Wholesaling in Texas Real Estate
Sale and Assignment of Earnest Money Contracts
by David J. Willis J.D., LL.M.
Both the legislature and TREC have moved in recent years toward greater regulation of the business of wholesaling. Wholesaling, for those who do not know, is an investor practice of getting a property under contract and then selling that contract to another investor who, after closing, usually does rehab work with the intention of selling the property at a profit, all within a short-term timeframe (usually a year or less). Several statutes now work together to impose a sort of “truth in advertising” disclosure requirement upon those engaged in wholesaling.
Occupations Code Section 1101.002.(A) – Definitions
Do you need a real estate broker’s license to engage in wholesaling? Chapter 1101 of the Occupations Code answers this question with a definite maybe. As is the case with most statutes, the first part of the law defines relevant terms, including in this case a definition of what constitutes real estate brokerage in the wholesaling context. Chapter 1101 states that a real estate broker “means a person who, in exchange for a commission or other valuable consideration or with the expectation of receiving a commission or other valuable consideration, performs for another person one of the following acts . . . deals in options on real estate, including buying, selling, or offering to buy or sell options on real estate. . . .” Since many earnest money contracts (depending on the stage they are in) can be considered a kind of option to buy real estate, if one is buying or selling such contracts (i.e., wholesaling), and if these contracts are offered and advertised as interests in real estate, then a broker’s license is required.
Occupations Code Section 1101.0045 – Equitable Interests in Real Property
Again, the Occupations Code focuses on licensing. This section offers a loophole for wholesalers who are working without a broker’s license, but only so long as they make express disclosure that what they are selling is merely an “equitable” interest, which generally means an interest that is less tangible, less certain, and more contingent than a solid and present fee simple ownership interest. The statute reads: “(a) A person may acquire an option or an interest in a contract to purchase real property and then sell or offer to sell the option or assign or offer to assign the contract without holding a license issued under this chapter if the person: (1) does not use the option or contract to purchase to engage in real estate brokerage and (2) discloses the nature of the equitable interest to any potential buyer. (b) A person selling or offering to sell an option or assigning or offering to assign an interest in a contract to purchase real property without disclosing the nature of that interest to a potential buyer is engaging in real estate brokerage.”
Section 1101.0045 wants wholesalers to make it clear to buyers of contracts that what is being offered is not the realty itself, but only contract rights to acquire the property in the future (This is what is meant by an “equitable interest.”). Accordingly, wholesalers who assign contracts are not illegally acting as brokers if they fully disclose the nature of the interest they are selling.
22 Texas Administrative Code Section 535.6 – Equitable Interests in Real Property
The TAC contains TREC rules applicable to real estate license holders. Section 535.6 states that a “person may acquire an option or enter into a contract to purchase real property and then sell or offer to sell the option or assign or offer to assign the interest in the contract without having a real estate license if the person: does not use the option or contract to purchase to engage in real estate brokerage; and discloses the nature of their equitable interest to any potential buyer. A person selling or offering to sell an option or assigning or offering to assign an interest in a contract to purchase real property without disclosing the nature of that interest to a potential buyer is engaging in real estate brokerage. A license holder who is engaging in real estate brokerage by selling or buying or offering to sell or buy an option or assigning or offering to assign an interest in a contract to purchase real property must disclose to any potential seller or buyer that the principal is selling or buying an option or assigning an interest in a contract and does not have legal title to the real property. A license holder acting on his or her own behalf or in a capacity described by Sec.535.144(a) who is selling an option or assigning an interest in a contract to purchase real property must disclose to any potential buyer that the license holder is selling an option or assigning an interest in a contract and that the license holder does not have legal title to the real property.”
This section of the Administrative Code echoes a theme found elsewhere in the TREC rules: a license holder should disclose, disclose, disclose.
