DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
LEASE-OPTIONS IN TEXAS REAL ESTATE
by David J. Willis, J.D., LL.M.
Lease-Options have always been a favorite tool of Texas residential 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. These contracts have been traditionally popular in Texas for two reasons: first, it was easy to get tenant/buyers into a home by offering a low down payment; and second, it was easy to evict them through the forcible detainer process if they defaulted (allowing the seller to keep the down payment).
However, 2005 changes to Chapter 5 of the Texas Property Code (Sec. 5.061 et seq.) define residential lease-options for longer than 180 days as "executory contracts" that are subject to strict regulation and penalties if not done exactly right. Numerous initial and ongoing requirements must be observed, and the burden is entirely on the seller to meet these. Failure to do so incurs not only penalties under the Property Code (return of all payments made by the buyer, including monthly payments) but liability under the 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 in the first place.
The risk to the seller of using lease-options (or any other executory contract) is now significant, and investors should use this device with caution. Alternatives include wraparounds and land trusts. For detailed information on wraps and trusts, read our articles on these subjects at LoneStarLandLaw.com.
Why are lease-options "executory contracts?"
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 title to the property and when does the buyer get the deed?
Executory contracts can often be recognized by their similar structure. Typically, one party (the seller) holds "legal title" to the property over a specified term. This usually means the seller retains a deed to the property in his or her name. The other party (the buyer) holds "equitable title," meaning that the buyer has only an equitable right to receive true legal title at some time in the future, but only if certain conditions are met. This arrangement gives an advantage to the seller, because enforcement of "equitable rights" by a purchaser generally involves filing suit and asking that one´s equitable rights be recognized by a court and enforced – a lengthy and expensive process at best. Buyers under financial pressure are more likely to abandon their option rights along with their down payments
With specific reference to lease-options, the Texas definition is found in Property Code Section 5.062(a)(2): "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 Sec. 5.062(c) – 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 et seq.
In the past, unscrupulous landlord/sellers used this situation to their advantage. They disregarded tenant/buyers´ 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
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 et seq. contain many onerous burdens on the seller, including but not limited to requirements that the seller provide the Buyer with a survey which is no older than a year, or a current plat; that the seller provide the Buyer with copies of liens, restrictive covenants, and easements affecting the Property; that a "Seller´s Disclosure of Property Condition" be provided by the seller; that if the Property is not located in a recorded subdivision, then the seller is required to provide a separate disclosure form stating utilities may not be available to the Property until the subdivision is recorded; that advertisements related to executory contracts disclose information regarding the availability of water, sewer, and electric service; that the seller provide the Buyer with a tax certificate from the collector for each taxing unit that collects taxes due on the Property; that the seller provide the Buyer with a copy of any insurance policy, binder, or evidence that indicates the name of the insurer and insured along with a description of the insured Property and the policy amount; that a Buyer may cancel an executory contract for any reason within 14 days of signing, even if all of the statutory requirements pertaining to executory contracts have been met; that the seller 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; that a 7 day notice letter be given to both an existing lender and the Buyer; that excessive late fees are banned, as are pre-payment penalties and any clause that prohibits the Buyer from pledging the Buyer´s interest in the Property as security to obtain a loan or place improvements on the Property; that the seller shall record an executory contract, including the attached disclosure statement, on or before the 30th day after the date the contract is executed; 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; that 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 (i.e., a deed); and that the Buyer is allowed 30 days unconditional right to cure any default, unless the Buyer has paid in 40% or more of the purchase price, or the equivalent of 48 monthly payments, in which case a 60 day notice and opportunity to cure is required.
Penalties for Non-Compliance
What happens if the foregoing requirements are not met? Firstly, failure to do so by the seller is defined as "false, misleading, or deceptive act or practice" under the DTPA, which provides for treble damages plus attorney fees; 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 would include any down payment plus all 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.
The Short-Term Lease Option
Having offered the foregoing dire description of the legal risks of lease-options, it is nonetheless true that these are still useful devices if the term is 180 days or less or if the property is paid for (which means that a lender´s consent will not have to be obtained). Accordingly, one should not refrain from utilizing a 180 day (or less) lease-option if it is appropriate under the circumstances to do so – particularly if there is a reasonable possibility that the option could be exercised during that period. Also, if the parties decide in good faith to renew that option for another 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 stated to be "month-to-month?" If it includes an option to purchase, do the requirements (and penalties) of Sec. 5.062 et seq. apply? The answer is 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. This arrangement is therefore an executory contract.
A Potential Solution: Stacking Short-Term Options
So what about the possibility of "stacking" six-month option contracts – i.e., allowing the option to expire and then renewing it? This is a clear loophole and, in the opinion of this author, stacking is the only practical way that a long-term residential lease-option may still be done, although at some risk. This method provides that an option attached to a residential lease automatically renews after the expiration of 179 days unless the parties agree otherwise.
What is the danger of stacking? If challenged in a future lawsuit by the buyer, it is possible that a judge will examine the intent of the parties and declare that the arrangement is a de facto executory contract that violates the statute. It all comes down to whether or not the buyer becomes disgruntled and decides to challenge the transaction with a lawsuit. There are no executory contract police. No challenge, no issue.
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.
Lease-Options Compared to a Right of First Refusal ("ROFR"):
An option to purchase, in a technical sense, is a unilateral contract which gives the holder of the option the right to compel sale of the property at certain price. It must be in writing, exercisable within a specific term, and either recite a price or a formula to compute a price.
By contrast, a ROFR merely requires the owner, when and if he or she decides to sell, to first offer the property to the holder of the ROFR (i.e., the buyer) at the market price then prevailing. Depending on how the ROFR is worded, the seller may be required to first negotiate a specific deal with a third-party buyer and then freeze that transaction momentarily while the holder of the ROFR is given a chance, for a specified time, to buy the property upon the same price and terms. Often the price is to be determined by what fair market value is at the time of sale. Beware: as soon as one includes a specific sales price in a ROFR, it becomes an option. ROFR´s are therefore not an effective alternative for an investor seller who wants to pre-set an above-market price in order to lock in a future profit.
From the perspective of the landlord/seller, there is a problem with a ROFR: it may inhibit the landlord/seller from marketing the property for sale while the ROFR is in place
Lease-Options Compared to Other Preferential Rights:
There are two lesser forms of preferential or pre-emptive rights that are relevant to this discussion:
(1) a right of first offer ("ROFO") which obligates the seller to notify a buyer of his intention to sell, and the buyer will then have the right to make an offer, the terms of which are not specified in advance; and
(2) a right of first negotiation ("ROFN"), which obligates the seller to negotiate exclusively with the buyer for a prescribed period of time. Price and terms of sale are open.
ROFR´s, ROFO´s, and ROFN´s are all potentially useful substitutes for a lease-option, but they must be carefully structured and worded so as not to fall into the executory conveyance "trap."
Beware of Seminar 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.
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 landlords and sellers for doing them improperly. However, one should not hesitate to utilize the "180 days or less" exemption if it suits the transaction, and the "stacking" of short-term options is a potential solution.
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 real estate transaction documents should be drafted as if they will one day need to be defended 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 © 2013 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