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Contracts for deed, lease-purchases, and lease-options have always been favorite tools of residential real estate investors. It is easy to get tenant/buyers into such an arrangement (because of the low down payment) and has traditionally been easy to get them out through the forcible detainer (eviction) process if they default (See our companion article, Evictions in Texas). No longer. These devices are now considered "executory contracts" under Chapter 5 of the Texas Property Code as revised in 2005. 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 Act. 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.

The risk to the seller of engaging in executory contracts has therefore discouraged their use, and investors have moved away from these devices in favor of wraparounds and land trusts. However, lease-options may still have some utility if the term is less than 6 months or if the property is paid for (which means that a lender´s consent will not have to be obtained).

Executory contracts include any transaction that defers some 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 today. 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 the deed? The classic executory contracts are contracts for deed, also referred to as land sales contacts, and lease-options. Both of these devices now fall under the extensive rules and regulation of Sec. 5.061 et seq of the Texas Property Code.

Contracts for deed and lease-options for longer than 6 months are 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 "six months or less" exemption exists because – otherwise – the residential sales contract promulgated by the Texas Real Estate Commission would violate this provision when combined with a temporary lease. Note that options that are not combined with a residential lease as well as options on commercial property are not affected by Sec. 5.061.

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 rights" 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.

In the past, unscrupulous sellers 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.

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:

What happens if the foregoing requirements are not met? Firstly, failure to do so is defined as "false, misleading, or deceptive act or practice" under the DTPA (Sec. 17.46, Texas Business & Commerce Code); secondly, the purchaser is entitled under 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 would include any down payment plus monthly payments that have been made.

Note that 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.

An additional pre-closing requirement is imposed by Sec. 5.071, which requires that the seller provide a thorough 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 violation of it is not defined as a DTPA violation.

Another, related pre-closing requirement is contained in 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 at this time 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.

Sec. 5.073 prohibits these. Excessive late fees are banned, as a 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. . . ."

In the past, lease-options 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.

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.

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. The seller has no choice in the matter so long as the buyer tenders the balance owed under the contract.

Executory contracts are a form of owner financing and therefore the S.A.F.E. Act applies. The Act 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, the Act applies; however, the seller is required to be licensed only if the property is not the seller's homestead and/or the sale is not to a family member. If the subject property is an investment rental house being sold to a non-family member, then the seller is required to have a residential mortgage loan origination (rmlo) license from the Texas Department of Savings and Mortgage Lending.

The Commissioner of the TDSML has ruled that the SAFE Act will not be applied to "non-pros" – persons who make five or fewer owner-financed loans in a year, thus preserving the so-called "de minimus exemption" under Finance Code Sec. 156.202(a)(3).

Does the SAFE Act 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" who, for a fee ranging from half a point to a point (i.e., 1%) of the loan amount, will step in and satisfy the Act's requirements. The intermediary agent will supply the new 2010 Good Faith Estimate, Truth in Lending disclosures, order an appraisal, give state-specific disclosures, and the like, and insure that all "cooling periods" are observed in the loan process. So, non-homestead OF deals can still be done, but at a higher net cost. The result is better consumer protection in order to avoid the abuses of the past.

Note that the SAFE Act licensing rule applies only to residential owner financing.

Dodd-Frank overlaps the SAFE Act in its 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. Seller is obligated to investigate 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., there is no balloon); 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.

It is not permissible to simply evict a buyer under an executory contract if there is a default. The Property Code 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 30 days unconditional right to cure the default before an eviction can be filed. If the judge grants possession to the seller, then the buyer´s down payment is forfeited.

And then there is the "40 or 48 Rule" contained in 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.

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 often perceived as profiteers preying upon the weak and helpless. It often does not matter how clever your legal argument is. If a transaction does not pass the "smell test" a seller/landlord will likely lose. 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 Deceptive Trade Practices-Consumer Protection Act. Section 17.50(a)(3) of the Act prohibits "any unconscionable action or course of action by any person" – an exceptionally broad statement.

Forfeiture remains a hot-button area. 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 lease-option 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 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.