DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
EXECUTORY CONTRACTS IN TEXAS REAL ESTATE
by David J. Willis, J.D., LL.M.
Contracts for deed, lease-purchases, and lease-options have been traditional tools of Texas residential real estate investors. Why? Because it was easy to get tenant/buyers into such arrangements (only a minimal down payment was required) and it was relatively easy to get them out through the forcible detainer (eviction) process if they defaulted (See our companion article, Evictions in Texas). No longer. Since 2005, these devices are considered "executory contracts" and are heavily regulated under Chapter 5 of the Texas Property Code. The lender, if any, must give consent. Numerous initial and ongoing requirements must be observed, and the burden is on the seller to meet these. Violation by the seller "entitles the purchaser to cancel and rescind the executory contract and receive a full refund of all payments made to the seller." This "does not limit the purchasers remedy against the seller" (i.e., treble damages plus attorney´s fees)" if the buyer also makes a claim under the Deceptive Trade Practices-Consumer Protection Act ("DTPA"). Add up the numbers. You can see that the potential downside is significant – and the statute contains no defenses for well-meaning sellers who thought they were giving the buyer a good deal, even if the whole arrangement was the buyer´s idea in the first place.
Accordingly, the new risks to the seller of engaging in executory contracts have discouraged and nearly eliminated their use. Investors have moved away from these devices in favor of wraparounds (see Wraparound Transactions in Texas), land trusts ("exit trusts" as we call them – see Land Trusts in Texas), and lease-options with "stacked" purchase options that are effective for 180 days or less (although these are risky – see Lease-Options in Texas).
What exactly is an executory contract?
Executory contracts include any transaction that defers some material action by either party that pertains to ownership or possession of real property into the future. Think of it this way: an "executed" contract is one that is fully performed at closing. It is done, finished. An "executory" contract, on the other hand, leaves something dangling. Usually the dangling item is the most important item of all, namely, who owns the property and when do they get title? The classic executory contract is the contract for deed, also referred to as a land sales contact, which provides that the buyer gets a deed (title) to the property after making payments over a period of years. All such devices now fall under the extensive rules and regulations of Sec. 5.061 et seq. of the Property Code.
Contracts for deed, lease-purchases, and lease-options for longer than 180 days are unambiguously defined as "executory contracts." Look at Section 5.062(a)(2) of the Property Code: "An option to purchase real property that includes or is combined or executed concurrently with a residential lease agreement, together with the lease, is considered an executory contract for conveyance of real property." The "180 days or less" exemption exists as an accommodation to real estate brokers, because – otherwise – the residential sales contract promulgated by the Texas Real Estate Commission would violate this provision when combined with the TREC temporary lease.
Changes to the Investor Environment
Why did the Texas legislature make these changes? Because executory contracts had traditionally given a tremendous advantage to the seller, who technically retained "legal title" to the property. The buyer, on the other hand, had only "equitable title" which required filing an expensive lawsuit to enforce. Buyers under financial pressure were therefore more likely to abandon the property (along with their down payments) and move on.
In the past, unscrupulous sellers and investors used this situation to their advantage. They disregarded the buyer´s equitable rights, representing to Justices of the Peace that such buyers were ordinary tenants subject to ordinary leases, obtaining evictions for minor or technical defaults, and often confiscating large down payments in the process. The seller was then free to move on to his next "victim" and obtain another down payment. The legislature rightly acted to stop such abuse.
Executory Contracts: Requirements for Validity
Make no mistake, one can still do a transaction by means of an executory contract – but many requirements now exist that did not apply before the 2005 revisions to the Property Code. Sections 5.069 and 5.070 contain a number of these requirements, which must be met before the executory contract is signed by the purchaser (i.e., before and not at closing):
5.069(a) (1) requires that the seller provide the purchaser with a survey which is no older than a year, or a current plat. This section also requires the seller to notify the buyer that there "are no restrictive covenants, easements, or other title exceptions or encumbrances that prohibit construction of a house on the property. An additional notice is required advising the buyer to "obtain a title abstract or title commitment covering the property and have the abstract or commitment reviewed by an attorney before signing a contract of this type, and purchase an owner´s policy of title insurance covering the property."
5.069(a)(2) requires that the seller provide the purchaser with copies of liens, restrictive covenants, and easements affecting the property.
5.069(a)(3) requires that a "Seller´s Disclosure of Property Condition" be provided by the seller, just as in the case of an outright sale.
5.069(b) states that if "the property is not located in a recorded subdivision, the seller shall provide the purchaser with a separate disclosure form stating that utilities may not be available to the property until the subdivision is recorded as required by law."
5.069(c) pertains to advertising the availability of an executory contract. It requires that the advertisement disclose information regarding the availability of water, sewer, and electric service.
5.070(a)(1) requires the seller to provide the purchaser with a tax certificate from the collector for each taxing unit that collects taxes due on the property.
5.070(a)(2) requires the seller to provide the purchaser with a copy of any insurance policy, binder, or evidence that indicates the name of the insurer and insured; a description of the insured property; and the policy amount.
