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Copyright © 2016. All rights reserved worldwide.

LEASE-OPTIONS IN TEXAS REAL ESTATE


by David J. Willis, J.D., LL.M.

Introduction

Lease-Options have always been a favorite tool of Texas real estate investors. They are one of the “Big Three” – alongside contracts for deed and lease-purchases – all of which are creative devices for getting less than fully-qualified buyers into a home immediately. However, 2005 changes to the Texas Property Code (Sec. 5.061 et seq.) define residential lease-options for longer than 180 days as “executory contracts” subject to strict regulation and penalties if not done exactly right. Exactly right. Specific requirements must be observed and the burden is entirely on the seller to do so. Violation incurs not only penalties under the Property Code (return of all payments made by the buyer including monthly payments) but potential liability under the dreaded Deceptive Trade Practices – Consumer Protection Act (“DTPA”) which can involve treble damages plus attorney’s fees. The most sobering aspect of executory contract regulation is that there are no seller defenses, even if the arrangement was the tenant/buyer’s idea to begin with. Read our chapter on Executory Contracts in Texas.

The Pure Option to Purchase

Before continuing our discussion of lease-options, it is worth remembering that there is such thing as a stand-alone option to purchase, disconnected from a lease. It consists of a contractual right granted to a potential buyer which may be exercised in writing, at a time of the buyer’s choosing, without the requirement of a triggering event, to purchase the property at a pre-determined price. It is not sufficient, however, to say “I have the option to purchase 123 Oak Street for $250,000” and let it go at that. How long does this option last (what is the option term, in other words)? Is it a one-time right or a continuing right? Is the option assignable? Just as important, what are the terms of the prospective purchase—cash, third-party financed, or seller-financed? How long will the buyer have to close after notice of the exercise of the option is given? When you think about it, a well-written option agreement is going to contain all the key points and material terms that are usually found in an earnest money contract. So beware of the “one-liner” option, since it often raises more questions than it answers.

What are executory contracts and why do lease-options fall within this category?

Another area that should be explored is the connection between any preferential right to buy real estate and executory contracts, since the latter are now heavily regulated by the Property Code.

Executory contracts include any transaction that defers some material action by either party that pertains to real property ownership or possession into the future.So why do lease-options fall within this definition?  Because the Property Code says so. Section 5.062(a)(2) states: “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.”There is an exception for lease-options for 180 days or less under section 5.062(c)—otherwise, the TREC 1-4 contract would violate this provision when combined with a short-term lease. Commercial lease-options are not affected.

A case from the Texarkana court of appeals provides a good definition of an executory contract: “In a typical real estate contract, the seller and purchaser mutually agree to complete payment and title transfer on a date certain, the closing date, at which time the purchaser generally obtains both title and possession.  By contrast, in an executory contract, the purchaser is usually given immediate possession, but is required to satisfy numerous obligations over an extended period of time before the seller has an obligation to transfer actual title.” Bryant v. Cady, 445 S.W.3d 815, 822-23, (Tex.App.—Texarkana 2014, no pet.). 

Executory Contracts: Requirements

Just for the record, one can still do a long-term lease-option or other types of executory contracts—but consider the requirements. The landlord/seller must provide the Buyer with a recent survey or a current plat; copies of liens, restrictive covenants, and easements; a Seller’s Disclosure of Property Condition; a disclosure for nonsubdivision properties stating utilities may not be available until the subdivision is recorded; tax certificates; a copy of the insurance policy showing the name of the insurer and insured along with a description of the insured property and the policy amount; a seven-day notice letter; and an annual accounting that includes amounts paid, amounts owed, payments remaining, taxes paid, and the amount paid for insurance premiums plus an accounting for any insurance proceeds. All of this must be done before the contract is signed. See Prop. Code §§5.069 et seq.

Additionally, it is required that sales advertisements disclose the availability of water, sewer, and electric service. The seller must provide a thorough disclosure of the financial terms of the transaction, including the interest rate, amount of interest charged for the term of the contract, the total amount of principal and interest to be paid, and the non-existence of a pre-payment penalty. Excessive late fees and pre-payment penalties are banned.

Even if all the foregoing statutory requirements are met, the buyer may still cancel an executory contract for any reason within 14 days of signing. Prop. Code §5.074.

