Owner financing is a legitimate and effective way to sell real estate in an economy where traditional lender financing may be difficult to obtain. However, recent state and federal legislation make the owner-financing process more difficult than it used to be.
For one thing, residential lease-options exceeding six months (formerly a favorite of investors) and contracts for deed were both dealt a near-death blow by changes to the Property Code made in 2005. As a result, only a few types of residential owner financing remain practicable.
Traditional methods of owner financing include: (1) contracts for deed, lease-options, lease-purchases (all of which fall under the category of “executory contracts”); (2) the traditional (or classic) owner finance, used when the property is paid for; (3) wraparounds (the property is not paid for), which involve giving the buyer a deed and arranging for the buyer to make monthly payments to the seller so the seller can in turn pay an existing lender until the underlying note is discharged; and (4) land trusts, where the property is deeded into a trust as a parking place of sorts until a credit-impaired buyer can obtain financing.
PART ONE: LAWS APPLICABLE TO OWNER FINANCING
The following are the principal state and federal statutes that affect owner financing:
a. the 2009 SAFE Act which requires that sellers of non-homestead property to non-family members have a residential mortgage loan origination license;
b. Title XIV of the “Mortgage Reform and Anti Predatory Lending Act,” also known as Dodd-Frank; and
c. Chapter 5 of the Texas Property Code which since 2005 has imposed burdensome requirements and penalties upon seller financing of residential properties.
The SAFE Act Licensing Requirement
The federal SAFE Act and its Texas equivalent “T-SAFE” impose a licensing requirement on certain types of owner financing provided by professional investors. Since traditional owner finance transactions, wraps, and land trusts are all forms of owner finance, the SAFE Act applies; 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. If the subject property is an investment rental house being sold to a non-family member, then the seller is required to have a residential mortgage loan origination (RMLO) license from the Texas Department of Savings and Mortgage Lending.
The Commissioner of the TDSML has ruled that the SAFE Act will not be applied to non-pros – persons who make five or fewer owner-financed loans in a year, thus preserving the so-called “de minimus exemption” under Finance Code Section 156.202(a)(3).
Does the SAFE Act shut the door on non-homestead owner finance for persons who do more than five such deals per year? Not necessarily. The TDSML has expressly approved the role of an intermediary agent – called an “RMLO” – who, for a fee ranging from half a point to a point (i.e., 1%) of the loan amount, will step in and satisfy the Act’s requirements. The RMLO supplies the new form of Good Faith Estimate, Truth in Lending disclosures, order an appraisal, give state-specific disclosures, and the like, and insures that all cooling periods are observed in the loan process. So, non-homestead owner financing deals can still be done but at a higher net cost. The result is more paperwork but better consumer protection in order to avoid the abuses of the past.
Note that the SAFE Act licensing rule applies only to residential owner financing.
The Dodd-Frank Law (Title XIV – Mortgage Reform and Anti-Predatory Lending Act)
Title XIV of the Dodd-Frank law pertains to residential loans and lending practices. Dodd-Frank overlaps the SAFE Act in its regulatory effect and legislative intent. It requires that a seller-lender in a residential owner-financed transaction determine at the time credit is extended that the buyer-borrower has the ability to repay the loan.
The Consumer Finance Protection Board (CFPB), charged with implementing Dodd-Frank, has issued the following rule: “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 §1026.43(c)(1)). The lender is obligated to investigate eight specific factors relating to the borrower:
current income or assets
current employment status
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 lender should also consider how much a borrower will have left over for life’s necessities at the end of the month, after all bills have been paid. All of this must be based on verified and documented information. This is referred to as the “ATR” (ability to repay) requirement.
The intent of Dodd-Frank is essentially to put an end to the practice of making loans to people who cannot afford to pay them back.
Are balloon notes forbidden by Dodd-Frank?
One could be forgiven for reading the text of Dodd-Frank and concluding that non-standard loans such as balloons are forbidden. However, the CFPB, which has been aggressive about rulemaking and has taken significant liberties in its interpretation of the statute, has decided that balloon notes are acceptable in residential owner finance so long as the buyer is evaluated and is determined to have the ability to repay the note (the ATR rule).
Exceptions to Dodd-Frank
There is a de minimus exception for persons doing not more than three owner-financed transactions per year (so long as the seller/lender is not in the building business) – but the loan must be fully amortizing (no balloon) unless the sale is a one-time event within twelve months by a non-builder; the seller must determine that the buyer has the ability to repay the loan (and this must be supported by verifications and documentation), but with the same exception as with balloon notes; and the note must have a fixed rate or, if adjustable, may adjust only after five or more years and be subject to reasonable annual and lifetime limitations on interest rate increases.
Texas Property Code Sec. 5.061: Statutory Requirements for Executory Contracts
Texas Prop. Code Section 5.061 et seq. applies to “executory contracts” which are transactions that are incomplete or unfinished in some material respect, usually the delivery of a warranty deed. The principal financing techniques affected are contracts for deed, lease-options, and lease-purchases.
The Property Code was extensively amended in 2005 to remedy what were perceived as executory-contract abuses such as collecting a large down payment and then, if the buyer fell behind, using the eviction process to remove the buyer as if the buyer were no more than an ordinary tenant. This approach unfairly confiscated any equity that had been deposited and accumulated by the buyer in the property.
Because of this history, rules and restrictions now apply in transactions where title is not immediately conveyed. Such contracts must be recorded, a through 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. Other requirements:
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.
