PART ONE: DESCRIPTION OF THE WRAP PROCESS AND DOCUMENTS
This article is divided into two parts. Part one discusses the basics of wraparounds—how they work, the situations for which they are suited, and the documents generally required. Part two addresses applicable law, administrative rules, and enforcement.
What is a wraparound transaction?
A wraparound transaction is a form of creative seller financing that leaves the original loan and lien in place when a property is sold. In the typical case, the buyer-borrower makes a down payment, gets a warranty deed, and signs a new note to the seller-lender (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 behind the existing first lien. The buyer-borrower makes monthly payments to the seller-lender on the wrap note and the seller-lender in turn makes payments to the first-lien lender. The original lender’s existing 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).
Often the principal of the wrap note to the seller-lender exceeds the amount of the payoff on the wrapped note. This is seller profit. The main difference between a wrap and a conventional sale is that the seller must wait until the wrap note is paid (or refinanced) in order to receive the full sales proceeds.
An alternative approach is for the buyer-borrower to make a cash payment to the seller-lender for the seller’s equity, and the wrap note payment will then be structured to correspond closely to the amount of the payment on the wrapped note. This is called a mirror wrap.
Specific wrap terms can vary, but the principle remains the same. Wraps may be done on both residential and commercial properties.
Wrap paperwork begins with the earnest money contract, which should include an addendum (customized by an attorney) setting forth the terms of the wrap. If the parties are clear on terms and do not need formal inspections or a title policy, they can skip the earnest money contract phase and ask an attorney to prepare wrap documents for immediate closing.
Wraps are a form of seller financing. There is no disputing it. Seller-financing laws and regulations apply, including Dodd-Frank, the SAFE Act, and the Texas Finance Code. Applicable law and regulations are covered in part two of this article.
Wraparound financing is sometimes referred to as subordinate-lien financing.
Essential documents include the usual note, deed, and deed of trust (all suitably customized for a wraparound transaction)—but since these documents may not sufficiently cover all the miscellaneous wrap details involved, a comprehensive wraparound agreement should be included as well. A complete package of wrap documents would therefore include a:
(1) custom lawyer-prepared wraparound addendum for the TREC 1-4 contract (since neither TREC nor TAR promulgates an addendum specifically for wraps);
(2) 7-day notice to purchaser of existing prior recorded liens (right to rescind) pursuant to Prop. Code Sec. 5.016 (not applicable where a policy of title insurance will be issued to the purchaser);
(3) 7-day notice to lienholder of proposed sale of security property pursuant to Prop. Code Sec. 5.016;
(4) notice to purchaser regarding potential property insurance coverage issues pursuant to Finance Code Sec. 159.101 (must be given at least 7 days before closing);
(5) general warranty deed with vendor’s lien containing wrap-specific language;
(6) new wraparound note signed by the buyer and payable to the seller (which is subordinate to the existing wrapped note);
(7) wraparound deed of trust securing payment of the wraparound note;
(8) wraparound agreement covering miscellaneous details of the wrap.
All required notices should be either personally signed for and dated by the recipient or sent by certified mail return receipt requested in order to prove that the notice was duly given.
The Wraparound Indebtedness
The wraparound indebtedness is to be distinguished from the wrapped indebtedness (which is the existing note to the seller’s lender—this is the indebtedness that is being wrapped).
The interest rate on a wrap note is often higher than that on the wrapped note since seller financing usually carries a rate slightly higher than market. Typical amortization is 15 or 30 years. In the past, most wrap notes were ballooned in 3 to 7 years, giving the investor a reasonably short time horizon for realizing a profit. However, Dodd-Frank now requires that the seller affirmatively determine that the buyer has the ability to repay before a balloon may be used.
A short-term note for part of the down payment may also be included. For example, the seller-lender might agree to accept $20,000 down—$10,000 at closing and $10,000 paid over the next 180 days. For this, one needs to add a down payment note to the above document list.
How is a wrap different from a contract for deed?
Contracts for deed belong to the general category of “executory contracts” which are real estate transfers where an important component of the transaction remains unaccomplished at closing. This unaccomplished part of an executory transaction is usually the execution and delivery to the buyer of a warranty deed (title) to the property.
Wraparounds are not executory contracts because they are fully accomplished (executed) at closing, including delivery of the warranty deed. In the event of default, the seller-lender must foreclose in order to get title to the property back, it not being sufficient to merely cancel the wrap. It is true that an existing lien is not being discharged (the wrapped note) but this does not prevent the transaction from being fully executed as to the immediate parties.
The Property Code was amended in 2005 to impose requirements and severe penalties on sellers in executory-contract transactions if strict rules are not followed. Now, for the first time, a portion of the executory-contract rules has been imported from the Property Code to the Finance Code and made specifically applicable to wraparounds. This is the “Section 5.061 notice” warning to the buyer that the property is encumbered by an existing lien that will not be paid at closing. Details of this required notice are discussed in part two of this article.
What about doing a wrap but delaying delivery of the deed to the buyer?
Some wraparound arrangements provide that the deed to the buyer will be held in escrow (perhaps by a lawyer) as security for a period of time—until the buyer pays in the full down payment, for instance. The wrap paperwork then states that the buyer is only leasing until the deed is delivered out of escrow. This is generally a bad idea. A material item of the transaction—the most material term, in fact—is unexecuted. Since the deal is unfinished, it not a completed wrap but an executory contract subject to Property Code requirements and penalties. These include a tie-in provision that makes violation of the executory-contract rules (found in Property Code Section 5.061 et seq.) also a violation of the Deceptive Trade Practices Act (the “DTPA,” located at Business & Commerce Code Section 17.50 et seq.).