Cancellation and Refund
What happens if the foregoing requirements are not met? Firstly, failure to do so is defined as a "false, misleading, or deceptive act or practice" under Sec. 17.46 of the DTPA; secondly, the purchaser is entitled under Property Code Sec. 5.069(d)(2) to "cancel and rescind the executory contract and receive a full refund of all payments made to the seller." That includes any down payment plus all monthly payments that have been made.
Note that Property Code Sec. 5.074(a) entitles a purchaser to cancel an executory contract for any reason within 14 days of signing, even if all of the statutory requirements have been met.
Financial Disclosure Required
An additional pre-closing requirement is imposed by Property Code Sec. 5.071, which requires that the seller provide a thorough RESPA-like disclosure of the financial terms of the transaction: "Before an executory contract is signed by the purchaser, the seller shall provide to the purchaser a written statement that specifies: (1) the purchase price of the property; (2) the interest rate charged under the contract; (3) the dollar amount, or an estimate of the dollar amount if the interest rate is variable, of the interest charged for the term of the contract; (4) the total amount of principal and interest to be paid under the contract; (5) the late charge, if any, that may be assessed under the contract; and (6) the fact that the seller may not charge a prepaying penalty or any similar fee if the purchaser elects to pay the entire amount due under the contract before the scheduled payment due date under the contract."
There is some slight relief under this section in that a violation by the seller is not defined as a DTPA violation.
The 7 Day Letter
Another, related pre-closing requirement is contained in Property Code Sec. 5.016, which states that "A person may not convey an interest in or enter into a contract to convey an interest in residential real property that will be encumbered by a recorded lien" without giving a 7 day notice to both the lender and the purchaser. The section sets out the required content of this notice, which is quite technical. It should be observed, however, that this section provides no real penalties other than to allow the purchaser to back out of the transaction prior to closing if the 7 day notice was not given. After closing, there is no buyer remedy and no liability on the part of the seller. The result? The 7 day letter requirement is widely ignored. Expect a future legislature to revisit this statute and insert penalties for non-compliance.
Certain Punitive Fees and Clauses
Property Code Sec. 5.073 prohibits these. Excessive late fees are banned, as are pre-payment penalties and any clause that "prohibits the purchaser from pledging the purchaser´s interest in the property as security to obtain a loan or place improvements. . . ." This codifies what has been traditional in Texas: Justices of the Peace have always been loathe to grant exorbitant late fees in an eviction judgment.
In the past, lease-options and other executor contracts did not need to be recorded in the real property records. No longer. Sec. 5.076 states that "the seller shall record the executory contract, including the attached disclosure statement . . . on or before the 30th day after the date the contract is executed. Additionally, any instrument that "terminates the contract" must also be recorded.
Annual Accounting Statement
Sec. 5.077 requires that the seller provide an annual accounting statement every January, which must include the amounts paid, the remaining amount owed, the number of payments remaining, the amount paid in taxes, the amount paid for insurance, an accounting for any insurance monies paid by the insurer, and a copy of the current insurance policy. A comprehensive status report, in other words.
Buyer´s Right to Convert to a Deed
The buyer has an absolute right "at any time and without paying penalties or charges of any kind" to convert an executory contract to "recorded, legal title" under Sec. 5.081. That means a deed – probably a general warranty deed, but no less than a deed without warranties. The seller has no choice in the matter so long as the buyer tenders the balance owed under the contract.
The S.A.F.E. Act Licensing Requirement
Executory contracts are a form of owner financing and therefore the federal S.A.F.E. Act applies. The Texas implementation of the S.A.F.E. Act (sometimes called "T-S.A.F.E.") places a licensing requirement on certain types of owner financing provided by professional investors. Since traditional owner-finance transactions, wraps, and land trusts are all a form of owner finance, T-S.A.F.E. applies; however, the seller is required to be licensed only if the property is not the seller's homestead and/or the sale is not to a family member. So, by way of example, if the subject property is an investment rental house being sold to a non-family member, then the seller is required to have a residential mortgage loan origination (RMLO) license from the Texas Department of Savings and Mortgage Lending (TDSML).
The Commissioner of the TDSML has (thankfully) ruled that T-S.A.F.E. will not be applied to "non-pros" – persons who make five or fewer owner-financed loans in a year, thus preserving the so-called "de minimus exemption" under Finance Code Sec. 156.202(a)(3). A side note here: some investors have attempted to utilize the new Texas series LLC as a means of circumventing the de minimus exemption – i.e., by claiming that the each separate series of the LLC is entitled to its own five or fewer exemption. Nice try, but wrong. Although individual series have wide statutory latitude to operate as if they are separate entities, they are not – technically speaking – and therefore the de minimus exemption applies to the LLC as a whole.
Does T-S.A.F.E. effectively shut the door on non-homestead owner finance for persons who do more than five such deals per year? Not necessarily. The TDSML has expressly approved the role of an "intermediary agent" – the RMLO – who, for a fee typically ranging from half a point to a point (i.e., 1%) of the loan amount, will step in and satisfy the Act´s requirements. The RMLO supplies the Good Faith Estimate (revised in 2010), Truth in Lending disclosures, orders an appraisal, provides disclosures, and insures that all "cooling periods" are observed in the loan process. So, non-homestead owner-finance deals can still be done, but at a higher net cost. The results are higher closing costs but better consumer protection in order to avoid the abuses of the past.
