DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
EXECUTORY CONTRACTS IN TEXAS REAL ESTATE
by David J. Willis, J.D., LL.M.
Contracts for deed, lease-purchases, and lease-options have long been traditional tools of Texas residential real estate investors. Why? Because it was easy to induce tenant/buyers into such arrangements (with a minimal down payment) and easy to evict them using the forcible detainer process if they defaulted. No longer. Since 2005, these devices are considered "executory contracts" and are heavily regulated under Chapter 5 of the Property Code. The lender, if any, must give consent. Numerous initial and ongoing requirements must be observed, and the burden is on the seller to meet these. Violation entitles the purchaser to cancel and rescind the contract and receive a full refund of all payments made to the seller. That is not all, since a claim may also be made under the Deceptive Trade Practices-Consumer Protection Act which can result in treble damages plus attorney’s fees. Add up the numbers and one can easily see that the potential downside is significant. Note that the statute contains no significant defenses for well-meaning sellers who thought they were giving the buyer a good deal, even if the whole arrangement was the buyer's idea in the first place.
Accordingly, the risks to an investor of engaging in executory contracts have nearly eliminated their use in the residential context.
What exactly is an executory contract?
Executory contracts include any transaction that defers material 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 at closing. It is done, finished. An executory contract, on the other hand, leaves something dangling–usually the most important item of all, the delivery of a deed. The classic executory contract is the contract for deed (or land sales contact), which provides that the buyer gets title after making payments over a period of years. All such devices now fall under the extensive rules and penalty provisions of Property Code sections 5.061 et seq.
Contracts for deed, lease-purchases, and lease-options for longer than 180 days are unambiguously defined as executory contracts. Look closely at section 5.062(a)(2): "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." The "180 days or less" exemption exists as an accommodation to real estate brokers, because otherwise the TREC 1-4 contract could violate this provision when combined with a TREC temporary lease. Options that are not combined with a residential lease as well as options on commercial property are not affected by Property Code section 5.061.
Changes to the Investor Environment
Why did the Texas legislature make these changes? Because executory contracts had traditionally given a tremendous advantage to the seller, who technically retained "legal title" to the property. The buyer, on the other hand, had only "equitable title"–a fuzzy concept that requires filing an expensive lawsuit to enforce. A buyer under financial pressure was therefore more likely to abandon the property, along with the down payment, and move on. Unscrupulous sellers and investors used this situation to their advantage, disregarding buyers’ equitable rights and representing to justices of the peace (the authority in eviction cases) that such buyers were ordinary tenants subject to ordinary leases. Evictions were obtained for minor or technical defaults and down payments were confiscated in the process, freeing the seller to move on to the next victim. The legislature rightly acted to stop such abuse.
Executory Contracts: Requirements for Validity
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 2005. 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 (i.e., before and not at closing):
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. Subsection (a) also requires the seller to notify the buyer that there are no restrictive covenants, easements, or other title exceptions or encumbrances that prohibit construction of a house on the property. An additional notice is required advising the buyer to "obtain a title abstract or title commitment covering the property and have the abstract or commitment reviewed by an attorney before signing a contract of this type, and purchase an owner’s policy of title insurance covering the property."
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, just as in the case of an outright sale.
5.069(b) states that if "the property is not located in a recorded subdivision, the seller shall provide the purchaser with a separate disclosure form stating that utilities may not be available to the property until the subdivision is recorded as required by law."
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? First, failure to do so is defined as a "false, misleading, or deceptive act or practice" pursuant to section 17.46 of the DTPA; second, the purchaser is entitled under Property Code section 5.069(d)(2) to "cancel and rescind the executory contract and receive a full refund of all payments made to the seller." That includes down payment plus any money expended by the buyer on permanent improvements to the property. What about monthly payments? Not included. "While the buyer remains entitled to a ‘full refund of all payments made to the seller,’ cancellation and recission of a contract also requires that the buyer restore to the seller the value of the buyer’s occupation of the property." Morton v. Nguyen, WL 4493799 (Tex. Aug. 2013).
Also, Property Code section 5.074(a) entitles a purchaser to cancel an executory contract for any reason within 14 days of signing, even if all statutory requirements have been met.
Financial Disclosure Required
An additional preclosing requirement is imposed by Property Code section 5.071, which requires a seller to provide financial information similar to a RESPA disclosure:
Before an executory contract is signed by the purchaser, the seller shall provide to the purchaser a written statement that specifies:
There is some slight relief under this section (if you want to look at it that way) in that a violation by the seller is not defined as a DTPA violation.
(1) the purchase price of the property;
(2) the interest rate charged under the contract;
(3) the dollar amount, or an estimate of the dollar amount if the interest rate is variable, of the interest charged for the term of the contract;
(4) the total amount of principal and interest to be paid under the contract;
(5) the late charge, if any, that may be assessed under the contract; and
(6) the fact that the seller may not charge a prepaying penalty or any similar fee if the purchaser elects to pay the entire amount due under the contract before the scheduled payment due date under the contract.
