One consideration in using creative methods to convey real estate is whether or not such methods will enable a lender to accelerate the existing loan using the due-on-sale clause in the deed of trust. There are a variety of contractual and statutory factors that need to be considered. However, the fundamental fact is this: if a transaction involves a title transfer without prior consent of the lender, then the risk of acceleration (however small) is present if the lender’s deed of trust contains a due-on-sale clause. And nearly all of them do. So the focus shifts from inquiring whether or not a lender can call a note due to how likely that is to take place.
Historically, mortgage lenders have not been inclined to foreclose upon 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. However, some will send irate letters demanding that the new owner apply and qualify to assume the loan or threatening that the property will otherwise be posted for foreclosure (Wells Fargo tends to do this). Whether or not that threat is real or just a bluff is a gamble, depending on the deed of trust involved and the lender’s practices in this area. The spread between the note rate and the current prevailing rate is also a factor. In a higher interest rate environment, it is conceivable that lenders could decide to start utilizing the due-on-sale clause to recover funds loaned out at a low rate in order to be able to re-lend those same funds at a higher rate. To date, however, there has not been widespread evidence of this.
Even though acceleration of a performing note may be unlikely for now, it is nonetheless clear that acceleration can happen. The risk cannot be reduced to zero.
The wording of a due-on-sale clause is critical and one should carefully examine the deed of trust before transferring title to property without the lender’s permission. These clauses may be custom-written, but most often they are standardized depending on the type of deed of trust used.
The Usual Due-on-Sale Clause in Residential Deeds of Trust
The due-on-sale clause most frequently encountered in residential deeds of trust is found in Fannie Mae/Freddie Mac Uniform Deed of Trust which is used to secure most residential loans. It reads as follows:
18. Transfer of the Property or a Beneficial Interest in Borrower. As used in this section 18, “Interest in the Property” means 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 at a future date to a purchaser. 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 [italics added] require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if such exercise is prohibited by Applicable Law.
The due-on-sale clause in the FHA deed of trust is worded differently:
9(b) Lender shall [italics added], if permitted by applicable law . . . and with the prior approval of the Secretary, require immediate payment in full of all sums securing this instrument if : (i) all of part of the Property, or a beneficial interest in a trust owning all or part of the Property, is sold or otherwise transferred (other than my devise or descent, and (ii) the Property is not occupied by the purchaser or granter as his or her principal residence. . . .”
Clearly, a transfer of title without an FHA lender’s permission in this circumstance would be problematic, since acceleration is made expressly mandatory. Still, there is the real-world question of what action a lender will actually take.
It is important to understand that conveying title without lender consent is not a violation of either the Fannie Mae or FHA deed of trust, nor is it a crime. These clauses provide only that the lender may choose to accelerate the loan if the borrower does so. The lender has the option but not the obligation to do so.
Secondly, paragraph 18 expressly states that a lender may not act if such action is “prohibited by Applicable Law.” What is that? In a nutshell, it is a federal law that allows transfer of the property to a family living trust. See more on this below.
Notice to Lender Required by Property Code Section 5.016
Property Code Section 5.016 makes an attempt at regulating due-on-sale by (1) requiring seven days’ notice to the buyer before closing that an existing loan is in place; (2) giving the buyer this same seven-day period in which to rescind the contract to purchase; and (3) also requiring that a seven-day notice be sent to the lender, theoretically giving the lender an opportunity to accelerate and call the loan due. Lender consent is not required. Clearly, this statute is designed to discourage transaction structures that separate title from debt and result in a lender losing control over its loan. Still, there is nothing illegal or even unethical about doing this. It happens often, most notably in “subject to” and wraparound transactions.
