Assignment (Wholesaling) of Residential Earnest Money Contracts in Texas

Topics Covered

Part One: Strategies Begin Before the Earnest Money Contract is Signed
Part Two: Methods of Wholesaling a Real Estate Contract
Part Three: The Interim Contract to Assign
Part Four: Due Diligence by the Buyer-Assignee
Part Five: Closing Assignment of the Contract
Part Six: Recourse Against the Assignor
Part Seven: Statutory Law Applicable to Wholesaling

Real Estate Contracts are Assignable

As a general rule, a real estate interest (including the interest of buyer or seller in an earnest money contract) is assignable in Texas unless it is expressly provided otherwise by the contract itself. Wholesaling is the term for getting a property under contract and selling that contract to a real estate investor who then does fix-up work before re-selling the property at a profit. Contracts may be assigned more than once. Wholesaling of this type is largely a matter of short-term flips rather than long-term holds.

One must distinguish between absolute assignments (a permanent transfer to a new owner and holder) versus collateral assignments (made to a lender as collateral for a loan). An interest or asset may be assigned in either way. This chapter focuses solely on the absolute assignment of real estate contracts.

For purposes of this discussion, there are seller-assignors and buyer-assignees. Technically, it is the seller-assignor who is the wholesaler as that term is used in real estate investing. The owner of the real property is the property seller.

Assignment of a real estate earnest money contract is comparable in many ways to assigning a promissory note. A main difference is that earnest money contracts, unlike notes, are not negotiable instruments subject to the Uniform Commercial Code.

TREC Definition of Wholesaling

According to the TREC website, “wholesaling is a model where a person enters into a contract to buy real estate and then sells their contractual interest in the property to a third party prior to closing. Individuals engaged in wholesaling are not required to hold a real estate license as long as they disclose the nature of their interest to potential buyers and do not otherwise engage in real estate brokerage activity.” There are no required standardized TREC or TXR forms for wholesaling, so custom documents should be prepared with the assistance of an attorney.

The TREC 1-4 Family Residential Contract is simply not designed to be sold and assigned as an investment tool. It is not written with contract flippers in mind. Customization to include wholesaling provisions is therefore key to a successful assignment.

The Mechanics of the Sale and Assignment Process

Best practices for the assignment of any real estate interest or asset include several steps: (1) a non-binding letter of intent setting out a tentative agreement (LOI); (2) a contract to sell the asset (e.g., an earnest money contract) that allows for an inspection or option period for due diligence, a cure period for objections, and an unrestricted buyer right to terminate; followed by (3) a formal closing where a final sale and assignment instrument is executed and the interest or asset is delivered to the assignee-buyer.

Bypass or shortcut any these vital steps at your peril.

The assignee-buyer should expect to make three main payments: (1) a preliminary deposit plus a non-refundable option fee to cover the inspection period; (2) a second, more substantial payment due at the end of the inspection period and a cure-objections period, and then (3) payment of the balance of the sales price or assignment fee at formal closing where a final sale and assignment instrument is assigned. These steps are subject to some variation depending on the circumstances but always follow a similar pattern.

Drafting the Agreements

The are two main agreements involved in the sale and assignment of an earnest money contract: (1) the interim contract to assign and (2) the final sale and assignment instrument that is executed at closing.

Since there are no standard forms in this area, wholesaling documents range from very primitive to sophisticated and complex. Forms produced by wholesaling seminars for investors are usually of low quality and not specific to Texas. When taken to an attorney, these forms must be replaced, not merely reviewed. A good law firm will throw them in the trash.

Investors in search of simplicity and low legal fees ask, “Why can’t you fit this on one-page?” The attorney’s answer is: I just can’t. There are too many deal points and too many steps if you want to do this prudently and correctly. Do you want me to protect your interests or not?

Customization Matters

Which clauses and provisions appear in wholesaling documents usually depends on which side has prepared the documents—the seller-assignor (wholesaler) or the buyer-assignee. Each party has very different interests, so depending on who prepared them these documents can look very different. There is no truly neutral approach in this area.

Attorneys often hear requests to “represent both sides.” This is impossible.

PART ONE:
WHOLESALING STRATEGIES BEGIN
BEFORE THE EARNEST MONEY CONTRACT IS SIGNED

Express Statement of Assignability

A residential earnest money contract that is destined to be assigned should expressly state that it is assignable. Omitting this step—and assuming that the property seller will simply go along with an assignment—is hazardous.