Using a Security Deed
These are popular among wrap sellers though they are of dubious enforceability. The wrap buyer-borrower is given title at closing, as usual, but a “security deed” from the wrap buyer-borrower conveying the property back to the wrap seller-lender is also executed (but not recorded)—a variation of the deed in the drawer technique.
The idea is for the seller-lender to hold onto the security deed but only record it if the wrap buyer-borrower defaults. This would be done in lieu of going through a proper foreclosure pursuant to Chapter 51 of the Property Code. Problem is, the security deed may be an illegal “deed as mortgage” in violation of Chapter 21A of the Business & Commerce 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 unless a subsequent purchaser of the residential real estate, for valuable consideration, obtains an interest in the property after the deed was recorded without notice of the violation, including notice provided by actual possession of the property by the grantor of the deed. The residential real estate continues to be subject to the security interest of a creditor who, without notice of the violation, granted an extension of credit to a borrower based on the deed executed in violation of this section.
(c) A purchaser or borrower must bring an action to void a deed executed in violation of this section not later than the fourth anniversary of the date the deed was recorded.
(d) A purchaser or borrower who is a prevailing party in an action to void a deed under this section may recover reasonable and necessary attorney’s fees.
To date, there is no known case interpreting this statute in the context of a wraparound.
Remember, real estate investors are not the most beloved of persons in the halls of justice. The common perception is that investors are greedy predators exploiting the unfortunate. Juries are often happy to award treble damages and attorney’s fees against investors, so caution is in order when using creative techniques designed to work around statutory requirements. These seldom survive court scrutiny.
Isn’t a wrap the same thing as an assumption?
No. In an assumption, the buyer formally assumes the legal responsibility for paying the existing note. Sometimes this is done with the approval of the seller’s lender, paying an assumption fee, and signing onto the debt; more often, the promise to assume the existing debt is made directly (and only) to the seller by means of an assumption deed. Either way, it is expressly stated that the buyer is taking on the legal obligation of paying and discharging the first-lien note. This is not the case in a wrap, which is a “subject to” transaction. The wrapped first-lien note remains the sole and exclusive responsibility of the seller.
In a wrap, therefore, the first-lien note and the deed of trust securing it remain undisturbed. A new note (the wrap note) secured by a new wraparound deed of trust is created. In other words, there are two separate and independent sets of payment obligations. The seller-lender is obligated on the wrapped first-lien note until it is paid and released; and the buyer-borrower is obligated to the seller-lender on a new wrap note and wrap deed of trust. These obligations coexist and the property becomes subject to both liens.
What if there is more than one existing lien?
It is not uncommon to wrap more than one note and lien (e.g., a first and a second). The prior liens may even be to different lenders. The principle is the same: the buyer-borrower pays the seller-lender on the wraparound note, and the seller-lender then pays both prior notes. The lien securing the wraparound note is subordinate and inferior to both of the prior liens.
Example of a Wrap
Consider the example of 123 Oak Street which is valued at $100,000 but has been slow to move. There is a first lien in the amount of $50,000 to Apple Bank and a second lien in the amount of $25,000 to Orange Bank which, taken together, result in $25,000 equity. In the usual case, a purchaser would make a down payment and obtain third-party institutional financing, allowing the seller to receive his equity at closing and go happily on his way. But what if the buyer is unable to get traditional financing? The solution may be a seller-financed wrap note in a premium amount—say $110,000—which is subordinate to the notes due Apple and Orange Banks. The wrap note will likely bear a higher than market rate of interest. It will be secured by a wrap deed of trust that enables the seller to foreclose if the buyer-borrower defaults on the wrap note.
Is a wrap a device to get sub-prime buyers into homes?
Perhaps, but prudent investors will nonetheless require the buyer-borrower to have a substantial down payment. The seller-lender should evaluate and approve the buyer-borrower’s qualifications as would any other lender. In fact, Dodd-Frank requires this with its ability-to-repay (ATR) rule. A wraparound is a legitimate device to sell property to reasonably qualified buyers who have money to put down and can afford the monthly payments.
Can wraps be used in conjunction with land trusts?
Yes. There may be circumstances where it may be a good idea to first transfer the property into a land trust and then do a wrap, but this requires more complex documentation since a trust agreement will also have to be prepared. Expect higher attorney’s fees.
Are wraps just for homes?
No. Both residential and commercial wraps are possible. Commercial deeds of trust are more likely, however, to contain provisions that actually prohibit any transfer of title without prior lender consent. This contrasts with most residential due-on-sale clauses that only threaten possible acceleration if the borrower transfers title without lender consent, which is not the same as an outright prohibition. Also, seller-financing statutes and regulations pertaining to wraps do not apply to commercial wraparounds.
In all cases, but especially in commercial cases, one should carefully review the deed of trust securing the existing loan before proceeding with a wrap.
Why would a seller do a wrap?
A wrap seller can often sell at a higher-than-market price. The seller gets some cash today (the down payment) which either goes into the seller’s pocket or is used to reduce principal on the wrapped note (or a negotiable combination of both). The seller is then out from under the payment burden, although he or she must continue to be involved in the mechanics of collecting and forwarding payments to the first lienholder unless a third-party servicer is used. The seller also gets the benefit of any spread between the interest rate on the wrapped note and wraparound note.
Why would a buyer do a wrap?
That is an easy question. The buyer does not have to apply and qualify for a new loan, at least not immediately (The wraparound agreement may provide that the buyer must refinance the wraparound loan within a certain period). The buyer gets both title and immediate possession without lengthy application delays, expensive loan fees, and closing costs.
Why would a broker encourage a wrap transaction?
Firstly, the wrap transaction may meet the objectives of the broker’s client, and the broker is under a fiduciary obligation to see that this occurs. Secondly, the buyer’s down payment supplies cash for the broker’s commission to be paid at closing just as with a conventional transaction.