Section 5.016(c) lists eleven express exceptions to the seven-day notice rule:
(c) This section does not apply to a transfer:
(1) under a court order or foreclosure sale;
(2) by a trustee in bankruptcy;
(3) to a mortgagee by a mortgagor or successor in interest or
to a beneficiary of a deed of trust by a trustor or successor in interest;
(4) by a mortgagee or a beneficiary under a deed of trust who
has acquired the real property at a sale conducted under a power of sale under a deed of trust or a sale under a court-ordered foreclosure or has acquired the real property by a deed in lieu of foreclosure;
(5) by a fiduciary in the course of the administration of a decedent’s estate, guardianship, conservatorship, or trust;
(6) from one co-owner to one or more other co-owners;
(7) to a spouse or to a person or persons in the lineal line
of consanguinity of one or more of the transferors;
(8) between spouses resulting from a decree of dissolution of
marriage or a decree of legal separation or from a property settlement agreement incidental to one of those decrees;
(9) to or from a governmental entity;
(10) where the purchaser obtains a title insurance policy
insuring the transfer of title to the real property; or
(11) to a person who has purchased, conveyed, or entered into contracts to purchase or convey an interest in real property four or more times in the preceding 12 months.
The most obvious available exception between non-family members is a transaction where title insurance is issued (an odd exception, actually, since it was never the purchaser’s title that was in doubt).
Transfers into a trust do not constitute an exception, although transfers by an existing trustee are excepted. So creating a land trust is not a means around the seven-day notice requirement.
No time period is specified during which a lender must act on the notice, if at all. The actual effect of this statute remains unclear, particularly since the only sanction is to allow a prospective purchaser to back out of a contract before closing (not after).
Due-on-Sale and Executory Contracts
Due-on-sale considerations are more problematic in the case of executory contracts, which are contracts that delay delivery of the deed to the buyer until some point in the future after certain conditions have been met. Executory contracts are subject to burdensome 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.” This means that the lienholder must be informed of and consent to an executory transaction, which is unlikely to ever occur as a practical matter. Accordingly, residential executory contracts longer than 180 days are effectively limited to paid-for properties. Residential investors owning property subject to a lien now tend to 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.
Transfer to a Living Trust – the Due-on Sale Exception Provided by Applicable Law
The federal Garn-St. Germain Depository Institutions Act, 12 U.S.C. Sec. 1701j-3, is among the applicable law that limits lenders’ ability to act in matters of due-on-sale:
(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.
Subsection (8) usually gets the most attention. This exception was intended to allow individuals to create family trusts for estate-planning purposes, especially probate avoidance, without worries about due-on-sale. Note that this section says nothing about any requirement that a trust be revocable or irrevocable.
Are investor land trusts a solution to an investor’s due-on-sale risk?
No. Only a conventional living trust for the homestead accomplishes this. Land trusts for investment properties do not.
Subsection (8) is also the exception relied upon by many investors who use land trusts with the intention of avoiding the applicability and enforceability of due-on-sale. As stated above, this was not the purpose of the exception; however, setting that point aside, there remain an obvious pitfall to this approach: such trusts make use of a lease, lease-option, or other document allowing the buyer-beneficiary to move into the property immediately—which clearly “relates to a transfer of rights of occupancy.” So while land trusts may in the right circumstances be effective creative vehicles, it cannot be claimed that they are a surefire method of dodging due-on-sale under Garn-St. Germain.
Other “applicable law” exists. For instance, the FDIC has promulgated 12 C.F.R. Section 591.5(b)(1) which is even more restrictive than Garn-St. Germain. It requires that in order for a land trust to avoid enforcement of a due-on-sale clause, the property must continue to be owner-occupied—something which is almost never true in the typical investor case. This rule reads:
Section 591.5 (b)(1). Limitation on Exercise of Due-on-Sale Clauses
591.5 (b)(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.
Investor and seminar gurus often make extravagant claims that their complex and expensive forms provide immunity from due-on-sale issues, ironclad asset protection, expedited eviction in event of default, and other proprietary strategies that will lead an investor along the gold brick road to prosperity. Such claims are usually false. Few of these form packages are customized for Texas, nor do they take into account the executory contract rules, violations of which are defined to be deceptive trade practices. Seminar guru forms can get investors in real trouble.
In summary, transferring title to an investment property into an investor’s personal LLC is highly unlikely to result in the lender accelerating a performing note, although this could change if interest rates continue to rise.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. 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.
Copyright © 2023 by David J. Willis. All rights reserved. Mr. 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, www.LoneStarLandLaw.com.