There is no substitute for a clear and unequivocal assignability clause within the earnest money contract (or a custom wholesaling addendum attached to it) if there is to be a smooth and successful assignment. Specifically, this means the right to wholesale the contract at any time before closing without notice to or consent by the property seller.

A common practice is to list the property buyer as (for example) “ABC LLC and/or its assigns.” This is helpful but not really sufficient for professional-grade wholesaling. A careful investor will want to add a custom special provisions addendum that is designed to specifically address wholesaling issues, including (but not limited to) the issue of assignability. Example: Will the property seller sign a consent if the contract assignee or the title company requests one? Allow the new buyer to do an inspection? Agree to recognize the new buyer and cooperate by signing a deed at closing? These potential pitfalls should be anticipated rather than dealt with haphazardly at the last minute.

Lack of cooperation from the property seller can kill the deal, so such cooperation should never be simply assumed.

Interests of the Property Seller

The property seller has interests that are entirely separate from those of the assignor and assignee of the earnest money contract. A property seller wants a contract with stable terms. He may also not appreciate being involuntarily compelled to do business with someone he did not sign a contract with. To many ordinary people, this smacks of something underhanded. There may be resistance.

If the property seller consults an attorney, he will likely be advised to include a custom contract clause along the following lines:

Seller may review and approve (and consult legal counsel) at least three business days in advance as to any assignment-related documents that require Seller’s signature. Seller shall not be required to sign or consent to any assignment-related document or closing document that differs in any material respect from the terms of the Contract or its Addenda, and Seller shall not be in default or subject to a suit for specific performance if Seller declines to do so.

In other words, the property seller wants to ensure that wholesaling the contract does not materially alter or affect the agreed-upon terms of sale.

Obtaining a Signed Consent to Assignment

Even if a contract is expressly stated to be assignable, it is always a good idea for a wholesaler to get a signed “Consent to Assignment of Contract” from the property seller and attach this consent as an exhibit to the assignment instrument. Ideally, this consent should be obtained from the property seller at the same time the earnest money contract is signed.

PART TWO:
METHODS OF ASSIGNING A REAL ESTATE CONTRACT

There are two main methods of selling and assigning earnest money contracts. Actually, these two methods apply to the purchase of any real estate-related instrument or interest including contracts, notes, liens, options, etc.

The First Assignment Method: One Step

In the first method, the instrument is sold as a one-time, one-payment, one-document event that is entirely independent from subsequent closing of the sale of the property. There is no formal due-diligence phase for the assignee-buyer to inspect and evaluate the contract and the underlying real property. Due diligence is brief and informal without a structured inspection period.

The full consideration for the assignment is paid contemporaneously with execution of the final assignment instrument. Afterwards, the assignor-seller of the contract leaves the picture permanently. The deal (or at least the wholesaling portion of it) is done.

Consideration typically consists of an assignment fee plus reimbursement for the down payment previously posted by the contract seller-assignor. The buyer-assignee then assumes the role of buyer under the contract and goes forward to closing.

Drawbacks of the One-Step Method

The one-step method is viable only if the real estate contract is issue-free, the property seller is cooperative, and everything goes smoothly at closing of the property sale. Here’s the problem: one-step documentation does not eliminate the contractual and transactional considerations that inevitably accompany the purchase and sale of every real estate instrument or interest. It just pushes them aside and pretends they are not important. In effect, the parties choose to ignore these factors because they perceive the transaction as “simple.” Much of the motivation in pursuing the one-step approach is based on avoiding lawyers and legal fees.

The Second Assignment Method: Traditional Three Steps

The second method is the time-honored, best practices approach to assignments in general. The process starts with (1) a non-binding letter of intent, followed by (2) a contract to assign which is similar to an earnest money contract) that includes a first installment toward the assignment fee, a due diligence inspection-option period to examine the contract, look at the property, get an opinion of value, consult an attorney, etc., and then (3) a final sale and assignment of earnest money contract that is executed at a closing along with payment of the balance of the assignment fee. These steps are clearly delineated and accomplished, one at a time, over a period of a week or two. Breaking the process and the payment into incremental steps is what it takes to do the job prudently and correctly.

This step-by-step approach significantly benefits the buyer-assignee of the contract because it breaks up the payment of the consideration low-risk steps—a small initial deposit, a nominal option-inspection fee, a second deposit of funds when the inspection period ends, and then payment of the balance of the assignment fee at a closing where a final assignment instrument is executed.

