wrapped note payoff by the amount of the seller’s equity. Alternatively, the buyer may make a cash payment to the seller for the seller’s equity, and the wraparound note payment will then be structured to correspond closely to the amount of the payment on the wrapped note.
The interest rate on the wraparound note is often higher than that on the wrapped note, since seller financing usually carries a rate that is slightly higher than market. The wraparound note is usually amortized over 15 or 30 years but balloons in 3 to 7 years (i.e., the buyer has that 3 to 7 year period in which to refinance and pay off the wraparound note). Occasionally, however, the seller will intend to keep the wraparound note as income, and therefore no balloon will be included. Specific terms can vary from transaction to transaction, but the wraparound principle remains the same.
When the buyer gets a refinance loan, the original, wrapped loan is paid and released, and the seller keeps any cash that exceeds the payoff amount of this first lien. The main difference between a wrap and a conventional sale is that the seller must wait until the wraparound note balloons in order to receive the full sales proceeds in cash.
For more information on wraps, see our companion article, Wraparound Transactions in Texas. Included is suggested a wrap addendum to be attached to earnest money contracts.At the end of this article is a checklist of information that is needed in order to prepare wrap documents.
There are three basic types of land trusts used by real estate investors: (1) an anonymity trust” (my term) designed to hold property without disclosing the names of any principals; (2) an “entry trust” (my term) used as a tool to acquire and then transfer real estate by means of an assignment of beneficial interest (sometimes called an “Illinois Land Trust”); and (3) an “exit trust” (my term again) designed to hold title to real estate while a credit-impaired buyer does credit repair until able to obtain a loan to take the property out of trust. We will examine each in turn.
(1) The anonymity trust is usually established as part of a broader asset protection plan. It is a relatively simple document that is executed along with a warranty deed conveying real property into the trust. The traditional way for a trust to hold property is in the name of “John Jones, Trustee for the 123 Oak Street Trust;” however, it is just as feasible to hold title in the name of the trust alone – e.g., the “123 Oak Street Trust.” County clerks have no problem recording a deed into the name of a trust so long as the trustor’s/grantor’s signature is acknowledged. In fact, this method is preferable since no individual names are disclosed (The trust agreement is not a recorded document).
Title companies do not seem to like this arrangement, however. They are reluctant to insure title in the name of the trust without the trustee being expressly named; and if a title company is handling the subsequent sale of property that is currently in an anonymity trust, they will ask to see and approve the trust agreement (which is not a problem so long as a properly drafted trust agreement exists). Most trust transactions of this type are handled in an attorney’s office, without the participation of a title company. If the buyer/trust beneficiary wants to know the status of title, a title report can always be purchased at a reasonable cost.
(2) In the case of the entry trust, an investor coaxes a distressed seller into transferring property by recorded deed into a trust, after which the seller then executes an unrecorded assignment of beneficial interest to the investor. This is usually done in anticipation of a foreclosure. However, these trusts do not delay or stop foreclosure unless the investor is willing to reinstate the loan and/or continue to make payments until the property is sold.
Drafting the trust is critical. Certain types of these trusts also allow the original seller to retain a beneficial interest (always a bad idea) that allows the original seller to a share of the profits when the property is flipped. Others permit the original seller to have a “power of direction” over the trustee – an even worse idea.
A significant risk, from the investor=s point of view, is that the original seller may still be able to transfer the property to someone else, in defiance of the unrecorded assignment of beneficial interest that has been given to the investor. For this reason, depending on the circumstances, a “subject to@ deed may be a simpler and better solution than an entry trust. If asset protection is important, then the grantee on the subject to deed should be the investor’s LLC.
(3) In the exit trust, the trustor/investor is the seller. Property is conveyed into a land trust that acts as a temporary “parking place@ for the property while a credit-impaired buyer (the trust beneficiary) takes immediate possession and works to obtain conventional financing in order to purchase the property outright at a specified price. Sound similar to a lease-option? It is, except that beneficial interests in a trust are personal property, not real property, and therefore arguably do not fall under the lease-option provisions of the Property Code.
For more information on land trusts, see our companion article, Land Trusts in Texas. Another article, Asset Protection in Texas, may also be of interest.
The Seven-Day Notice Requirement
This is an odd law that became effective on January 1, 2008. Property Code Sec. 5.016 requires the following: (1) 7 days notice to the buyer before closing that an existing loan is and remains in place; (2) giving the buyer this same 7 day period in which to rescind the contract to purchase; and (3) also that the 7 day notice be sent to the lender. These notices are the obligation of the seller and must be in the form prescribed by the statute. Actual lender consent, however, is not required. These notices, sent to the loan servicer (who is not often equipped to handle such communications), generally produce no response.
Note, however, that Property Code Sec. 5.016(c)10 provides an exception “where the purchaser obtains a title insurance policy insuring the transfer of title to the real property.” Thus if you are able to get a title company to insure your owner finance, you can dispense with the 7 day notice. Few title companies will insure “creative” transactions such as wraps and land trusts, however, so this exception is not much help.
This is a law that “has no teeth” to speak of, although future legislatures may change that. For now, it has not become a significant impediment to owner finance transactions.
Due on Sale Issues
Owner financing is neither illegal nor a breach of contract. It does not “violate” the due-on-sale clause in the underlying deed of trust. If you look carefully at the typical lender’s documents, you will see that they usually do not prohibit a transfer of property without the lender’s consent. They generally state that if the borrower transfers the property without the lender’s permission then the lender may, if it so chooses, declare the loan due. Look at paragraph 18 of the Fannie Mae/Freddie Mac Uniform Deed of Trust:
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.
This is not prohibitory language. It says the lender may accelerate the note if it wants to. When an investor transfers the property without consent from the lender, the investor makes it possible for the lender, if the lender so chooses, to accelerate. It is not a breach of the deed of trust. It is not fraud. As attorney Bill Bronchick puts it, “There is no due on sale jail.”
How often does a lender declare an otherwise performing loan due? They may not like the fact that the property has been sold to someone else, but – so long as payments continue on a timely basis – the risk that a lender will do anything about it is small. Some lenders now write threatening letters but generally do not follow through. It would appear that lenders have their plates full with loans that are in monetary default.
Owner finance, though more limited and regulated than ever before, is nonetheless alive and well in Texas. Greater protection of buyers has been achieved by Prop. Code Sec. 5.061 and the SAFE Act, but these measures have also had the effect of significantly raising closing costs, particularly if an “intermediary agent” is involved. Consult a qualified real estate attorney BEFORE entering into a sales contract calling for owner finance and NEVER use forms off the internet to set up a wrap or land trust. Liability under Texas’ new statutes is just too great to take the risk.
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.