Closing the Wrap: Is Title Insurance Available?
Yes, and a title company closing is now the preferred way to go since Finance Code Sec. 159.105 was amended to state that a lien securing a wrap mortgage loan is void unless the wrap mortgage loan and the conveyance of the residential real estate securing the loan are closed at a title company or in an attorney’s office.
Some title companies are more inclined to insure wraps than others. It may be necessary to shop title companies until a wrap-friendly title company is found. Be prepared to meet any additional underwriting requirements they may impose.
If a buyer-borrower wants an owner’s policy of title insurance, then closing will be held either at a title company or at the office of a fee attorney acting as agent for a title company. Now that regulation of wraps has been significantly expanded, this is actually better for everyone, especially since fewer attorneys are willing to become involved with wraps because of increased regulation and liability.
Isn’t a wrap a breach of contract with the lender? What about the due-on-sale clause?
A wrap transaction is neither a breach of contract nor a violation of the most commonly used residential due-on-sale clause (found at paragraph 18 of the FNMA deed of trust). This clause merely gives the lender an option to take action if it chooses. In other words, it says that a lender may (not must) accelerate. Transfer of title is not prohibited outright and lender may pursue action at the lender’s discretion.
Mortgage lenders are not usually interested in foreclosing upon a performing loan on merely technical grounds such as transfer of title by the borrower. However, some will send irate letters demanding that the new owner apply and qualify to assume the loan, threatening that the property could be posted for foreclosure. Even so, statistically speaking, actual acceleration of a performing loan based on due-on-sale seldom happens in today’s environment. However, this status quo could change as interest rates climb higher and lenders acquire an incentive to call due low-interest loans and replace them with loans providing a higher return.
What kind of down payment should the seller get on a wrap?
Down payments are an underwriting issue. In the case of a wrap, the seller is also the lender and (like any lender) should carefully consider the risks inherent in the transaction as well as the borrower’s creditworthiness and ability to repay—all of which should be examined before determining the amount of down payment and what interest rate to charge. Dodd-Frank requires such due diligence. Regardless of the borrower’s qualifications, it is likely that wraps with no down payment will fall within the risky category and be of questionable legality under Dodd-Frank.
Can part of the down payment be financed? Yes. There is no prohibition against it. Typically, the buyer-borrower would pay part of the down payment at closing and then promise to pay the balance within a short period—say 90 to 180 days—utilizing a second wrap note (a down-payment note). Again, this is an underwriting issue for the seller-lender but it is a common enough practice.
What if both notes are due on the first of the month?
The timing of payments is an issue and should be addressed in both the wraparound note and the wraparound agreement. It is a good idea to schedule payments on a wrap note seven to ten days before payments are due on the wrapped note to allow time for the seller-lender to collect payments from the buyer-borrower and then forward the funds to the wrapped lender in a timely manner.
What about casualty insurance on the property?
Sellers in wrap transactions nearly always want to cancel their casualty insurance policy. This is inadvisable. The wrapped lender, which usually collects an escrow or at the very least is named as additional insured, will be notified of the cancellation. The seller will then get a default letter from the wrapped lender who will “force place” another policy (usually a more expensive one) at the seller’s expense. The existing policy should therefore be left alone and the buyer should obtain his own policy. This appears to be an unavoidable imperfection in the wraparound process.
There is also an issue relating to the concept of “insurable interest.” What happens if there is a loss? Collecting on the seller’s insurance policy can be problematic since title to the property changed hands at closing of the wrap. The owner of record is now the wrap buyer-borrower, but the old policy names the seller-lender as loss-payee. Even if the seller agrees to make a claim on behalf of the buyer, the insurer may refuse to pay it, asserting that the seller no longer owns the property and thus no longer has an insurable interest. Worse, this could potentially be construed as insurance fraud.
For both of the above reasons, a wrap buyer-borrower should procure separate casualty and contents insurance, and any claims that arise should be made pursuant that policy. It is unfortunate that this results in two policies but there may be no reliable way around it. It is also in the wrap seller-lender’s best interest that this occur in order to ensure that a viable policy exists that may be collected upon in the event of damage to the property.
This is the reason that the Finance Code requires that wrap buyer-borrowers be warned about potential insurance pitfalls in wraparounds. See Finance Code Section 159.101 discussed at length in part two.
The subject of insurance should be thoroughly addressed in the wraparound agreement.
What about “double wraps”?
So long as the wrap deed of trust permits it, a wrapped loan can be wrapped and wrapped again, although the documentation can become prolific. This permits an investor to purchase property on a wrap and then sell it the same way (likely at a higher price and interest rate), collecting a down payment (the investor’s front-end profit) from a new buyer in the process. Usually, this new buyer commits to go through credit repair with the goal of paying off the wrap note early, at which time the investor gets his back-end profit.
Substitution of Collateral Clauses
Some investor-buyers on a wrap include a “substitution of collateral clause” in their wrap notes allowing for the property to be freed from the wrap lien so long as a different property of reasonably equivalent value is substituted in its place. If the wrap buyer-borrower is a real estate investor with multiple properties this could be a useful strategy so such a clause should be included.
What if the buyer defaults on the wrap note?
In a wraparound, the seller-lender receives a wrap deed of trust that enables the seller-lender to foreclose if the buyer-borrower defaults in payment of the wrap note. The seller-lender can also seek and obtain a deficiency judgment if the sales price at foreclosure is insufficient to discharge the wrap note including accrued interest and fees. Accordingly, the seller-lender has the same ability to enforce the wrap note and lien as does any other lender. The foreclosure of a wrap is no different from foreclosing on any other ordinary deed of trust lien. The same process applies.
