DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
LEASE-OPTIONS IN TEXAS REAL ESTATE
by David J. Willis, J.D., LL.M.
Lease-Options have always been a favorite tool of Texas real estate investors. They are one of the "Big Three" – alongside contracts for deed and lease-purchases – all of which are creative devices for getting less than fully-qualified buyers into a home immediately. However, 2005 changes to the Texas Property Code (Sec. 5.061 et seq.) define residential lease-options for longer than 180 days as "executory contracts" subject to strict regulation and penalties if not done exactly right. Exactly right. Specific requirements must be observed and the burden is entirely on the seller to do so. Violation incurs not only penalties under the Property Code (return of all payments made by the buyer including monthly payments) but potential liability under the dreaded Deceptive Trade Practices – Consumer Protection Act ("DTPA") which can involve treble damages plus attorney’s fees. The most sobering aspect of executory contract regulation is that there are no seller defenses, even if the arrangement was the tenant/buyer’s idea to begin with. Read our chapter on Executory Contracts in Texas.
The risk to the seller of using lease-options (or any other executory contract) is now significant, and investors should therefore use any such device with caution.
Why are lease-options "executory contracts?"
Executory contracts include any transaction that defers some action by either party that pertains to ownership or possession of real property into the future. An "executed" contract is one that is entirely completed, closed, and delivered today. If a material item remains unfulfilled or is deferred until some future time, the contract is "executory." In the past, unscrupulous landlord/sellers used executory contracts to their advantage by evicting defaulting tenant/buyers as if they were ordinary tenants subject to ordinary leases. As a result, even a minor misstep by the buyer/tenant could result in a major and inequitable loss of equity.
So why do lease-options fall within the definition of an executory contract? Because the statute says so. Prop. Code Section 5.062(a)(2) states: "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 180 days or less under Sec. 5.062(c) – otherwise, the residential sales contract promulgated by TREC would violate this provision when combined with a temporary lease. Commercial lease-options are not affected by this statute.
Executory Contracts: Requirements
Just for the record, one can still do a long-term lease-option – so long as the Code is followed. The landlord/seller is required to provide the Buyer with a survey which is no older than a year, or a current plat; copies of liens, restrictive covenants, and easements; a Seller’s Disclosure of Property Condition; a disclosure for non-subdivision properties stating utilities may not be available to the property until the subdivision is recorded; tax certificates; a copy of any insurance showing the name of the insurer and insured along with a description of the insured property and the policy amount; a 7 day notice letter; and an annual accounting statement that must include amounts paid, amounts owed, 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.
Additionally, it is required that sales advertisements disclose the availability of water, sewer, and electric service. The seller must 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. Excessive late fees and pre-payment penalties are banned.
Even if all the foregoing statutory requirements are met, the buyer may still cancel an executory contract for any reason within 14 days of signing.
The Short-Term Lease Option
Having offered a dire description of the legal risks, it is nonetheless true that lease-options may still be useful if the term is 180 days or less or if the property is paid for (which means that a lender’s consent will not be needed). Accordingly, an investor should not avoid utilizing a 180 day (or less) lease-option if it is appropriate under the circumstances – particularly if there is a possibility that the option could be exercised during that period. Also, if the parties decide in good faith to renew the option for another short option term, they should not hesitate to do so. In this context, we recommend using a 179 day option term just to avoid any issue about whether or not the statute has been violated, since it is never a good idea to cut matters too close when dealing with legal deadlines.
A Month-to-Month Lease Combined with an Option
What if the lease is stated to be "month-to-month?" If it includes an option to purchase, do the requirements (and penalties) of Sec. 5.062 et seq. apply? The answer is yes, so long as the term of the option fails to be expressly limited to 180 days or less. Since the lease can easily extend for longer than 180 days, the option can as well. This arrangement is therefore an executory contract.
A Potential Solution: Stacking Short-Term Options
What about the possibility of stacking six-month option contracts–i.e., allowing the option to expire and then renewing it again and again? This would appear to be a loophole, making stacking a possible way for a very aggressive investor to still do a lengthy lease-option without complying with the executory contract rules, although at some risk. If challenged by the tenant/buyer, a judge may examine the totality of the circumstances, including the intent of the parties, and declare that the arrangement is a de facto executory contract. It all comes down to whether or not the tenant/buyer becomes disgruntled and decides to (1) challenge the transaction with a lawsuit, or (2) resist an eviction based on an executory contract defense. No challenge, no issue. There are no executory contract police. Having said that, lease-option arrangements that endure in the aggregate for longer than 180 days are perilous. The legislature clearly intended to discourage their use in residential transactions and deliberately imposed significant liability on landlord/sellers for doing them improperly.
The Reality of the Courtroom
Why not just evade 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 unfortunate. 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 in court. 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 a court can still look to the "laundry list" of offenses under the DTPA. DTPA Section 17.50(a)(3) prohibits "any unconscionable action or course of action by any person" – an exceptionally broad statement.
Beware of Seminar Forms
Be cautious in the use of lease-option forms from "guru" seminars or obtained off the internet. These forms are suspect since they may not be designed specifically for Texas. They can now get an investor in real trouble. Often these forms are options with a different title. However, courts look to substance over form; and remember, courts do not like investors. A judge and jury will likely be angry with a seller who tries to pull a fast one with overly-clever verbiage – and more inclined to consider a finding of fraud.
Lease-options are now a risky business in Texas. The legislature clearly intended to discourage their use in residential transactions and deliberately imposed significant liability on landlord/sellers for doing them improperly.
Find a good real estate lawyer, one with courtroom experience. Pay attention to what he or she says about how a judge or jury will react to your proposed deal. A good lawyer knows that real estate transaction documents should always be drafted as if they will one day need to be defended 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 © 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