An Error: Collapsing the Steps

Lawyers often see attempts to collapse the wholesaling process by using an abbreviated and combined document that awkwardly bundles interim/executory terms with the language of a final assignment. Collapsed documentation attempts to cram executory and executed terms into one document—allegedly for the purpose of keeping things simple.

The result of collapsing the separate traditional steps is an unsatisfactory legal muddle akin to combining an earnest money contract for the sale of realty with a deed transferring title, all without a due-diligence period. Ordinarily, no sensible buyer of real estate would do that. Neither should an investor-buyer of an earnest money contract.

It is worth observing that institutions that buy and sell real estate instruments in bulk (the high-level professionals in this field) always do so in the orderly steps outlined above and always with an adequate due diligence-inspection period before tendering any serious money to a contract seller.

A good real estate attorney will encourage his client to slow down and create step-by-step documentation that includes the opportunity for due diligence on both the contract and the underlying realty. However, a client in the grip of FOMO may resist and rush to sign DIY documents or junk forms from the Internet. For professional liability reasons the lawyer should probably let such a client go. Some people are psychologically wired for imprudent and self-destructive behavior, and for liability reasons the lawyer may want to avoid being around when one of these deals inevitably implodes.

Recording the Contract to Assign

There is no requirement that a contract to assign an earnest money contract be recorded in the real property records. However, the assignee-buyer of the contract may prefer that recordation occurs in order to insure that the contract is not later wholesaled to another investor. Unscrupulous behavior is not uncommon in the wholesaling business.

PART THREE:
DUE-DILIGENCE CHECKLIST

Due Diligence by the Assignee-Buyer

The prospective buyer of a contract should insist on a due diligence-option-inspection period coupled with an unrestricted right to terminate without default. This is similar to a buyer’s right to terminate before expiration of the option period under paragraph 5 of the TREC residential contract. This inspection period is a valuable opportunity to take a hard look at the earnest money contract in order to assess its accuracy, legitimacy, and financial soundness.

The Property Seller

Is the property seller alive?
Is the property seller legally competent to enter into a contract?
Has the property seller’s spouse signed off as well?
Has the property seller given consent in writing to a contract assignment?
If not, is the property seller willing to do so before the end of the inspection period?

The Contract

Is the assignor-seller in possession of an original hard-copy earnest money contract?
Was the earnest money contract prepared by a professional?
Is the contract correctly completed (no blanks) and signed by all parties and spouses?
Is the contract a TREC or TXR contract or is it junk from the Internet?
Is a copy of the seller’s disclosure available?
Does the earnest money contract appear to be legally valid?

If an LLC is Involved

Is the LLC’s manager identified and available to sign for the LLC?
Is the LLC in good standing with the state in which it is registered?
Has current good standing been confirmed with the secretary of state?

The Property

Does the real property actually exist?
Is the property actually for sale?
What is the present use and condition of the property?
Has the prospective buyer of the contract actually laid eyes on the realty?
Is a recent inspection report available to include in the file?
Is a recent seller’s disclosure of property condition available?
Are documents or information available as to any recent repairs or rehab work?
Are there any other documents available in order to gain information on the property?

Property Sales Price

Does the property sales price make sense?
Is a recent appraisal available?
What are comparable properties on the same street selling for?
Is a substantial profit margin realistically available if the property sale closes?

Title to the Property

Is a recent title commitment available?
Is the property seller actually named in the title commitment as current owner?
Have spousal signatures been obtained?
Do any third parties have an interest in or claim to the property?
If the property is in an estate, have all possible heirs signed off?

Existing Loans and Liens

Will the property sale be done “subject to” existing loans or liens?
If so, are the existing note, deed of trust, and a recent loan statement available?
Does the existing deed of trust have a due-on-sale clause?
Are existing loans or liens in arrears? By how much?
Are property taxes and HOA dues current?

The Wholesaler

Has the wholesaler committed in writing to make full disclosure?
Is the wholesaler cooperative and forthcoming?
What is the reputation and track record of the wholesaler?
Is the assignment “as is” without recourse, representation, or warranty?
Or will the wholesaler be willing to offer representations, warranties, and an indemnity?
Will the wholesaler’s reps and warranties survive the assignment?

Closing The Final Sale and Assignment

Who will hold the contract buyer’s deposit? Is an escrow agent involved?
Who will prepare the final sale and assignment instrument?
Will the non-drafting party be able to review and approve final assignment?
What “outs” are available to the contract assignee-buyer?