Texas is fortunate to have an expedited non-judicial foreclosure process. Property Code Section 51.002 requires that a homeowner be given at least a 20-day notice of default and intent to accelerate the note if the default is not timely cured. If the deed of trust is on the FNMA form (which would be unusual for a wrap) then a 30-day notice and opportunity to cure is required. The default notice must be followed by a second letter stating that since the default was not cured, the note is being accelerated and the property is being posted for foreclosure. This second notice must be given at least 21 days before the first Tuesday of the month in which the foreclosure will be held. So most Texas residential foreclosures take a minimum of 41 days—51 days if a FNMA deed of trust is involved—although one should always avoid cutting it close when it comes to legal notices. It is prudent to allow a cushion.
What if the seller-lender defaults by not paying the wrapped lender?
The wrap agreement should provide that if the seller-lender fails to make payments to the wrapped lender, the buyer-borrower may do so and receive credit against the wrapped note. The buyer-borrower should also have the power to request documentary proof from the seller-lender that the wrapped note is current.
Note that Finance Code Section 159.202 gives the buyer-borrower a “right to deduct” if the wrapped lien is not being timely paid by the seller-lender. See part two for details.
Two related situations are of interest: what happens if the seller (1) files bankruptcy and seeks discharge of the wrapped debt, or (2) dies leaving the wrapped debt unpaid? In either case, the buyer-borrower could be forced to refinance the debt on short notice, which may be challenging. In the case of seller bankruptcy, the seller-lender should agree to execute a reaffirmation agreement on the wrapped debt rather than surrendering the property to the wrapped lender. As for premature death, the buyer-borrower should check to see if the seller-lender has or can add term life protection (payoff insurance). If not, the buyer-borrower might consider obtaining a term life insurance policy on the seller-lender in the amount of the balance on the wrapped debt. These details can be addressed in the wraparound agreement.
What about the interest deduction?
The seller continues to be able to deduct interest paid on the wrapped loan. Nothing has changed there. As to interest on the wrap note, interest received by the seller-lender must be reported as income, and interest paid by the buyer-borrower is deductible.
What are the disadvantages of a wrap?
There are shortcomings to a wrap. For instance, the seller-lender has to wait until the wrap note matures in order to receive the full proceeds of the sale. Also, the wrapped loan is frozen in place and cannot be refinanced for the duration of the wrap. Unless the seller-lender utilizes a third-party servicer, the seller-lender must collect and remit payments, which requires ongoing involvement. If the wrap buyer-borrower defaults, the seller-lender must foreclose. In the unlikely event a loan is accelerated, the buyer-borrower may have to quickly secure traditional financing, so the wraparound agreement should specify the amount of time in which this must be done. Finally, as noted previously, the parties may also be carrying duplicate casualty insurance policies.
Some caution is in order as to the duration (term) of the wraparound note. Statistically, the wrap is more likely to be successful the longer the time the borrower has to find substitute financing. Wraps with a two-year balloon have a high mortality rate.
Wraparounds are useful devices, but they are not perfect.
Going Forward with a Wrap
A properly drafted wraparound transaction will include at least four core legal documents—a warranty deed, a wraparound deed of trust, a wrap note, and a wraparound agreement to address the details. In addition, two statutory notices are required, one to alert the buyer-borrower that there is an existing unpaid lien (Fin. Code Sec. 101(a)(1)) and the other to warn of potential insurance coverage problems (Fin. Code Sec. 159.101(a)(2)). There may also be a down-payment note involved. These are sophisticated documents that should be customized for the specific transaction. Wraps are certainly not an area where real estate investors should be using dubious Internet templates, particularly considering new enforcement regulations. Only a qualified real estate attorney experienced in preparing wrap documents should draft this paperwork. Also, because there is no TREC or Texas Realtors addendum promulgated specifically for wraps, it is recommended that an attorney-prepared custom wraparound addendum be attached to the TREC 1-4 earnest money contract.
PART TWO: REGULATION OF WRAPAROUND TRANSACTIONS
Law and rules applicable to wraparounds range across the Texas Finance Code, the Texas Property Code, the Safe Act (both federal and state versions), Dodd-Frank, rules made by the Texas Department of Savings and Mortgage Lending, and regulations promulgated by the federal Consumer Financial Protection Bureau. If one is a real estate license holder, then aspects of the Real Estate License Act and TREC rules could come into play. And, as is the case with all consumer transactions, there is the Deceptive Trade Practices Act to contend with. Engaging in a wrap transaction is therefore not for the faint of heart when it comes to legal compliance.
The Texas Finance Code and Wraparound Transactions
The Texas Finance Code (“TFC”) has been significantly amended to beef up coverage of wraparound transactions. Licensing and registration requirements for wrap sellers were added in 2022, as were disclosure requirements, investigation and enforcement provisions, and an administrative penalty.
The Department of Savings and Mortgage Lending (subject to the oversight and under the jurisdiction of the Texas Finance Commission) is charged with adopting and enforcing rules necessary for investigation and enforcement of the statute addressing wraparound loans (Chapters 156 through 159 of the Finance Code). These rules may be found in Chapter 78 of the Texas Administrative Code and are posted on the secretary of state’s website.
The TFC covers wraparound mortgages in Chapters 156 through 159. Requirements relating to wraparounds (including registration and licensing) apply to all lenders and loan originators unless they are specifically made exempt. Section 159.051 states:
A person may not originate or make a wrap mortgage loan unless the person is licensed or registered to originate or make residential mortgage loans under Chapter 156, Chapter 157, or 342 [of the Finance Code] or is exempt from licensing or registration as provided under an applicable provision of those chapters.
Definition of a Wraparound Transaction
Chapter 159 of the Finance Code, entitled “Wrap Mortgage Loan Financing,” broadly applies to all residential wraps unless it expressly says otherwise.
