Owner or seller financing is a legitimate and effective way to sell real estate in an economy where traditional institutional financing may be difficult to obtain. It has a long and rich history in Texas, particularly in raw land sales. However, state and federal legislation in the last couple of decades make the owner-financing process more challenging than it used to be.
Traditional methods of seller financing include: (1) contracts for deed, lease-options, and lease-purchases; (2) the traditional (or classic) owner finance, used when the property is paid for (no unpaid liens on it); (3) wraparounds (the property is not paid for and a lien exists); and (4) land trusts, where title to the property is deeded into a trust as a parking place of sorts until a credit-impaired buyer can obtain financing, pay the sales price, and obtain a deed.
In certain seller-financing arrangements the seller retains title in anticipation of giving a deed to the buyer later, but only when payment is made in full. A contract for deed is a prime example. Changes to the Property Code made in 2005 labeled these transactions as executory contracts and imposed numerous requirements for their use. These requirements are so extensive and burdensome as to have effectively dealt a death blow to executory contracts in Texas—or at least those with a term longer than 6 months. Although still technically legal, executory contracts are seldom employed today. Most sellers (and their lawyers) view the regulatory burden and potential penalties as being too great. As a result, just a few alternatives that are not considered to be executory contracts remain feasible and practicable in the area of residential seller financing.
TEXAS LAW APPLICABLE TO OWNER FINANCING
Executory Contracts in Texas
A significant Texas law affecting seller or owner financing of residential properties is found in Chapter 5 of the Property Code which regulates executory contracts. Executory contracts are transactions that are incomplete or unfinished in some material respect, usually the delivery of a warranty deed to the buyer. Since 2005, Section 5.061 et seq. has imposed requirements and penalties upon seller financing if the buyer does not receive a deed (title to the property) at closing. Typical executory contracts are contracts for deed, lease-options, and lease-purchases (rent-to-own). Note that executory contract regulations do not apply to commercial transactions.
Prior to 2005, sellers frequently abused their position in seller-financed executory contracts. A substantial down payment was often required of the buyer, and then—if the buyer fell behind on payments or defaulted in some technical respect—the eviction process was used to remove him as an ordinary tenant. This approach resulted in forfeiture and confiscation of the buyer’s down payment and accumulated equity, a clearly inequitable result.
Because of this history, rules and restrictions now apply in transactions where title is not immediately conveyed at closing. Such contracts must be recorded, a thorough financial disclosure must be given to the buyer at closing, and the seller must provide an accounting statement every January. Buyers also have a right to convert to a deed, note, and deed of trust. A long list of other requirements (supplying a seller’s disclosure, a survey, a copy of restrictions, and more) must be met before the contract is signed.
Failure to comply may constitute a deceptive trade practice and result in treble damages (See the DTPA found in Chapter 17 of the Business and Commerce Code). Accordingly, contracts for deed and other executory contracts have fallen into disuse, which may have been the legislature’s exact intent.
Even if a seller is willing to endure the various restrictions and potential liability involved in engaging in a contract for deed, the SAFE Act licensing requirement will still apply.
Executory Contracts and the Seven-Day Notice Requirement
Property Code Sec. 5.016 requires the following: (1) 7 days notice to the buyer before closing that an existing loan will remain in place; (2) giving the buyer this same 7-day period in which to rescind the contract; and (3) also that the 7-day notice be sent to the lender. These notices are the obligation of the seller and must be in the form prescribed by the statute. Actual lender consent, however, is not required. As a practical matter, Section 5.016 notices (often sent to the loan servicer) usually produce no response.
Property Code Section 5.016(c)10 provides an exception to the notice requirement “where the purchaser obtains a title insurance policy insuring the transfer of title to the real property.” Thus if one is able to get a title company to insure an owner-financed deal, the 7-day notice may be dispensed with.
The 7-day notice requirement is a law that for now has no effective enforcement mechanism and, as a result, compliance is erratic. Future legislation may add penalties. For now, giving such notice has not been a significant impediment to seller-financing transactions.
Statute of Frauds in Texas
The Statute of Frauds needs to be mentioned in a discussion of seller financing since in Texas’ past many rural land sales were verbal and informal. The Statute of Frauds applicable to real estate is found in 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.”
Business & Commerce Code Chapter 21A and the Use of a Security Deed
Use of a security deed (a deed back to the seller-lender to be held in the event the buyer-borrower defaults) dates from the old days of unrestrained red-flag lot sales in the Texas countryside. Their use in owner-financing and wrap transactions remains popular today even though security deeds may be a violation of Chapter 21A of the Business & Commerce Code, which states that a “seller of residential real estate or a person who makes an extension of credit and takes a security interest or mortgage against residential real estate may not, before or at the time of the conveyance of the residential real estate to the purchaser or the extension of credit to the borrower, request or require the purchaser or borrower to execute and deliver to the seller or person making the extension of credit a deed conveying the residential real estate to the seller or person making the extension of credit.”
