In a typical lease-purchase (or “rent to own ”), a portion of each monthly rent payment is set aside and credited toward the tenant-buyer’s down payment. It is common (but not universal) for a lease-purchase to provide that after a certain amount is paid in, the tenant is able either (1) to convert the transaction from a lease to an owner-financed sales transaction in which the tenant gets a warranty deed and gives back a note and deed of trust to the seller; or (2) the seller agrees that the tenant-buyer may show the accumulated down payment on a loan application to a third-party lender and thereby qualify for take-out financing.
Lease-purchases, contracts for deed and lease-options have long been traditional tools of Texas residential real estate investors. No longer. Since 2005, these “executory contracts ” 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.
The Dark History of Executory Contracts
In the past, unscrupulous sellers abused executory contracts by disregarding the buyer’s equitable rights and misrepresenting to Justices of the Peace that such buyers were ordinary tenants subject to ordinary leases (untrue, since the buyers have equitable rights). Sellers were then able to obtain evictions for minor or technical defaults, often confiscating large down payments in the process. The seller was then free to move on to his next victim and obtain another down payment. The legislature rightly acted to stop such abuse.
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 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-purchases, contracts for deed, and lease-options for longer than 180 days are unambiguously defined as executory contracts subject to Property Code Sections 5.061 et seq. 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.
Does The Name of The Document Matter?
Because of the burdensome requirements and penalties of Property Code Sec. 5.061, a landlord-seller may be tempted to re-write a traditional lease-purchase in an attempt to call it something else or make it appear as if it is something else. The important point to remember is this: if the agreement is, in substance, an executory contract, then Sec. 5.061 applies – regardless of the title or wording of the document. Judges tend to look to substance over form (the “quacks like a duck” rule).
A complication that occurs with many lease-purchases (aside from the obvious fact that they are executory contracts) is that they may provide that once a sufficient down payment is paid in the tenant-buyer will have an option to purchase the property at a certain price. Result? The lease-purchase has become tangled up with a lease-option—and becomes become a hybrid “lease-purchase-option.”
What if the lease-purchase provides that payments will continue over a number of years until the property is paid for? Then it may not be a lease-purchase at all. It may an old fashioned contract for deed.
Two points are worth noting. The first is that each of these devices—lease-purchases, lease-options, and contracts for deed—can, if only slightly modified, become hybridized with something else, sinking the transaction deeper into the executory contract hole. The second point is that regardless of the ultimate form such hybrid contracts take, they remain executory contracts for purposes of the rules and penalties of Property Code Section 5.061 et seq. See our companion web article Executory Contracts in Texas.
Executory Contracts: Statutory Requirements
Make no mistake, one can still do a transaction by means of a lease-purchase longer than 180 days, 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.
Financial Disclosure Required
An additional pre-closing requirement for executory contracts 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.
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 statuteâ€™s word for it and simply assume that a recorded executory contract is as good as a deed. Basically, nothing is as good as 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).
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. This is true whether or not the executory contract was recorded.
The SAFE Act Licensing Requirement
Executory contracts, including lease-purchases, 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 generally requires that a seller-lender in an owner-financed transaction involving a residence (this includes a lease-purchase) make an informed determination that the buyer-borrower has the ability to repay the loan. Most sellers are therefore obligated to qualify the buyer-borrower in the same way any regular lender would. This law also has a de minimis 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 in a lease-purchase 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
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 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.
Prohibition of Forfeitures
Section 5.073(a)(4) prohibits a 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.
Right of First Refusal (ROFR)
Is a ROFR along with a lease a way out? Possibly, but caution is required. A ROFR requires the seller, when and if he or she decides to sell, to first offer the property to the buyer. ROFR’s do not specify a price. Depending on how the ROFR is worded, the seller may be required to first negotiate a specific deal with a third-party buyer and then freeze that transaction momentarily while the holder of the ROFR is given a chance, for a limited time, to buy the property at the same price and terms. Alternatively, the price may be determined by fair market value at the time of sale. Careful: As soon as the sellers includes a specific price, it is likely that the ROFR will be transformed into an option, and one again falls within the definition of an executory contract. ROFRs are therefore not an effective substitute for an investor seller who wants to pre-set an above-market price in order to lock in a long-term profit.
See our companion web article entitled Rights of First Refusal in Texas.
Statute of Frauds Applies
All preferential rights to real estate, including lease purchases and lease options, must be express (not implied) and be in writing in order to comply with the statute of frauds. Provisions of the Statute of Frauds applicable to real estate are found in the Business & Commerce Code sections 26.01 and 26.02(b): “[A] contract for the sale of real estate is not enforceable unless the promise or agreement, or a memorandum of it, is (1) in writing; and (2) signed by the person to be charged with the promise or agreement. . . .”
There is another statute that is applicable: Property Code section 5.021, sometimes referred to as the “Statute of Conveyances,” which states: “A conveyance of an estate of inheritance, a freehold, or an estate for more than one year, in land and tenements, must be in writing and must be subscribed and delivered by the conveyor or by the conveyor’s agent authorized in writing.”
Beware of Seminar Forms
Be cautious in the use of lease-option forms (or any other 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. If you have such forms entitled Purchase Option Agreement, Option Cancellation and Release Agreement, Option to Purchase Real Estate, Performance Mortgage to Secure Option, Secured Reverse Assignment Agreement, Slick Tricks to Get What I Want Without Telling Anyone What I’m Doing, and the like, they are toxic waste. One can call a cat a dog but that does not change the nature of the beast. Courts look to substance over form. And remember, courts do not like investors. Moreover, 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.
Residential lease-purchases for longer than 180 days are no longer a feasible strategy for most investors because of the multitude of requirements and the potential liability for doing them improperly. There is really no way to use a stacking technique here, as is at least theoretically possible in the case of lease-options. Add the fact that the Property Code declares open season on the investor-seller whenever a tenant-buyer becomes disgruntled with an executory contract, and there are more reasons to avoid lease-purchases than there are to do them—especially since loss of an executory contract lawsuit could present an extinction event for a small investor. So sensible investors avoid them. Many real estate lawyers will not do residential lease-purchases at all, since failure to comply with even the smallest requirement may trigger significant liability for the attorney preparing and filing the various disclosures and documents.
Information in this article is provided 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 © 2019 by David J. Willis. All rights reserved worldwide. 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, LoneStarLandLaw.com.