What qualifies as a wraparound transaction according to the TFC? Section 159.001(7) states that a wraparound mortgage loan is “a residential mortgage loan made to finance the purchase of residential real estate that will continue to be subject to an unreleased lien that attached to the residential real estate before the loan was made; and secures a debt incurred by a person other than the wrap borrower that was not paid off at the time the loan was made; and obligating the wrap borrower to the wrap lender for payment of a debt the principal amount of which includes the outstanding balance of the debt and any remaining amount of the purchase price financed by the wrap lender.” This definition is conventional and consistent our ordinary understanding of what constitutes a wrap.
Statutory Exemptions to Wraparound Regulation
A quick reading of the statute makes it clear that Finance Code Chapters 156 through 159 specifically target real estate investors who use creative wraparound financing in the sale of a substantial number of single-family homes (three or more) each year.
The statute does not apply to unimproved residential real estate (defined as residential real estate on which a dwelling has not been constructed) so long as the holder of [the] unreleased lien has consented to the sale of the residential real estate. . . .” TFC Sec.159.002 (a) and (b).
The statute does not apply to “a sale of residential real estate that is the wrap lender’s homestead.” TFC Sec. 159.002(b)(2).
As with Dodd-Frank and the SAFE Act, a broad de minimis rule applies. This exempts any owner of residential real estate who in any twelve consecutive-month period makes no more than three residential mortgage loans to purchasers of property for all or part of the purchase price of the residential real estate against which the mortgage is secured. Note that this would include any form of seller financing, not just wraparounds. TFC Sec. 157.0121(c)(2) and 159.003(4).
Lenders and loan originators are exempt from the rules if they are federally-regulated lenders, non-profits, licensed mortgage brokers, or Section 501(c)(3) organizations. Employees of these organizations are also exempt.
The statute anticipated that creative wrap seller-lenders and their attorneys would attempt to run around the de minimis rule by setting up entities for that purpose, so it provides specifically that one may not exceed the number of seller-financed transactions (including wraps) allowed under the de minimis rule by utilizing an LLC or other entity as a front for doing additional wraps. The rules apply in a combined way to an individual as well as that person’s affiliated entities: “In determining eligibility for an exemption under Subsection (a-1)(3), two or more owners of residential real estate are considered a single owner for the purpose of computing the number of mortgage loans made within the period specified by that subdivision if any of the owners are an entity or an affiliate of an entity, including a general partnership, limited partnership, limited liability company, or corporation. . . .” TFC Sec. 157.0121(f) and 159.003(b).
Disclosures Required for Wraparound Transactions
A wrap lender must, on or before the seventh day before the wrap mortgage loan agreement is entered into, provide to the wrap borrower a separate written disclosure statement in at least 12-point type that discloses details relating to the existing loan to be wrapped plus a warning that insurance coverage can be problematic. TFC Sec. 159.101.
Two disclosure notices are actually required. The first required notice borrows language from Section 5.016 of the Property Code and requires including the following:
WARNING: ONE OR MORE RECORDED LIENS HAVE BEEN FILED THAT MAKE A CLAIM AGAINST THIS PROPERTY AS LISTED BELOW. IF A LIEN IS NOT RELEASED AND THE PROPERTY IS CONVEYED WITHOUT THE CONSENT OF THE LIENHOLDER, IT IS POSSIBLE THE LIENHOLDER COULD DEMAND FULL PAYMENT OF THE OUTSTANDING BALANCE OF THE LIEN IMMEDIATELY. YOU MAY WISH TO CONTACT EACH LIENHOLDER FOR FURTHER INFORMATION AND DISCUSS THIS MATTER WITH AN ATTORNEY.
This generic notice must be accompanied by additional details specific to the subject transaction: (1) an identification of the property; (2) the name, address, and phone number of each wrapped lienholder; (3) the amount of debt that is secured by each existing lien; (4) a summary of the terms of any contract or law under which the existing loan to be wrapped is secured including the interest rate, the amount of monthly payments, and the account number; (5) the details of any insurance policy relating to the property including the name of the insurer and insured as well as the amount for which the property is insured; and (6) the amount of the property taxes. It must also be stated clearly whether or not the existing lienholder (the wrapped lender) has consented to the wraparound (even though, as previously discussed, lender consent is not technically required in most residential deeds of trust).
The second disclosure notice required by TFC Sec. 159.101 concerns property insurance. This notice must include a statement that is substantially similar to the following:
ANY INSURANCE MAINTAINED BY A SELLER, LENDER, OR OTHER PERSON WHO IS NOT THE BUYER OF THIS PROPERTY MAY NOT PROVIDE COVERAGE TO THE BUYER IF THE BUYER SUFFERS A LOSS OR INCURS LIABILITY IN CONNECTION WITH THE PROPERTY. TO ENSURE THE BUYER’S INTERESTS ARE PROTECTED, THE BUYER SHOULD PURCHASE THE BUYER’S OWN PROPERTY INSURANCE. BEFORE PURCHASING THIS PROPER-TY, YOU MAY WISH TO CONSULT AN INSURANCE AGENT REGARDING THE INSURANCE COVERAGE AVAILABLE TO YOU AS A BUYER OF THE PROPERTY.
The lien and insurance disclosures required by TFC Sec. 159.101 must be given to the wraparound buyer-borrower on or before the seventh day before the wrap mortgage loan agreement is entered into. It must be dated and signed by the wraparound borrower when the wrap borrower receives the statement.
Query: When is the wrap transaction “entered into?” When the earnest money contract is signed or when the transaction is closed? This is unclear, but the more likely interpretation is that the statute intended for this to mean closing.