Property Code Section 5.086 – Equitable Interest Disclosure
Mirroring the Occupations Code and Administrative Code, Section 5.086 of the Property Code provides: “Before entering into a contract, a person selling an option or assigning an interest in a contract to purchase real property must disclose to any potential buyer that the person is selling only an option or assigning an interest in a contract and that the person does not have legal title to the real property.”
Unlike the Occupations Code or the TAC, the Property Code is not focused on real estate license holders or the requirement of a broker’s license. The Property Code applies to everyone, licensed or not.
So even if one could argue that the Occupations Code and the Administrative Code do not apply because one is not a license holder, the Property Code makes it clear that a seller-assignor must still make the required disclosure. Looked at another way: wholesaling without the disclosure gets an investor in double trouble, both for a violation of the Property Code and for brokering real estate without a license. Note also that the license requirement of Occupations Code Section 1101.002.(A) refers to “dealing” in contracts (selling or buying), while Property Code Section 5.086 appears to only apply to persons selling a contract interest. So does an investor-buyer of a contract need to worry about whether or not the disclosure is present in the document assigning the contract? The prudent answer is yes.
Content of Required Disclosure
Our suggestion would be to include the following wording at or near the top of the instrument that assigns the earnest money contract:
EQUITABLE INTEREST DISCLOSURE PURSUANT TO TEXAS PROPERTY CODE SEC. 5.086: THIS INSTRUMENT REPRESENTS ONLY AN OPTION OR ASSIGNMENT OF AN INTEREST IN REAL PROPERTY. IT IS NOT A TRANSFER OF TITLE. ASSIGNOR DOES NOT HAVE LEGAL TITLE TO THE PROPERTY. CONSULT AN ATTORNEY PRIOR TO EXECU-TION IF YOU DO NOT UNDERSTAND THIS DISCLOSURE.
A buyer of an earnest money contract should want the assignment instrument to be recorded in the real property records of the county where the property is located. Why? As insurance that the contract will not later be sold by an unscrupulous seller to someone else. So the equitable interest disclosure would probably best be inserted just beneath the notice of confidentiality rights that is required by Texas county clerks to be present on filed documents:
NOTICE OF CONFIDENTIALITY RIGHTS: IF YOU ARE A NATURAL PERSON, YOU MAY REMOVE OR STRIKE ANY OR ALL OF THE FOLLOWING INFORMATION FROM ANY INSTRUMENT THAT TRANSFERS AN INTEREST IN REAL PROPERTY BEFORE IT IS FILED FOR RECORD IN THE PUBLIC RECORDS: YOUR SOCIAL SECURITY NUMBER OR YOUR DRIVER’S LICENSE NUMBER.
Assignability of the Contract
The contract in question should expressly state that it is assignable. This is a suggested way to list the buyer in paragraph 1 of the TREC contract: “ABC LLC and/or its assigns without Seller consent.” Of course, a careful lawyer would prefer a more comprehensive clause such as “It is expressly agreed that this contract may be assigned at any time by Buyer before closing without prior notice to or consent by Seller. The effect of any such assignment will be to immediately relieve any person signing as Buyer of any further obligations under the contract. Seller unconditionally agrees to accept the assignee as Buyer and timely close without objection according to the terms of this contract.” But the available line on the TREC 1-4 form is just too short for this, which is good reason to consider including a special provisions addendum.
The Assignment Instrument
It goes without saying that both the contract and the underlying real property should be precisely described in the assignment. A good practice is also to attach a copy of the contract as an exhibit to the assignment.
Assignment of an earnest money contract is often compared to selling a real estate note, since many of the same principles apply. The main difference is that earnest money contracts, unlike notes, are not negotiable instruments subject to the Uniform Commercial Code.
Characteristics shared by these two types of assignments are: (1) the necessity for thorough due diligence by the prospective assignee, which in the case of an assignment of contract requires not only an examination of the contract terms but also the underlying realty; (2) the general preference on the part of the assignor to make the transfer “as is” to the greatest extent possible; (3) the issue of representations and warranties and the extent to which they may be limited; (4) the period during representations and warranties will survive, if at all; and (5) the requirement that the assignor disclose any material issues, facts, or conditions (pending or threatened) that could reasonably influence the decision of the assignee to buy or not buy the interest being assigned. Failing to disclose known potential defects in the contract could be construed as fraud.