The Seven-Day Letter
Another, related preclosing requirement is contained in Property Code section 5.016: "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 seven-day notice to both lender and purchaser. The statute sets out the required content of this notice, which is quite technical, although no real penalties are imposed other than allowing the buyer a preclosing right of recission. After closing, there is no buyer remedy and no liability on the part of the seller. Result? The seven-day letter requirement is widely ignored. Anticipate that a future legislature may revisit this statute and insert penalties for non-compliance.
Punitive Fees and Clauses
Property Code section 5.073 prohibits these. Excessive late fees are banned, as are prepayment 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." This codifies the traditional view from the justice court bench: Exorbitant late fees are almost never allowed in an eviction judgment.
In the past, lease options and other executory contracts did not need to be recorded. No longer. Section 5.076(a) 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 be recorded.
Annual Accounting Statement
Section 5.077 requires an annual accounting statement every January, which must include 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 payments by the insurer, and a copy of the current policy–a comprehensive status report to the buyer, in other words. There is no requirement that this be recorded.
What if the seller makes a good-faith error in the annual accounting statement? Does that trigger Draconian statutory penalties? Is that a DTPA violation? Probably not, "unless the statement is so deficient as to be something other than a good faith attempt by the seller to inform the purchaser of the current status of their contractual relationship." See Morton v. Nguyen, 369 S.W.3d 659 (Tex. App.–Houston [14th Dist.] 2012). The Texas Supreme Court, when it later reviewed this case, left this part of the appeals court opinion in place.
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 section 5.081. That means a deed, probably a general warranty deed, but no less than a deed without warranties. The seller has no choice in the matter so long as the buyer tenders the balance owed under the contract.
The SAFE Act Licensing Requirement
Executory contracts are a form of owner financing and, therefore, both the federal Secure and Fair Enforcement for Mortgage Licensing Act ("SAFE Act") and the Texas version ("T-SAFE") apply. 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. The Commissioner of the Texas Department of Savings and Mortgage Lending ("TDSML") has ruled that T-SAFE will not be applied to persons who make five or fewer owner-financed loans in a year. Note that the T-SAFE licensing rule applies only to residential owner financing.
Dodd-Frank Law (Mortgage Reform and Anti-Predatory Lending Act)
Dodd-Frank and the SAFE Act were both born of the real estate collapse. Dodd-Frank requires that a seller/lender in an owner-financed transaction involving a residence make an informed determination that the buyer/borrower has the ability to repay the loan. The seller is therefore obligated to qualify the buyer/borrower in the same way any regular lender would. This law also has a de minimus exception that excludes persons doing no more than three owner-financed transactions per year, at least so long as the seller/lender is not in the building business. Although Dodd-Frank is roundly criticized by some politicians as an example of over-regulation, there is no doubt that corrective action was necessary in order to avoid another epidemic of toxic loans.
Termination of Executory Contracts
It is not permissible to simply evict a buyer under an executory contract if there is a default. Why? Because the buyer has equitable rights and is more than a mere tenant. The Property Code therefore requires ample notice and opportunity for the buyer to cure the default. Sections 5.063 and 5.064 specify the content of the default notice, which must be followed to the letter if it is to be valid. The buyer must be allowed a 30-day unconditional right to cure the default before an eviction can be filed. If the judge grants possession to the seller at the eviction hearing, then and only then is the buyer’s down payment forfeited.
There is also the "40 or 48 Rule" contained in Property Code section 5.066(a): If the buyer has paid in 40% or more of the purchase price, or the equivalent of 48 monthly payments, then a 60-day notice is required and, if the default is not cured, a traditional foreclosure (not an eviction) must be used to regain title. Clearly, the intent is to keep sellers from unfairly confiscating down payments and buyers’ equity.
The Reality of the Courtroom
Why not just ignore the executory contract rules and march merrily forward? The reason is that courts and juries do not favor investors and landlords, who are often perceived as profiteers preying upon the weak and helpless. It does not matter how clever the investor’s legal argument is. If a transaction does not pass the "smell test" a seller/landlord will likely lose. Even if the executory contract rules are found not to apply, the court can look to the laundry list of offenses under the DTPA, which prohibits "any unconscionable action or course of action by any person"–a very large hammer a jury can use against investors they do not like.
Note that pretending an executory contract is something else by renaming it will fool no one. A judge and jury may even be angry with an investor-seller who tries to pull a fast one with overly clever verbiage–and therefore more inclined to consider a finding of fraud, which brings the prospect of treble damages plus attorney fees.
Property Code section 5.073(a)(4) prohibits 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.
Landlords and sellers should generally avoid residential executory contracts because of the numerous requirements and potential liability for doing them improperly. Penalties fall entirely upon the seller, even if the purchaser was a willing participant in the transaction, and there are no significant defenses. Accordingly, such contracts are no longer advisable unless the property is paid for or used exclusively for commercial purposes.
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 and any statutes or cases referred to must be checked for updates. 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 © 2013 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 website, http://www.LoneStarLandLaw.com.