There is also a foreign language requirement. If negotiations preceding execution of the wrap closing documents are conducted primarily in a language other than English, the wrap seller-lender must provide the required disclosures in the language to the wrap buyer-borrower. Fin. Code Sec. 159.102.
The Department of Savings and Mortgage Lending has promulgated a model disclosure statement that may be found on the agency’s website.
Wrap Buyer-Borrower’s Rights of Recission
There are several specific recission rights granted by TFC Sec. 159.104:
Disclosures Timely Provided—Right of Recission. If the required disclosures are timely given and received prior to closing, the wrap buyer-borrower may rescind the transaction not later than the 7th day after the date of receipt of the disclosure statement.
Failure to Provide Disclosures—Right of Recission before Closing. If the required disclosures are not given and received before closing, the wraparound borrower may rescind the wrap mortgage loan agreement and the related purchase agreement at any time by providing the wrap lender notice of rescission in writing.
Failure to Provide Disclosures—Right of Recission after Closing. If the required disclosures are given and received by the wrap buyer-borrower after closing (but before any notice of recission is given) then the wrap buyer-borrower may rescind the wrap transaction in writing on or before the 21st day after the date of receipt of the disclosures. The wrap seller-lender must pay to the wrap buyer-borrower as damages for noncompliance the sum of $1,000 plus any reasonable attorney’s fees incurred by the wrap buyer-borrower.
Recission Amounts Due to the Wrap Buyer-Borrower. Upon recission, and not later than the 30th day after the date of recission, the wrap buyer-borrower is entitled to the return of any earnest money, escrow amounts, down payment, and other fees or charges that have been paid to the wrap seller-lender. TFC Sec. 159.101(d).
Avoidance of Recission by Wrap Seller-lender. Notwithstanding the above, the wrap seller-lender may avoid recission if not later than the 30th day after receiving the recission notice, the wrap seller-lender entirely pays off the wrapped loan (no mention is made of providing or recording a release of lien); pays any taxes due on the property; and pays to the wrap buyer-borrower $1,000 plus reasonable attorney’s fees. The wrap seller-lender is required to provide evidence of the foregoing actions. TFC 159.104(e)(1-4).
Tolling of the Statute of Limitations. If a wrap seller-lender fails to provide the disclosure statement as required by Section 159.101 or fails to provide disclosures in the language required by Section 159.102, the limitations period applicable to any cause of action of the buyer-borrower against the wrap seller-lender arising out of the wrap seller-lender’s violation in connection with the wrap transaction is tolled until the 120th day after the date the required disclosure statement is provided. TFC Sec. 159.103.
On the date when all funds are returned to the wrap buyer-borrower, the buyer-borrower shall re-convey the property to the wrap lender or its designee and surrender possession within 30 days. TFC Sec. 159.104(d). This provision has the effect (perhaps inadvertent) of stipulating the date on which the re-conveyance must be effective.
Rights of Wrap Buyers-Borrowers: The Right to Deduct
The “buyer’s rights” section of the Finance Code applies only to wrap loans made for the purchase of residential real estate to be used as the wraparound borrower’s residence. TFC Sec.159.201. Three important items are included in this section:
(1) Right to Deduct. The Finance Code allows the wrap buyer-borrower a “right to deduct” in the event that the wrapped lender is not being timely paid. TFC Sec. 159.202 provides that the “wrap borrower, without taking judicial action, may deduct from any amount owed to the wrap lender under the terms of the wrap mortgage loan: (1) the amount of any payment made by the wrap borrower to an obligee of a debt described by Section 159.001(7)(A)(ii) to cure a default by the wrap lender caused by the lender’s failure to make payments for which the lender is responsible under the terms of the wrap mortgage loan; or (2) any other amount for which the wrap lender is liable to the wrap borrower under the terms of the wrap mortgage loan.”
This provision is meaningful only if the wrap buyer-borrower has a means of ascertaining the status of the wrapped loan (the online login information, for instance). Otherwise, the wrap buyer-borrower may not be aware of any default issues with the wrapped loan until the property is posted for foreclosure by the wrapped lender—or worse, when a constable serves a forcible detainer (eviction) action after foreclosure has occurred.
Interestingly, the right-to-deduct provision does not require the wrap buyer-borrower to apply deducted funds to the cure of a default under the wrapped mortgage loan. Assuming, however, that the wrap buyer-borrower does so, then the “right to deduct” provision becomes the equivalent of a “right to cure” for purposes of avoiding foreclosure on the home.
(2) Fiduciary Duty. Collection of payments from a wrap buyer-borrower is subject to a fiduciary duty owed by wrap seller-lender to the wrap buyer-borrower. TFC Sections 159.151 and 159.152 state: “A person who collects or receives a payment from a wrap borrower under the terms of a wrap mortgage loan holds the money in trust for the benefit of the borrower. . . . A person who collects or receives a payment from a wrap borrower under the terms of or in connection with a wrap mortgage loan owes a fiduciary duty to the wrap borrower to use the payment to satisfy the obligations of the obligee under each [wrapped loan as well as] the payment of taxes and insurance for which the wrap lender has received any payments from the wrap borrower.”
It has long been a concern of residential wrap buyer-borrowers that the wrap seller-lender may not use monthly payments on the wrap note to discharge the underlying wrapped lien. The duty of the wrap seller-lender to make payments on the underlying loan is usually taken for granted as if it were a negligible term—when it is in fact at the very core of the wraparound relationship. However, absent a provision in a wrap agreement, the wrap seller-lender previously had no express duty in this area. The 2022 amendments to the Finance Code attempt to cure this problem by adding the right to deduct.
