Seller Finance in Texas Residential Sales Transactions

Introduction

Seller financing is a legitimate and effective way to sell real estate, particularly when traditional institutional financing is expensive or difficult to obtain. Texas has a long and rich history of seller financing. In the colorful days before the advent of much in the way of regulation, this was called “toting the note.”

State and federal legislation in the last two decades have combined to make the process more challenging for sellers. Viewing the seller-financing category broadly, there are a number of devices and strategies that are common:

(1) the classic owner finance, used when the property is paid for (no unpaid or unreleased liens exist);

(2) wraparounds (the property is not paid for and a subordinate lien is added to the existing first lien which remains in place);

(3) executory contracts including contracts for deed, lease-options, and lease-purchases; 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.

It is critical that the type of seller-financing be identified at the contract stage of the transaction and not left to be worked out later. Deal-specific details that will be included in the seller-financing legal documents at closing should be resolved early by means of a custom addendum to the earnest money contract. At present, neither TREC nor TR offer addenda that are sufficient for any of the above four categories.

THE 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 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 (RMLO) requirement does not apply. More on RMLOs below.

WRAPAROUNDS

Yes, a wraparound is a form of seller financing. 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 wraparound note) for the balance of the sales price. This wrap note, secured by a new deed of trust (the wraparound deed of trust), becomes a junior lien on the property. The buyer receives title (a general or special warranty deed) at closing, so a wrap is not an executory contract.

The usual plan is 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—thus a balloon note is often involved. 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 principally regulated by Chapter 159 of the Finance Code (Wrap Mortgage Loan Financing); Property Code Section 5.016 (Conveyance of Residential Property Encumbered by Lien); and the SAFE Act and Dodd-Frank.

The Seven-Day Notice Requirement

The Property Code contains a general notice requirement that applies whenever transfer of title occurs that does not result in the payoff and release of existing lienholders. This requirement applies to wraparounds, executory contracts, and any other circumstance where an existing lien will remain in place after closing. Property Code Section 5.016 requires that a seller:

(1) provide 7 days notice to the buyer before closing that an existing loan will remain in place;

(2) allow the buyer this same 7-day period in which to rescind the contract; and

(3) also send the 7-day notice to the lender.

These notices are the sole obligation of the seller and must be in the form prescribed by the statute. 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 a title company is willing to insure an owner-financed transaction then 7-day notices may be dispensed with.

As a practical matter, Section 5.016 notices (often sent to the loan servicer) usually produce no response. Also, since Section 5.016 is a law that has no effective enforcement mechanism, compliance is erratic. Future legislation may add penalties, but for now giving these notices has not been a significant impediment to seller-financing transactions.

The Security Deed Technique

A security deed (a deed back to the seller-lender to be held as security in the event the buyer-borrower defaults) is occasionally employed by an owner-financing seller to better fortify the seller’s position if the buyer defaults. These remain popular today in classic owner financing and in wraparounds even though security deeds violate the Business & Commerce Code:

Bus. & Com. Code Sec. 21A.002. Prohibition of Execution of Deeds Conveying Residential Real Estate in Certain Transactions

(a) 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. (b) A deed executed in violation of this section is voidable. . . .

EXECUTORY CONTRACTS

Contracts for Deed

In a contract for deed, the seller retains legal title in anticipation of giving a deed to the buyer later, but only after payment is made in full. Typical executory contracts are residential contracts for deed, lease-options, and lease-purchases (rent-to-own). These contracts are regulated by Property Sub-Chapter D (Executory Contract for Conveyance) in Section 5.061 and the provisions that follow.

Prior to 2005 changes to the Property Code, sellers under contracts for deed frequently abused their position. A substantial down payment was often required of the buyer, and then—if the buyer fell behind on payments or defaulted in some minor technical respect—the eviction process was used to remove him as if he were an ordinary tenant. Doing this 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. A long list of requirements (supplying a seller’s disclosure, a survey, a copy of restrictions, and more) must be met before the contract is signed. A thorough financial disclosure must be given to the buyer at closing, the contract for deed must be recorded in the real property records, and the seller must provide an accounting statement every January.