The Short-Term Lease Option

Having offered a dire description of the legal risks, it is nonetheless true that lease-options may still be useful if the term is 180 days or less or if the property is paid for (which means that a lender’s consent will not be needed). Accordingly, an investor should not avoid utilizing a 180 day (or less) lease-option if it is appropriate under the circumstances – particularly if there is a fair possibility that the option could be exercised during that period. Also, if the parties decide in good faith to renew the option for another short option term, they should not hesitate to do so. In this context, we recommend using a 179 day option term just to avoid any issue about whether or not the statute has been violated, since it is never a good idea to cut matters too close when dealing with legal deadlines. 

A Month-to-Month Lease Combined with an Option

What if the lease is “month-to-month?” If it includes an option to purchase, do the requirements and penalties of Property Code sections 5.062 et seq. apply? The answer is likely yes, so long as the term of the option fails to be expressly limited to 180 days or less. Since the lease can easily extend for longer than 180 days, the option can as well. Accordingly, a court would most likely find this arrangement to be an executory contract.

A Potential Solution: Stacking Short-Term Options

What about the possibility of stacking six-month option contracts—i.e., allowing the option to expire and then renewing it again and again? This would appear to be a loophole, making stacking a possible way for a very aggressive investor to still do a lengthy lease-option without complying with the executory contract rules, although at some risk. If challenged by the tenant/buyer, a judge may examine the totality of the circumstances, including the intent of the parties, and declare that the arrangement is a de facto executory contract. It all comes down to whether or not the tenant/buyer becomes disgruntled and decides to (1) challenge the transaction with a lawsuit, or (2) resist an eviction based on an executory contract defense. No challenge, no issue. There are no executory contract police. Having said that, lease-option arrangements that endure in the aggregate for longer than 180 days are perilous. The legislature clearly intended to discourage their use in residential transactions and deliberately imposed significant liability on landlord/sellers for doing them improperly.

Statute of Frauds Applies

All preferential rights to real estate, including lease purchases and lease options, must be express (not implied) and be in writing in order to comply with the statute of frauds. Provisions of the Statute of Frauds applicable to real estate are found in the Business & Commerce Code sections 26.01 and 26.02(b): “[A] contract for the sale of real estate is not enforceable unless the promise or agreement, or a memorandum of it, is (1) in writing; and (2) signed by the person to be charged with the promise or agreement. . . .”

There is another statute that is applicable: Property Code section 5.021, sometimes referred to as the “Statute of Conveyances,” which states: “A conveyance of an estate of inheritance, a freehold, or an estate for more than one year, in land and tenements, must be in writing and must be subscribed and delivered by the conveyor or by the conveyor's agent authorized in writing.”

Preferential Rights and Executory Contracts in the Real World

Preferential rights often cross the line into the zone of executory contracts, and the result has been to greatly inhibit their use in buying and selling real estate. Burdensome requirements and stiff penalties applicable to executory contracts cause sensible investors to avoid them. Many real estate lawyers will not do them at all, since failure to comply with even the smallest requirement may trigger significant liability not just for the seller but also for the attorney preparing and filing the various disclosures and documents.

The Reality of the Courtroom

Why not just evade 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 unfortunate. 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 in court. 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 a court can still look to the “laundry list” of offenses under the DTPA. DTPA Section 17.50(a)(3) prohibits “any unconscionable action or course of action by any person” – an exceptionally broad statement.

Beware of Seminar and Guru Forms

Be cautious in the use of lease-option forms from “guru” seminars or obtained off the internet. These forms are suspect since they may not be designed specifically for Texas. They can now get an investor in real trouble. Often these forms are options with a different title.   However, courts look to substance over form; and remember, courts do not like investors. 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. 

Conclusion

Lease-options are now a risky business in Texas. The legislature clearly intended to discourage their use in residential transactions and deliberately imposed significant liability on landlord/sellers for doing them improperly. The net effect of the burdensome requirements and stiff penalties applicable to executory contracts has been to greatly inhibit their use. Sensible investors avoid them. Most real estate lawyers will not do them at all, since failure to comply with even the smallest requirement may trigger significant liability for the attorney preparing and filing the various disclosures and documents.

Find a good real estate lawyer, one with courtroom experience. Pay attention to what he or she says about how a judge or jury will react to your proposed deal. A good lawyer knows that real estate transaction documents should always be drafted as if they will one day need to be defended in court.

DISCLAIMER

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 © 2016 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