Representations and Warranties (“Reps and Warranties”) by Assignor
An assignment may include extensive reps and warranties, limited reps and warranties, or no reps and warranties at all—in which case the assignment is made “as is” and almost always without recourse. It should be obvious that issues like these need to be made clear in the instrument, but often they are left unarticulated or muddled (Internet junk forms are particularly deficient in this respect). A poorly-written assignment is an invitation to a lawsuit.
It is imprudent to skip providing for representations and warranties. If this subject is not expressly addressed in the assignment, either or both parties may assume that reps and warranties exist when they do not, or they may later assert that these were somehow implied in the course of dealing between the parties. Either outcome can easily lead to litigation. So it does not work to simply dodge the subject. Legal issues do not go away merely because they are not explicitly addressed.
Covenants and Agreements
A well-drafted assignment should include express agreements by the parties to undertake further action if needed. Clarity is important. Nothing in this area should be assumed or implied. An example would agreement by the assignor to promptly deliver the original contract and any related documentation that may be in the assignor’s possession. The assignee should agree to be bound by the contract and perform accordingly. Both parties should agree to take such other and further action, including the execution and delivery of additional documents, as may be reasonable or necessary to effectuate the assignment.
Recourse in the Event the Contract or Closing Fails
As is the case with notes, contracts can be assigned with or without recourse against the assignor. Recourse comes in three varieties: none, full, or limited. “No recourse” means what it says—if the contract does not close, then the assignee is stuck with a failed contract and is solely responsible for pursuing remedies against the other party to the contract. Full recourse means that the assignee gets to give the contract back if the transaction fails to close through no fault of the assignee. Limited recourse can mean different things, but it falls somewhere between no recourse and full recourse. The assignment should provide that the availability of recourse—whether none, full, or limited—is contained within a specific time period.
It is most often the case that contracts are assigned without recourse, meaning “as is.” If sale of an earnest money contract is to be entirely “as is,” an effective clause for this purpose is essential. Drafting should be carefully done, since the assignor will want not only to disclaim assurances regarding the transferred contract but also any reps or warranties concerning the condition and value of the underlying real property. The “as is” provision should also include a clause disclaiming oral statements by either party and declaring that the express written assignment constitutes the sole and final agreement of the parties.
Express Consent from the Owner of the Property
It is important—vital, in fact—for a contract assignee to be sure that the owner of the property consents to the assignment and will honor the assignee’s status as the new buyer of the property. If overlooked, the assignee may wind up facing a hostile seller at closing who refuses to accept the assignee as the legitimate buyer.
It should not be assumed that property sellers in typical fix-and-flip contracts are sophisticated in the real estate business and will automatically go along with the assignment, even if the contract expressly states that it is assignable by the buyer. After all, the assignee of a fix-and-flip contract does not want to be put in the position of being forced to sue the seller for specific performance—an expensive event that could easily destroy the profitability of the transaction. Accordingly, the assignment should include consent wording along the following lines: “I/We, the undersigned, am/are listed as the seller in the Contract which is the subject of this Sale and Assignment. I/We give my/our unconditional consent to the sale and assignment of the Contract to the above-named Assignee, and agree to in all respects henceforth recognize Assignee as the rightful buyer under the Contract to purchase the Property.”
The addition of Property Code Section 5.086 requiring an equitable interest disclosure is the beginning of a regulatory scheme for wholesaling. Abuses and mishaps in this area will make the news from time to time, so it is likely that future Texas legislatures will build on Section 5.086 and expand it, just as occurred in the case of executory contracts. The pressure for regulation may also increase as cases inevitably appear seeking to bring wholesaling within the reach of the Deceptive Trade Practices Act.
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 © 2022 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.