Lease-Options in Texas

by David J. Willis J.D., LL.M.

Introduction

Lease-options, along with contracts for deed and lease-purchases, have long been among the traditional tools of Texas residential real estate investors. Why? Because it was easy to induce tenant-buyers into such arrangements with a minimal front-end money and easy to evict them using the forcible detainer process if they defaulted. No longer. Since 2005, lease-options are considered “executory contracts” and are heavily regulated under Chapter 5 of the Property Code. Many requirements now apply, and the burden is on the seller to meet these. Also, the existing lender, if any, must give consent. Violation may entitle the purchaser to cancel and rescind the contract and receive a full refund of payments made to the seller. That is not all, since a claim may also be made under the Deceptive Trade Practices-Consumer Protection Act (“DTPA”) 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 fair 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, at least as to contracts exceeding 180 days.

When discussing lease-options in this article, we are referring to a lease that contains an option to purchase the property . . . but does not provide for any payments toward the purchase to be made during the lease term.

Executory Contracts Generally

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 title (a deed) to the buyer. The classic executory contract is the contract for deed (or land sales contract), which provides that the buyer gets title after making payments over a period of years.

“In a typical real estate contract, the seller and purchaser mutually agree to complete payment and title transfer on a date certain, the closing date, at which time the purchaser generally obtains both title and possession. By contrast, in an executory contract, the purchaser is usually given immediate possession, but is required to satisfy numerous obligations over an extended period of time before the seller has an obligation to transfer title. Under an executory contract, the buyer has the right, but not the obligation, to purchase. . . . But, in a typical real estate contract, the buyer must complete the purchase.” Bryant v. Cady, 445 S.W.3d 815, 822-23 (Tex.App.-Texarkana 2014, no pet.).

Lease-options, contracts for deed, and lease-purchases for longer than 180 days are unambiguously defined as executory contracts subject to Property Code Sections 5.061 et seq. 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.

The Unsavory History of Executory Contracts

Why does the Texas legislature continue to reform the law relating to executory contracts? In order to balance the equities. Executory contracts have 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 arises by operation of law and requires filing an expensive lawsuit to enforce. A buyer under financial pressure was therefore more likely to abandon the property, forfeit money paid, 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 lease-option in Texas, 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 title to the property.

5.069(a)(3) requires that a statutory disclosure be given to the buyer addressing such pragmatic issues as whether or not the property is in a recorded subdivision; if water, sewer, and electric power are available; if the property is in a floodplain; who is responsible for maintaining the road to the property; and the like. An affirmative statement is required to the effect that no one but the seller owns or claims to own the property or have an interest therein.

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 by Section 5.069(d)(1) 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 the 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, 412 S.W.3d 506 (Tex. 2013).

Also, Property Code Section 5.074(a) entitles a purchaser to cancel any executory contract, including a lease-option, for any reason within 14 days of signing, even if all statutory requirements have been met.

Financial Disclosure Required

An additional pre-closing 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:

(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.

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.

The Seven-Day Letter

Another, related pre-closing 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 pre-closing 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.

Recording Requirement

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. In 2017, Section 5.079(a) was amended to provide that a “recorded executory contract shall be the same as a deed with a vendor’s lien. The vendor’s lien is for the amount of the unpaid contract price, less any lawful deductions, and may be enforced by foreclosure sale under Section 5.066 or by judicial foreclosure. A general warranty is implied unless otherwise limited by the recorded executory contract.” It would not be prudent practice, however, to take the statute’s word for it and simply assume that a recorded executory contract is as good as a deed. Basically, nothing is as good as a general warranty deed that conveys a fee simple interest.

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.” 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.

The Tyler Court of Appeals further discussed the issue of damages for failure to provide an annual accounting statement. The court noted that Civil Practices & Remedies Code Section 41.008 limits the amount of exemplary damages that a plaintiff can recover in lawsuits generally. The issue was whether or not this statute specifically applies in the context of failure to provide the required accounting under Property Code Section 5.077. Why is that relevant? Because in this case, the plaintiff failed to show actual damages. The court ruled that Chapter 41 applies in these situations. In other words, to recover the exemplary damages provided by Section 5.077, actual damages in more than a nominal amount must be proven by clear and convincing evidence. Smith v. Davis, 462 W.W.3d 604 (Tex.App.-Tyler 2015, pet. denied).

The Reality of the Courtroom

Even if the executory contract rules are found not to apply in a particular case, 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 re-naming 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. We often see forms generated by real estate investment seminars that purport to make a lease-option easy and safe to use, even if the duration of the option term exceeds 180 days. Nearly all of these are junk – not even specific to Texas law – and likely to get an investor into trouble.

Conclusion

Landlords and sellers should generally avoid residential lease-options lasting more than 180 days 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 generally inadvisable unless the property is used exclusively for commercial purposes.

DISCLAIMER

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. 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 expressly retained in writing to do so.

Copyright © 2019 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, www.LoneStarLandLaw.com.