5.069(a)(2) requires that the seller provide the purchaser with copies of liens, restrictive covenants, and easements affecting the property.
5.069(a)(3) requires that a “Seller’s Disclosure of Property Condition” be provided by the seller.
5.069(b) states that if the property is not located in a recorded subdivision, then the seller is required to provide a separate disclosure form stating utilities may not be available to the property until the subdivision is recorded.
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.
Failure to comply may constitute a deceptive trade practice and result in treble damages. Accordingly, contracts for deed and other executory contracts have fallen into disuse – which was exactly the legislature’s 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 still apply.
Note that the executory contract does not apply to commercial transactions.
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. Section 5.016 notices, often sent to the loan servicer (who is not usually equipped to handle such communications), usually produce no response.
Note, however, that 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 you are able to get a title company to insure your owner-financed deal, you can dispense with the 7 day notice. Few title companies will insure creative transactions such as wraps and land trusts, however, so this exception may not be of much help.
This is a law that has no effective enforcement mechanism and, as a result, compliance is erratic. Watch for future legislation that may add penalties. For now, Section 5.016 has not become a significant impediment to owner financing transactions.
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.”
PART TWO: OWNER FINANCING TECHNIQUES
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. This is a far cry from the old days when contracts for deed were common, particularly in rural areas, where it was literally the wild west in terms of dollar-down deals.
Lease-options were a traditional way for investors to get less-than-qualified buyers into a home. These too are now 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 covered.
Some sellers have attempted to continue to use lease-options by creatively re-writing the contract to call for a right of first refusal rather than an option – but be careful: as soon as a price is named it becomes an option. Clever draftsmanship (including giving old documents new names) will not avoid the requirements or consequences of Section 5.061. Courts look to substance over form. They will look at what a transaction actually is, not what the parties (or their lawyers) pretend it to be.
Stacking 6 month lease-options is a possible method of avoiding the statute. For instance, the documents can be written to provide that the option to purchase expires after, say, 179 days and then automatically renews for another 179 day term. This exploits a loophole in the law. The risk is that a disgruntled borrower may challenge the transaction in court, alleging that the true intent of the parties was to do a longer term deal – even though the written documents state differently. If the court agrees (and a liberal-minded judge might make this determination) then the various penalties contained in Section 5.061 could rain down upon the seller. In spite of this risk, a substantial number of investors are using the stacking method.
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 (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.
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 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. 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.
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 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 in event of default.
Traditional owner-financed transactions often close in a lawyer’s office without title insurance, although it is prudent for a buyer in such transactions to at least obtain a title report indicating what liens, lawsuits, and judgments may affect the property.
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.
Money flows as follows: the buyer makes monthly payments to the seller on the wrap note and the seller in turn makes payments to the original lender. The original lender’s note is referred to as the “wrapped note,” and it remains secured by the “wrapped deed of trust.” It is possible to wrap more than one prior note (e.g., an “80/20”).
When the buyer gets a refinance loan, the original, wrapped note is paid and released, and the seller keeps any cash that exceeds the payoff amount of this first lien. 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.
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. We will examine each in turn:
(1) The Anonymity Trust. The anonymity trust is usually established as part of a broader asset protection plan. It is executed along with a warranty deed conveying the property into trust. The traditional way for a trust to hold property is in the name of “John Jones, Trustee for the 123 Oak Street Trust;” however, it is just as feasible to hold title in the name of the trust alone – e.g., the “123 Oak Street Trust.” County clerks have no problem recording a deed into the name of a trust so long as the trustor’s/grantor’s signature is acknowledged. Title companies do not like this arrangement, however. They decline to insure title in the name of the trust without the trustee being expressly named, citing the fact that a trust is not a legal entity; and if a title company is handling the subsequent sale of property that is currently in an anonymity trust, they will certainly ask to see the trust agreement and will likely also require that a new deed be executed into the trust which names the trustee. This re-deeding is not usually a problem for investors, since their anonymity has been maintained throughout the duration of ownership. Mission accomplished, from the perspective of anonymity.
Most trust transactions are handled and closed in an attorney’s office without the participation of a title company. If the buyer/trust beneficiary wants to know the status of title, a title report can always be purchased at a reasonable cost.
(2) Entry Trust. In the case of the entry trust, an investor coaxes a distressed seller into transferring property into a trust, after which the seller executes an unrecorded assignment of beneficial interest to the investor. This is usually done in anticipation of a foreclosure. However, these trusts do not delay or stop foreclosure unless the investor is willing to reinstate the loan and/or continue making payments until the property sells.
Drafting the trust is critical. Certain types of these trusts also allow the original seller to retain a beneficial interest (always a bad idea) that allows the original seller to a share of the profits when the property is flipped. Others permit the original seller to have a power of direction over the trustee – an even worse idea.
A significant risk, from the investor=s point of view, is that the original seller may still be able to transfer the property to someone else in defiance of the unrecorded assignment of beneficial interest that has been given to the investor. For this reason, depending on the circumstances, a “subject to@ deed may be a simpler and better solution than an entry trust. Since asset protection is important the grantee on the “subject to” deed should be the investor’s LLC.
(3) The Exit Trust. In the exit trust, the trustor/investor is the seller. Property is conveyed into a land trust that acts as a temporary parking place for the property 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 specified 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.
Due-on-Sale Issues in Owner Finance
What if the property to be conveyed 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.
Owner finance, 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 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 © 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.