Texas SAFE Act
The Texas SAFE Act (Texas Finance Code Section 180.001 et seq.) is an implementation of the federal SAFE Act and is discussed below. It imposes an RMLO requirement for seller-financed sales of homestead property to non-family members and is enforced by the Texas Department of Savings and Mortgage Lending (TDSML).
FEDERAL LAW APPLICABLE TO OWNER FINANCING
The SAFE Act
The SAFE Act (S.A.F.E. Mortgage Licensing Act of 2008 found at 12 U.S.C. Section 5101) and its Texas equivalent T-SAFE (Finance Code Section 180.001 et seq.) require that sellers of non-homestead property to non-family members have a residential mortgage loan origination (RMLO) license. If the seller is not himself licensed, then an independent RMLO may be brought in to satisfy the statutory requirement.
Involvement of an RMLO is intended to inject fairness and disclosure into the seller-financing process. The RMLO, for a fee ranging from half a point to a point (1%) of the loan amount, supplies the latest form of good-faith estimate, truth-in-lending disclosures, orders an appraisal, gives state-specific disclosures, and insures that cooling periods are observed in the loan application and approval process. As a result, non-homestead owner financing deals can still be done but at a higher net cost. The outcome is more paperwork but better consumer protection in order to avoid abuses of the past.
Since traditional seller-finance transactions, wraps, and land trusts are all forms of owner finance, the SAFE Act applies; however, the seller is required to be licensed as an RMLO only if the property is not the seller’s homestead and/or the sale is not to a family member. Example: if the subject property is an investment rental house being sold to a non-family member, then the seller is required to have a RMLO license from TDSML.
TDSML has ruled that the SAFE Act will not be applied to non-professionals—persons who make five or fewer owner-financed loans in a year, thus preserving the de minimis exemption under Finance Code Section 156.202(a)(3). And of course the SAFE Act licensing rule does not apply to seller-financing of commercial properties.
The Dodd-Frank Law as Enforced by CFPB Regulations
Dodd-Frank (a federal law passed in 2010 as Title XIV of the Mortgage Reform and Anti-Predatory Lending Act) pertains to residential loans and lending practices. Now in its second iteration (“Dodd-Frank 2.0”) this law overlaps the SAFE Act in its regulatory effect and legislative intent. The goal of Dodd-Frank is to put an end to the practice of making seller-financed loans to people who cannot afford to pay them back. Accordingly, a principal requirement is that a seller-lender in a residential owner-financed transaction must affirmatively act to determine, at the time credit is extended, that the buyer-borrower has the ability to repay the loan. This is referred to as the ATR rule.
The Consumer Finance Protection Bureau (CFPB), charged with implementing Dodd-Frank, states the ATR rule as follows: “A creditor shall not make a loan that is a covered transaction unless the creditor makes a reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms.” 12 C.F.R Sec. 1026.43(c)(1). The seller-lender is obligated to investigate eight specific factors relating to the buyer-borrower: current income or assets; current employment status; credit history; monthly mortgage payment; other monthly mortgage payments arising from the same purchase; monthly payment for other-mortgage-related expenses (e.g., property taxes); the borrower’s other debts; borrower’s debt-to-income ratio (DTI). This is a non-exclusive list, a minimum standard that lenders must follow.
A prospective seller-lender should also consider how much a buyer-borrower will have left over for life’s necessities at the end of the month, after bills are paid. All of this must be based on verified and documented information. Evidence of ATR compliance should be kept as a permanent part of the seller-lender’s file in the event of a future lawsuit by the buyer-borrower.
CFPB Regulations Sections 1026.36(a)(4) and (5) provide a de minimis exception for individuals who do only one transaction in any twelve-month period; and for entities (such as LLCs) who do three or fewer owner-financed transactions in any twelve-month period.
Viewing the category broadly, there are a number of devices and strategies that may be considered as falling under the heading of seller or owner finance.
Traditional (or Classic) Owner Finance
A traditional owner-financed transaction involves conveying paid-for property to a buyer by warranty deed with the seller taking back a real estate lien note secured by a first-lien deed of trust. There are no worries about an existing lien-holder; therefore, the deed of trust put in place usually becomes a first lien against the property. If the buyer defaults, the seller can foreclose in the usual manner. Since Texas has a swift non-judicial foreclosure statute, the seller is in a good position to recover the property event of default. Also, so long as the property is the seller’s homestead or is being sold to a family member, the SAFE Act licensing requirement does not apply.