Query: Why not just expressly state that the wrap seller-lender has an affirmative duty to use the wrap buyer-borrower’s monthly payments for the purpose of paying down the wrapped loan? Or did the statute drafters believe that imposing a fiduciary duty would cover this issue? In any case, a well-drafted wraparound agreement will make this duty clear.
(3) Waivers Prohibited. Any purported waiver of a wrap buyer-borrower’s rights or purported exemption of a person from liability for violation of the above rules (no matter how cleverly worded) is void. “A person who is a party to a residential real estate transaction may not evade the application of this subchapter by any device, subterfuge, or pretense, and any attempt to do so is void and a deceptive trade practice. . . .” TFC Sec. 159.107. The tie-in with the DTPA gives this provision extra power since the DTPA broadly prohibits “any unconscionable act or practice”—something easily found by jurors when they want to punish a defendant. Bus. & Com. Code Sec. 17.50 et seq.
When combined, the right to deduct, the lender’s fiduciary duty, and the “no waiver” provision go a long way toward redressing the disparity of rights and power that has previously been inherent in Texas wraparound transactions.
Remedies of Wrap Buyers-Borrowers
If wrap provisions of the Finance Code are violated, a wrap buyer-borrower may bring a lawsuit against the wrap seller-lender to: (1) obtain declaratory or injunctive relief to enforce Code provisions; (2) recover any actual damages suffered by the wrap buyer-borrower as a result of the violation; or (3) obtain other remedies by using the Deceptive Trade Practices Act, which is a very significant weapon in the hands of a competent plaintiffs’ attorney. The wrap buyer-borrower who prevails in a suit against the wrap seller-lender may recover court costs and reasonable attorney’s fees. Finance Code Sec. 159.106.
An additional remedy (of sorts) is the ability of the wrap buyer-buyer to report a violation to the Department of Savings and Mortgage Lending which may then launch an investigation, although this remedy is limited by Sec. 159.251 to registered wrap lenders—a puzzling and unfortunate limitation. The investigatory process is outlined in Sec. 159.252(a):
The commissioner may conduct an inspection of a wrap lender registered under Chapter 158 as the commissioner determines necessary to deter-mine whether the wrap lender is complying with that chapter and applicable rules. The inspection may include an inspection of the books, records, documents, operations, and facilities of the wrap lender. The commissioner may share evidence of criminal activity gathered during an inspection or investigation with any state or federal law enforcement agency. (b) For reasonable cause, the commissioner at any time may investigate a wrap lender registered under Chapter 158 to determine whether the lender is complying with that chapter and applicable rules. (c) The commissioner may conduct an undercover or covert investigation only if the commissioner, after due consideration of the circumstances, determines that the investigation is necessary to prevent immediate harm and to carry out the purposes of Chapter 158. (d) The finance commission by rule shall provide guidelines to govern an inspection or investigation under this section, including rules to: (1) determine the information and records of the wrap lender to which the commissioner may demand access during an inspection or investigation; and (2) establish what constitutes reasonable cause for an investigation. (e) Information obtained by the commissioner during an inspection or investigation under this section is confidential unless disclosure of the information is permitted or required by other law. (f) The commissioner may share information gathered during an investigation under this section with a state or federal agency. The commissioner may share information gathered during an inspection with a state or federal agency only if the commissioner determines there is a valid reason for the sharing. (g) The commissioner may require reimbursement of expenses for each examiner for an on-site examination or inspection of a registered wrap lender under this section if records are located out of state and are not made available for examination or inspection by the examiner in this state. The finance commission by rule shall set the maximum amount for the reimbursement of expenses authorized under this sub-section.
Information obtained during an investigation may be shared with “a state or federal agency.” TFC Sec. 159.252(f). The clear implication here is that the Commission may make criminal referrals to state and federal prosecutors. This continues the decades-long trend in U.S. law of effectively criminalizing offenses that were previously civil in nature.
During an investigation, a subpoena may be issued requiring a person to give a deposition, produce documents, or both. If a person disobeys the subpoena, refuses to appear for a deposition, or refuses to testify, the Department of Savings and Mortgage Lending may turn to the Travis County District Court for assistance, specifically a court order requiring the person to obey the subpoena, testify, or produce documents. This provision opens an important door to enforcement by means of judicial contempt (fine or imprisonment). TFC Sec. 159.253(b). Although contempt in this event would be a civil and not a criminal matter, a real estate investor sitting in jail could be forgiven for not appreciating the difference.
Cease and Desist Order; Administrative Penalty
If there is reasonable cause to believe that a wrap lender or wrap mortgage loan originator is in violation, then TFC Sec.159.301 provides for a cease and desist order and an administrative penalty:
[The Finance Commissioner] may issue without notice and hearing an order to cease and desist from continuing a particular action or an order to take affirmative action, or both, to enforce compliance with this chapter. (b) An order issued under Subsection (a) must contain a reasonably detailed statement of the facts on which the order is made. If a person against whom the order is made requests a hearing, the commissioner shall set and give notice of a hearing before the commissioner or a hearings officer. The hearing shall be governed by Chapter 2001, Government Code. Based on the findings of fact, conclusions of law, and recommendations of the hearings officer, the commissioner by order may find a violation has occurred or not occurred. (c) If a hearing is not requested under Subsection (b) on or before the 30th day after the date on which an order is made, the order is considered final and not appealable. (d) The commissioner, after giving notice and an opportunity for hearing, may impose against a person who violates a cease and desist order an administrative penalty in an amount not to exceed $1,000 for each day of the violation. In addition to any other remedy provided by law, the commissioner may institute in district court a suit for injunctive relief and to collect the administrative penalty. A bond is not required of the commissioner with respect to injunctive relief granted under this sub-section.