Note that the T-S.A.F.E. licensing rule applies only to residential owner financing.
The Dodd-Frank Law (Mortgage Reform and Anti-Predatory Lending Act)
Dodd-Frank overlaps the S.A.F.E. Act in regulatory effect. It requires that a seller/lender in an owner-financed transaction involving a residence to determine at the time credit is extended that the buyer/borrower has the ability to repay the loan. The seller is obligated to investigate the buyer´s credit history, current and expected income, current obligations, debt-to-income ratio, employment status, and the like in order to make this determination. This law provides for a de minimus exception for persons doing not more than three owner-financed transactions per year (so long as the seller/lender is not in the building business) – but the loan must be fully amortizing (i.e., balloon notes are prohibited); the seller must determine that the buyer has the ability to repay the loan; and the owner-financed note must have a fixed rate or, if adjustable, must adjust only after five or more years and be subject to reasonable annual and lifetime limitations on interest rate increases.
The intent of Dodd-Frank is essentially to put an end to the practice of making of loans to people who cannot afford to pay them back. Although roundly criticized by some politicians as an example of over-regulation, there is no doubt that corrective action was necessary in order to avoid another epidemic of toxic loans.
Termination of Executory Contracts
It is not permissible to simply evict a buyer under an executory contract if there is a default. Why? Because such a buyer has equitable rights and is more than a mere tenant. The Property Code therefore requires ample notice and opportunity for the buyer to cure the default. Sections 5.063 and 5.064 specify the content of a notice of default, which must be followed to the letter if the notice is to be valid. The buyer is allowed a 30 day unconditional right to cure the default before an eviction can be filed. If the judge grants possession to the seller at the eviction hearing, then (and only then) is the buyer's down payment forfeited.
And then there is the "40 or 48 Rule" contained in Property Code Sec. 5.066(a): if the buyer has paid in 40% or more of the purchase price, or the equivalent of 48 monthly payments, then a 60 day notice is required and, if the default is not cured, then a traditional foreclosure (not an eviction) must be used to regain possession and title (Sec. 5.066). Clearly, the intent of this provision was to keep sellers from unfairly confiscating buyers' substantial down payments or equity in the property.
The Reality of the Courtroom
Why not just ignore the executory contract rules and march merrily forward? The reason is that courts and juries generally do not favor investors and landlords, who are perceived as profiteers preying upon the weak and helpless. It often does not matter how clever the investor´s legal argument is. If a transaction does not pass the "smell test" a seller/landlord will likely lose – and lose big. Underestimate a jury of 6 or 12 of your peers at your peril. Even if the executory contract rules are found not to apply, remember that the court can look to the "laundry list" of offenses under the DTPA. Section 17.50(a)(3) of the DTPA prohibits "any unconscionable action or course of action by any person" – an exceptionally broad statement that gives a jury ample opportunity to hammer an investor with a punitive judgment.
Forfeiture remains a hot-button area. Property Code Section 5.073(a)(4) prohibits a forfeiture of a buyer´s down payment or option fee if a monthly payment is late. This is an important change, because it codifies what judges and juries have been telling lawyers for quite some time. They hate forfeitures. The trend in the law is to view any substantial forfeiture as unreasonable and unconscionable, whether within the context of an executory contract or not, if it results in a buyer losing either a large down payment or the home itself.
Landlords and sellers should generally avoid executory contracts because of the numerous requirements and potential liability for doing them improperly. In addition to stiff penalties contained in the Property Code, certain violations are defined to be DTPA violations, which can result in treble damages plus attorney´s fees. These penalties fall entirely upon the seller, even if the purchaser was a willing participant in the transaction. There are no significant defenses. Accordingly, such contracts are no longer advisable for property in Texas unless the property is paid for or used exclusively for commercial purposes.
Another caution: Beware of "seminar forms" or forms off the internet, which were never much good since they were not designed specifically for Texas. These can now get you in real trouble. If you have such forms entitled Purchase Option Agreement, Option Cancellation and Release Agreement, Option to Purchase Real Estate, Performance Mortgage to Secure Option, Secured Reverse Assignment Agreement, Slick Tricks to Get What I Want Without Telling Anyone What I´m Doing, and the like, they are toxic waste in the State of Texas. Throw them away. One can call a cat a dog but that does not change the nature of the beast. Courts look to substance over form. Moreover, a judge and jury will likely be angry with a seller who tries to pull a fast one with overly-clever verbiage – and therefore more inclined to consider a finding of fraud.
Find a good real estate lawyer, one with courtroom experience, and consult him regularly. His fees are cheap insurance. Pay attention to what he says about how a judge or jury will react to your proposed deal. A good lawyer knows that documents should be drafted as if you will one day have to defend them in court.
Information in this article is proved 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 © 2012 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 web site, http://www.LoneStarLandLaw.com.