The first point to realize is that wraparound transactions are a form of owner finance. Wraps have become more popular since the advent of the executory contract rules. A wrap leaves the original loan and lien in place when the property is sold. The buyer makes a down payment and signs a new note to the seller (the wrap note) for the balance of the sales price. This wrap note, secured by a new deed of trust (the wrap deed of trust), becomes a junior lien on the property.
The plan is often to leave the wrap in place for a relatively short term (3, 5, or 10 years) while the buyer applies for a refinance loan that will take out the entire structure. The main difference between a wrap and a conventional sale is that the seller must wait until the wrap note matures in order to receive the full sales proceeds.
Wraparound transactions are now as heavily regulated as executory contacts.
Lease-options were a traditional way for investors to get less-than-qualified buyers into a home. These too are considered to be executory contracts and are subject to Property Code Section 5.061. There is an exception for lease-options shorter than six months and, of course, commercial transactions are not included.
Some sellers attempt to use lease-options by creatively re-writing the contract to call for a right of first refusal rather than an option—however, as soon as a price is named it becomes an option. Problem is, courts tend to look to substance over form and will likely see through this tactic.
Lease-options continue to have a role in short-term residential transactions and in commercial deals, but are otherwise less common given the substantial risk to the seller.
In a typical lease-purchase (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 other financing.
The buyer has an absolute right “at any time and without paying penalties or charges of any kind” to convert a lease-purchase (or any other executory contract) to “recorded, legal title” under Property Code 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.
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. All things considered, 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. Many real estate lawyers will not handle residential lease-purchases at all, since failure to comply with even the smallest requirement may also trigger significant liability for the attorney who prepared and filed the various disclosures and documents. Again, this is a result of Property Code Section 5.061 et seq., applied in conjunction with the Deceptive Trade Practices Act.
Land trusts used to be more popular before the 2008 recession. Since then, title companies view them less favorably and are more inclined to heavily scrutinize any transaction with the word trust in it.
There are three basic types of land trusts used by real estate investors: (1) an anonymity trust (our term) designed to hold property without disclosing the names of any principals; (2) an entry trust (our term) used as a tool to acquire and then transfer real estate by means of an assignment of beneficial interest; and (3) an exit trust (our term again) designed to hold title to real estate while a credit-impaired buyer does credit repair until able to obtain a loan to take the property out of trust.
Land trust transactions can sometimes bear a striking resemblance to executory contracts, so caution is required. Take the exit trust as an example: in this arrangement, property is conveyed into a land trust that acts as a temporary parking place for title while a credit-impaired buyer (the trust beneficiary) takes immediate possession and works to obtain financing in order to purchase the property outright at a pre-set price. Sound similar to a lease-option? It is, except that beneficial interests in a trust are personal property, not real property, and therefore arguably do not fall under the executory-contract rules. It remains to be seen if this argument will prevail with a Texas judge.
Most land trust transactions are handled and closed in an attorney’s office without the participation of a title company. Although a deed into the trust may be recorded, the trust agreement itself is not required to be recorded.
Contracts for Deed
As a result of Property Code Section 5.061 et seq., contracts for deed (sometimes called “land sales contracts” or just “land contracts”) have all but vanished from Texas residential transactions, even from rural land sales. This is a far cry from the old days when it was literally the wild west in terms of dollar-down deals for land in the country.
What if the property to be conveyed in a seller-financed transaction still has a lien on it? Owner financing while a loan is in place is neither illegal nor a breach of contract. It does not violate the due-on-sale clause in the underlying deed of trust. If you look carefully at the typical lender’s documents, you will see that they usually do not prohibit a transfer of property without the lender’s consent. They generally state that if the borrower transfers the property without the lender’s permission then the lender may, if it so chooses, declare the loan due.
Notwithstanding the foregoing, conveying title to property that still has a lien on it invokes Property Code Section 5.016 (mentioned above in the discussion of executory contracts) entitled “Conveyance of Residential Property Encumbered by Lien.” This statute requires that the seller (1) give seven days’ notice to the buyer before closing that an existing loan will remain in place; (2) inform the buyer that buyer has this same seven-day period in which to rescind the earnest money contract without penalty; and (3) also provide a 7-day notice to the lender. These notices are all the obligation of the seller. Actual lender consent, however, is not required.
Seller financing, though more limited and regulated than ever before, remains alive and well in Texas, if not as widespread and uncontrolled as in days past. Greater consumer protection has been achieved by Property Code Section 5.061, the SAFE Act, and Dodd-Frank, but these measures have also had the effect of raising closing costs, particularly if an RMLO intermediary agent is involved. Consult a qualified real estate attorney before entering into a sales contract calling for seller or owner finance, and never use forms off the Internet to document such transactions.
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 © 2023 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.