Exemptions from Investigation and Enforcement
TFC Section 180.003 provides that certain persons are exempt from the investigation and enforcement provisions: (1) a registered mortgage loan originator when acting for a licensed entity; (2) an individual who offers or negotiates terms of a residential mortgage loan on behalf of an immediate family member; (3) a licensed attorney who negotiates the terms of a residential mortgage loan on behalf of a client as part of the attorney’s representation of the client, unless the attorney either takes a residential mortgage loan application or offers or negotiates the terms of the residential mortgage loan (It is better for attorneys to stay away from “negotiating” wrap loans altogether); (4) an individual who offers or negotiates terms of a residential mortgage loan secured by lien on the individual’s residence; (5) an owner of residential real estate who in any 12-consecutive-month period makes no more than three seller-financed residential mortgage loans; and (6) an owner of a dwelling who in any 12-consecutive-month period makes no more than three seller-financed residential mortgage loans.
The same “rule against combinations” (as good a name as any) applies as elsewhere in the statute, i.e., “two or more owners of residential real estate are considered a single owner for the purpose of computing the number of mortgage loans made within the period specified by that subdivision if any of the owners are an entity or an affiliate of an entity, including a general partnership, limited partnership, limited liability company, or corporation. . . .” TFC 180.003(d). Thus setting up additional entities solely for the purpose of evading Finance Code transactional limitations is to no avail.
Property Code Section 5.016: The 7-Day Notice
Property Code Section 5.016 is entitled “Conveyance of Residential Property Encumbered by Lien.” Since this is exactly what wraparounds do, this statute is directly applicable. It 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, which makes this a rather odd law. Lender notices, often sent to the loan servicer, generally produce no response.
Exceptions are made for certain transfers including from one co-owner or spouse to the other. Property Code Section 5.016(c)(10) also provides an exception to the notice requirement when “the purchaser obtains a title insurance policy insuring the transfer of title to the real property.” Thus if you close at a title company you may dispense with seven-day notices. Investors who are “pros” in the business (defined as those who have “purchased, conveyed, or entered into contracts to purchase or convey real property four or more times in the preceding 12 months”) need not be given the notice. Prop. Code Sec. 5.016(c)(11).
The buyer’s opportunity for failure to give the seven-day notice is an exclusively pre-closing remedy. There is no right of rescission after closing on this basis once closing has occurred.
SAFE Act, T-SAFE, and Dodd-Frank
Since wraps are a form of seller financing, any law that applies to seller financing applies to wraps. Federal laws on this subject include the SAFE Act (or T-SAFE as it is implemented in Texas) and Dodd-Frank.
The SAFE Act imposes a licensing requirement on certain types of seller financing extended by persons who are regularly engaged in offering such financing in the sale of residences. A seller-lender is required to be licensed as an RMLO if the property is not the seller’s homestead and/or if the sale is not to a family member. So, if the property is a rental house (i.e., not the seller’s homestead) that is being sold to a non-family member, then the seller is required to have an RMLO license, which requires training, a background check, and an exam. This licensing rule applies only to residential wraps and is not applied to persons making three or fewer seller-financed residential loans in a year.
Dodd-Frank overlaps the SAFE Act in regulatory intent and effect. It requires that a seller-lender in a residential seller-financed transaction (including wraps) determine at the time credit is extended that the buyer-borrower has the ability to repay the loan (the “ATR rule”). The ATR rule obligates the seller to investigate the buyer-borrower’s credit history, current and expected income, financial obligations, debt-to-income ratio, employment status, and the like in order to make a determination that a buyer-borrower has the reasonable ability to repay.
Dodd-Frank provides for a de minimis exception for persons doing no more than three owner-financed transactions per year (so long as the seller-lender is not in the building business)—but (1) the seller must take thorough steps to determine that the buyer has a reasonable ability to repay; and (2) 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 caps. CFPB Reg. Sec. 1026.36(a)(4). In its comments to the rule, CFPB states that “A person in good faith determines that the consumer to whom the person extends seller financing has a reasonable ability to repay the obligation if the person complies with Sec.1026.43(c) [by considering] evidence of the [buyer-borrower’s] current or reasonably expected income.” Evidence of compliance with the ATR rule should always be retained in the seller’s file as a defensive measure against potential future lawsuits.
Dodd-Frank is a hugely complex law and continues to undergo interpretation and rule-making by the Consumer Financial Protection Bureau (CFPB). These rules are a challenge to understand, interpret, and apply—even for experienced attorneys who focus in this area.
Future Rules Relating to Wraparounds
As is the case with many statutes, Chapters 156 through 159 of the Finance Code delegate rulemaking authority to an administrative agency—in this case the Department of Savings and Mortgage Lending under the jurisdiction of the Finance Commission. The general tendency of administrative agencies to take the rulemaking ball and run with it by producing a plethora of regulations is well established at both the state and federal levels (The federal Consumer Financial Protection Bureau is a prime example). Wrap transactions may still be done in Texas after the 2022 statutory amendments, but carefully and with attention to both the statute and the rules designed to enforce it. More such rules will inevitably be released in the years to come, making this a challenging area for all involved—whether they be real estate investors. lenders, title companies, or attorneys.
In many ways, these developments are reminiscent of the approach the legislature took in cracking down on executory contracts in 2005. The net effect of that legislation was to drastically reduce the number of such transactions and substantially increase the risk for everyone involved in them. The same forces are now in effect when it comes to wraparounds. This should not necessarily be viewed as a negative development. As was the case with executory contracts, the world of wraparounds has historically been full of abuse due to a fundamental power imbalance between seller and buyer. The Finance Code attempts to redress that inequity. The degree to which it is effective in doing so without eliminating wraparounds entirely remains to be seen.
Information in this article is provided for general informational and 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 expressly retained in writing to do so.
Copyright © 2023 by David J. Willis Attorney. 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.