Due-On-Sale in Texas

Introduction

What is the risk that a lender will invoke the due-on-sale clause if title to property is transferred without prior lender consent? Since many lenders require that real estate investors take title to investment properties in their personal names (at least initially) this issue is immediately relevant after closing. What then should be done with the property? For asset protection purposes, it is usually in the best interest of the investor to promptly convey the property into an LLC or corporation (where there is the benefit of a liability barrier).

FANNIE MAE/FREDDIE MAC
UNIFORM DEED OF TRUST

Lender’s Option to Act

The case for placing investment properties in an LLC is compelling. One can always simply request formal permission from the lender to do this, but it is more common for real estate investors to immediately convey title to newly-acquired properties into an existing asset protection structure. When it comes to due-on-sale, what is the risk of doing this?

The wording of a due-on-sale clause in the investor’s deed of trust should always be examined before transferring title without the lender’s permission, since due-on-sale clauses can vary. (Some deeds of trust may not include a due-on-sale clause at all.) The clause most frequently encountered (by far) in residential deeds of trust is found in paragraph 19 of the Fannie Mae/Freddie Mac uniform deed of trust (form 3044, revised 1/24):

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, Lender will not exercise this option if such exercise is prohibited by Applicable Law.

Two things are worth noting. First, conveying title to security property without prior lender consent is not a violation or default under the Fannie Mae instrument. It is merely an event that triggers the availability of certain action on the part of the lender.

Second, the language of the due-on-sale clause is optional and not mandatory. The lender has the option but not the obligation to exercise its due-on-sale rights by accelerating the note. As attorney Bill Brochick has said, “There is no due-on-sale jail.”

Since there is nothing automatic about the due-on-sale clause, the focus shifts from inquiring whether or not a lender can call a note due to how likely that is to take place.

What is the likely outcome?

The consequences of transferring title without prior lender consent can depend on several factors: (1) whether the note remains in performing status (no monetary or technical defaults); (2) whether that transfer is made into a real estate investor’s LLC for asset protection purposes (as opposed to selling the property to a third party); (3) the specific lender’s policies and practices; and (4) economic conditions including interest rates.

Historically, mortgage lenders have been disinclined to accelerate a performing loan on merely technical (non-monetary) grounds such as transfer of title by the borrower—particularly when that transfer is made to the borrower’s LLC for asset protection purposes and payments remain current.

Some lenders will send irate letters demanding that the new owner apply and qualify to assume the loan or the property will be foreclosed. There may or may not be any follow-up to this. Usually there is not. It is up to the individual lender, but actual acceleration of a performing loan remains statistically unlikely. It is nonetheless clear that acceleration can happen. The risk, however small, cannot be eliminated.

The spread between the note interest rate and the current market rate could become a factor in a lender’s decision to move forward with due-on-sale. In a higher interest rate environment, lenders could theoretically decide to utilize the due-on-sale clause to recover funds loaned out at lower rates so as to be able to re-lend those same funds at higher rates. As yet, there has not been widespread evidence of this practice.

NOTICE AND OPPORTUNITY TO
CURE BEFORE ACCELERATION

Even if a lender chooses to act on due-on-sale, Fannie Mae paragraph 19 provides that notice of acceleration must be given to the borrower:

If Lender exercises this option [to accelerate based on due-on-sale], Lender will give Borrower notice of acceleration. The notice will provide a period of not less than 30 days from the date the notice is given in accordance with Section 16 within which Borrower must pay all sums secured by this Security Instrument. If Borrower fails to pay these sums prior to, or upon, the expiration of this period, Lender may invoke any remedies permitted by this Security Instrument without further notice or demand on Borrower. . . .

Paragraph 20 then offers the borrower an opportunity to cure and reinstate:

If Borrower meets certain conditions, Borrower will have the right to reinstate the Loan and have enforcement of this Security Instrument discontinued at any time up to the later of (a) five days before any foreclosure sale of the Property, or (b) such other period as Applicable Law might specify for the termination of Borrower’s right to reinstate. This right to reinstate will not apply in the case of acceleration under Section 19. To reinstate the Loan, Borrower must [take curative action and pay any lender expenses].