The buyer has an absolute right “at any time and without paying penalties or charges of any kind” to convert any 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.

Failure by a seller to comply with the rules applicable to executory contracts may constitute a deceptive trade practice and result in treble damages (DTPA, Chap. 17, Bus. & Com. Code).

Contracts for deed 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 raw land in the country. Most sellers (and their lawyers) now view the regulatory burden and potential penalties as being simply too great.

Lease-Options

Lease-options were once considered an easy way for real estate investors to get less-than-qualified buyers into a home. Since 2005, they are viewed as executory contracts and are subject to the extensive rules of Section 5.061 et seq. 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. 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 liability risk to the seller.

Lease-Purchases

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;

(2) or the seller agrees that the tenant-buyer may show the accumulated down payment on a loan application to a third-party lender to assist in qualifying for traditional financing.

Residential lease-purchases for longer than 180 days are a risky strategy for most real estate investors because of the multitude of requirements and the potential liability for doing them improperly. Many lawyers will not handle residential lease-purchases at all since failure to comply with even the smallest requirement could also result in significant liability for the attorney.

Statute of Frauds

The Statute of Frauds should be mentioned since past executory-contracts transactions were so often informal and verbal. There are a couple of relevant statutes to look at in this context.

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 relevant statute, Property Code Section 5.021 (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.”

LAND TRUSTS

Types of Land Trusts

Investor 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.

THE SAFE ACT

The SAFE Act Licensing Requirement

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 by 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 seller 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.

The SAFE Act is enforced by the Texas Department of Savings and Mortgage Lending (TDSML). Since classic 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 an 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.

Guidance from the TDMSL

TDSML offers the following guidance on its website:

Who is required to be licensed as a residential mortgage loan originator (RMLO) under the Texas SAFE Act?
The Texas SAFE Act and Finance Code Chapter 157, Subchapter D require an individual acting in the capacity of an RMLO to be licensed, unless he or she is exempt from licensing requirements. Limited exemptions to the requirements from licensure may found in Finance Code § 157.0121 and Finance Code § 180.003. An RMLO is defined as an individual who, for compensation or gain, or in the expectation of compensation or gain, 1) takes a residential mortgage loan application or 2) offers or negotiates the terms of a residential mortgage loan. See Finance Code § 180.002(19).

A licensed RMLO acts on behalf of (and must be sponsored by) an appropriate entity holding a company license or registration (a licensed mortgage company or registered mortgage banker). An RMLO cannot conduct business “on their own” with the RMLO license but may conduct business in their own name by using a sole proprietorship that is separately licensed or registered.

The Texas SAFE Act also requires an individual who provides clerical or support duties other than a W-2 employee for an appropriate entity (an independent contractor loan processor or underwriter) to be licensed. See Finance Code § 180.051(b).

Unlicensed residential mortgage loan origination activity may subject the unlicensed individual to sanctions, administrative penalties, and even criminal charges.

DODD-FRANK AND 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.

A central 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 (the ATR rule).

The Consumer Finance Protection Bureau (CFPB), charged with implementing Dodd-Frank, states the ATR rule as follows:

12 C.F.R Sec. 1026.43(c)(1). [ATR 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.

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 litigation.

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.

DUE-ON-SALE ISSUES

What if the property to be conveyed in a seller-financed transaction still has a lien on it? Seller financing while a loan remains in place is neither illegal nor (in most cases) a breach of contract. It does not violate the usual due-on-sale clause in the underlying deed of trust. If you look carefully at typical residential lender documents, you will see that they 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.

CONCLUSION

Seller financing, though more regulated than ever before, remains alive in Texas but not as widespread and uncontrolled as in days past. Greater consumer protection has been achieved by Property Code Section 5.061, Finance Code Chapter 159, the SAFE Act, and Dodd-Frank—but these measures have also had the effect of raising closing costs, particularly if an RMLO is involved. Consult a qualified real estate attorney before entering into a sales contract calling for seller financing, and never use forms off the Internet to document such transactions.