Closing The Property Sale

Will title company be used for the closing?
Will the deed be a general warranty deed or a special warranty deed?
If the property is leased, will there be an assignment of lease, rents, and security deposit?

Recourse against Contract Seller

Will the assignee-buyer of the contract have recourse against the assignor-seller if the property sale fails?
Is so, will recourse be full or limited? How long is the recourse period?
What are the precise terms of any recourse, refund, or buyback mechanism?
Is recourse available if the property seller fails to appear or sign a deed?
If that occurs, will the assignee-buyer get the full deposit back?

Due-Diligence Overview

Has all relevant information and documentation been obtained and examined?
Has the contract to be assigned been fully examined and evaluated?
Does the deal make common sense?
Is there enough prospective profit margin plus a decent buffer for unforeseeable events?
What does your attorney think of the deal?

Disclosure Obligations of the Wholesaler

An affirmative obligation to disclose material facts should be an essential part of an agreement to assign a real estate contract. An express provision should require the wholesaler to disclose all known material facts, defects, and adverse circumstances affecting the contract and the realty.

Failure by the assignor-seller of an earnest money contract to disclose known material facts involving either the contract or the underlying realty may constitute fraud.

PART FOUR:
CLOSING THE ASSIGNMENT OF THE CONTRACT

Closing Assignment of the Contract

At this closing, (1) a final sale and assignment of earnest money contract is executed; (2) the assignee-buyer pays the balance of the assignment fee with credit for deposit money paid at the interim stage, with the wholesaler usually receiving credit for earnest money paid to the property seller; and (3) the assignee-buyer receives possession of an original of the earnest money contract.

The best practice is to attach copies of the signed earnest money contract and the seller’s disclosure as exhibits to the final assignment instrument. If a recent title commitment is available then that may be attached as well.

Availability of Recourse

The final sale and assignment instrument should clearly state whether or not there will be recourse against the wholesaler if the property sale fails to close. Recourse comes in three varieties: none, full, or limited.

No recourse means what it says: wholesaling of the contract is accomplished “as is, without representation, warranty, or recourse.” If the earnest money contract is deficient or the property sale does not close then the contract assignee is stuck. Remedies, if any, will be solely against the property seller.

Full recourse means that the contract assignee gets to give the earnest money contract back to the wholesaler and obtain a full or partial refund if the property sale fails to close through no fault of the buyer-assignee.

Limited recourse is a flexible and highly customizable category falling somewhere between no recourse and full recourse.

The assignment documentation should expressly address whether or not recourse is available and, if it is, (1) the exact nature of the recourse mechanism and (2) how long recourse will remain available.

PART SIX:
LAW APPLICABLE TO WHOLESALING

Occupations Code Licensing Requirement

Is a real estate broker’s license required in order to engage in wholesaling? Section 1101.002 of the Occupations Code answers this question with a definite maybe depending on how one defines the brokerage of real estate. Chapter 1101 states that a real estate broker “means a person who, in exchange for a commission or other valuable consideration or with the expectation of receiving a commission or other valuable consideration, performs for another person one of the following acts . . . deals in options on real estate, including buying, selling, or offering to buy or sell options on real estate. . . .” An executed earnest money contract can be considered a kind of option to buy real estate. It definitely represents an interest in real estate. So if one is buying or selling such contracts (engaging in wholesaling) then a broker’s license may be required. More on this below.

Occupations Code Disclosure Requirement

Section 1101.0045 of the Occupations Code offers a loophole for wholesalers who are working without a broker’s license, but only so long as they make express disclosure that what they are selling is merely an equitable interest—as opposed to a legal interest. The difference can be challenging for non-lawyers to understand; however, an equitable interest means an interest that is less tangible, less certain, and more contingent than a solid and present legal interest. The statute reads:

OCC Sec. 1101.0045. Equitable Interests in Real Property

(a) A person may acquire an option or an interest in a contract to purchase real property and then sell or offer to sell the option or assign or offer to assign the contract without holding a license issued under this chapter if the person: (1) does not use the option or contract to purchase to engage in real estate brokerage; and (2) discloses in writing the nature of the equitable interest to any seller or potential buyer.

(b) A person selling or offering to sell an option or assigning or offering to assign an interest in a contract to purchase real property without disclosing the nature of that interest as provided by Subsection (a)(2) is engaging in real estate brokerage.