Accordingly, it is likely that a lender’s due-on-sale action could be forestalled or reversed by re-conveying title back to the person or entity originally named on the note.

INVESTOR LAND TRUSTS
AS A DUE-ON-SALE WORKAROUND

The Garn-St. Germain Act

The FannieMae deed of trust expressly states that a lender may not accelerate a loan if such action is “prohibited by Applicable Law.” A law often cited is the federal Garn-St. Germain Depository Institutions Act (12 U.S.C. Sec. 1701j-3). In a nutshell, Garn-St. Germain allows transfer of an owner-occupied residence into a family living trust, a common strategy for avoiding probate. Here is the actual text:

12 U.S.C. Sec. 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.

Item (7) gets the most attention. Its purpose is to allow individuals to transfer title to a homestead into a living trust for estate-planning and probate-avoidance purposes without acceleration as a consequence of due-on-sale.

Clearly, this is not what happens in an investor land trust scenario, where the beneficiary (the buyer) is usually allowed to move into the property immediately. This “relates to a transfer of rights of occupancy” and is a fatal flaw. So while investor land trusts may be useful, it cannot be claimed that Garn-St. Germain allows trusts to dodge due-on-sale.

The FDIC Rule

An FDIC regulation found at 12 C.F.R. Section 591.5(b)(1) provides (as does Garn-St. Germain) that in order for a land trust to avoid enforcement of due-on-sale, the property must continue to be owner-occupied—something that is almost never true in the typical investor land trust:

12 C.F.R. Section 591.5(b). Specific limitations. With respect to any loan on the security of a home occupied or to be occupied by the borrower, (1) 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.

The Texas Property Code

Texas law echoes the federal prohibitions against lenders utilizing due-on-sale in the case of owner-occupied living trusts for the homestead:

Prop. Code Sec. 591.5 (b)(1). Limitation on Exercise of Due-on-Sale Clauses

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.

Despite much hype on the Internet and in investor seminars, land trusts for investment properties do not qualify as a means of avoiding due-on-sale. While such trusts may be useful for other reasons, it cannot be claimed that applicable law (or Garn-St. Germain specifically) allows them to dodge due-on-sale.

EXECUTORY CONTRACTS AND DUE-ON-SALE

Are executory contracts a means of avoiding due-on-sale?

No. Using a contract for deed to avoid due-on-sale does not work. The language of paragraph 19 of the Fannie-Mae deed of trust is clear: it applies to the property or any interest therein, whether legal, equitable, or beneficial, specifically “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 to a purchaser at a future date.” Accordingly, contracts for deed and the like are not a viable workaround when it comes to due-on-sale.

Texas Executory Contract Rules

The typical executory contract is a contract for deed that delays delivery of title to the buyer after full payment of the purchase-money obligation—but delivers possession to the buyer now. This clearly relates to a transfer of occupancy rights and is thus flawed in the same way that an investor land trust is flawed.

Executory contracts are subject to extensive restrictions and requirements by the Texas Property Code, including Section 5.085(b)(3)(C) which requires in the case of an executory contract 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.” The lienholder must be informed of and consent to an executory transaction. This statutory requirement goes beyond the more lenient wording of Fannie Mae paragraph 19.

Lender consent to an executory contract is unlikely to occur as a practical matter. Accordingly, residential executory contracts longer than 180 days are effectively limited to paid-for properties. Residential real estate investors owning property subject to a lien now look to other alternatives—wraparounds, land trusts, or leases with a right of first refusal—all of which still require consideration of due-on-sale.

Conclusion

In summary, it is important to understand that conveying title without lender consent is usually not a breach or violation of a residential deed of trust. In most cases, the due-on-sale clause merely triggers a choice on the part of the lender: it may choose to accelerate if the borrower transfers title but it does not have the obligation to do so. However, due-on-sale clauses vary. It is essential to carefully read the specific deed of trust before proceeding with a title transfer.

Extra caution is advised when dealing with Internet and seminar-marketed trust packages that make extravagant claims about how their complex and expensive forms provide immunity from due-on-sale issues, ironclad asset protection, expedited remedies, and other advantages that assure success for real estate investors. These claims are usually false. Few trust packages in this category are customized for Texas, nor do they take into account a proper reading of applicable law.