OCC Section 1101.0045 wants wholesalers to make full disclosure, which means making it clear that what is being transferred is not the property itself but only an equitable right to acquire the property subject to the terms and conditions of the contract being assigned.

Accordingly, wholesalers who assign contracts are not illegally acting as real estate brokers if they fully disclose the nature of the interest they are selling. The difference between a broker’s license being required or not required comes down to disclosure.

Texas Administrative Code Disclosure Requirement

The Texas Administrative Code (TAC) contains TREC rules applicable to real estate license holders. Rule 535.6 states:

22 TAC Sec. [TREC Rule] 535.6. Equitable Interests in Real Property

(a) A person may acquire an option or enter into a contract to purchase real property and then sell or offer to sell the option or assign or offer to assign the interest in the contract without having a real estate license if the person: (1) does not use the option or contract to purchase to engage in real estate brokerage; and (2) discloses the nature of their equitable interest to any potential buyer.

(b) A person selling or offering to sell an option or assigning or offering to assign an interest in a contract to purchase real property without disclosing the nature of that interest to a potential buyer is engaging in real estate brokerage.

(c) A license holder who is engaging in real estate brokerage by selling or buying or offering to sell or buy an option or assigning or offering to assign an interest in a contract to purchase real property must disclose to any potential seller or buyer that the principal is selling or buying an option or assigning an interest in a contract and does not have legal title to the real property.

(d) A license holder acting on his or her own behalf or in a capacity described by §535.144(a) who is selling an option or assigning an interest in a contract to purchase real property must disclose to any potential buyer that the license holder is selling an option or assigning an interest in a contract and that the license holder does not have legal title to the real property.

This TREC rule echoes a theme found in the Real Estate License Act, the Property Code, and case law: full disclosure of material facts is always the safer route whether one is a license holder or not.

Property Code Disclosure Requirements

The Property Code sets out two disclosure requirements (in Sections 5.0205 and 5.086) that apply in the context of the sale and assignment of earnest money contracts:

Prop. Code Sec. 5.0205. Equitable Interest Disclosure

Before entering into a contract to sell an option or assign an interest in a contract to purchase real property, a person must disclose in writing to (1) any potential buyer that the person is selling only an option or assigning an interest in a contract and the person does not have legal title to the real property; and (2) [to] the owner of the real property that the person intends to sell an option or assign an interest in a contract.

This is the second disclosure requirement:

Prop. Code Sec. 5.086. Equitable Interest Disclosure

Before entering into a contract, a person selling an option or assigning an interest in a contract to purchase real property must disclose to any potential buyer that the person is selling only an option or assigning an interest in a contract and that the person does not have legal title to the real property.

These sections of the Property Code apply to everyone whether licensed or not. Every seller-assignor (wholesaler) must comply.

Reading the above statutes together, it should be clear that wholesaling without providing the required equitable interest disclosure (to the property owner and the buyer-assignee of the contract) can get an investor in double trouble, both for violating the Property Code and potentially for brokering real estate without a license.

Equitable Interest Disclosure

The following proposed wording at or near the top of the contract assignment would likely satisfy equitable interest disclosure requirements:

EQUITABLE INTEREST DISCLOSURE PURSUANT TO TEXAS PROPERTY CODE SECTIONS 5.0205 AND 5.086: THIS INSTRUMENT REPRESENTS ONLY AN OPTION TO PURCHASE REAL PROPERTY OR AN ASSIGNMENT OF AN INTEREST IN REAL PROPERTY. IT IS NOT A SALE OF THE PROPERTY OR A TRANSFER OF TITLE TO THE PROPERTY. ASSIGNOR DOES NOT HAVE LEGAL TITLE TO THE PROPERTY. ASSIGNOR IS NOT A REAL ESTATE BROKER AND HAS NOT GIVEN ASSIGNEE REAL ESTATE ADVICE. CONSULT AN ATTORNEY PRIOR TO EXECUTING THIS DOCUMENT IF YOU DO NOT UNDERSTAND IT.

The equitable interest disclosure requirement of the Property Code could be the beginning of a regulatory scheme for the wholesaling of earnest money contracts. Abuses and mishaps in this area make news from time to time, so a future Texas legislature may decide to build on existing disclosure requirements and expand them, just as occurred in the case of executory contracts in 2005. The pressure for regulation may also increase as cases appear seeking to bring wholesaling within the reach of the Deceptive Trade Practices Act.