DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
OWNER FINANCE IN
TEXAS RESIDENTIAL SALES TRANSACTIONS
by David J. Willis, J.D., LL.M.
Owner financing, also referred to as seller financing, is a legitimate and effective way to sell real estate in an economy where conventional financing is difficult to obtain. However, recent state and federal legislation make the process more difficult than it used to be.
For one thing, residential lease-options exceeding 6 months (formerly the favorite of investors) and contracts for deed were both severely restricted by changes to the Texas Property Code made in 2005. Because these changes impose severe penalties on sellers (not buyers) if burdensome rules are not followed (details below), sellers have moved away from lease-options and contracts for deed. Thus only a few types of residential owner financing remain practicable:
- the traditional owner finance, used when the property is paid for;
- the wraparound, which involves giving the buyer a deed and arranging for the buyer to make monthly payments to the seller so the seller can in turn pay the existing lender; and
- the land trust, which involves deeding the property into a trust as a "parking place" of sorts until a credit-impaired buyer can obtain financing. In our terminology, this is called an "exit trust."
Those interested in wraps or land trusts should read the articles on these subjects available at LoneStarLandLaw.com.
One of the more significant changes in owner-financed transactions is that the Dodd-Frank Law (details below) prohibits balloon notes – i.e., owner-finance notes must now be fully amortizing.
PART ONE: LAWS APPLICABLE TO OWNER-FINANCED TRANSACTIONS
Three Sets of Laws Apply
- the 2009 S.A.F.E. Act which requires that sellers of non-homestead property to non-family members have a residential mortgage loan origination license;
- Title XIV of the Dodd-Frank law, also known as the "Mortgage Reform and Anti Predatory Lending Act;" and
- Chapter 5 of the Texas Property Code which since 2005 has imposed burdensome requirements and penalties upon seller financing of residential properties.
We will look at each of these statutes in more detail.
The S.A.F.E. Act Licensing Requirement
The federal S.A.F.E. Act and its Texas equivalent "T-S.A.F.E." place 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 S.A.F.E. 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 S.A.F.E. 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" – commonly called an RMLO – 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 RMLO will supply the new form of 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 more paperwork but better consumer protection in order to avoid the abuses of the past.
Note that the S.A.F.E. Act licensing rule applies only to residential owner financing. See our companion web article The S.A.F.E. Act in Texas.
The Dodd-Frank Law (Title XIV – Mortgage Reform and Anti-Predatory Lending Act)
Title XIV of the Dodd-Frank law, entitled "The Mortgage Reform and Anti-Predatory Lending Act," pertains to residential loans and lending practices. Dodd-Frank overlaps the S.A.F.E. Act in its regulatory effect and legislative intent. It requires that a seller/lender in a residential owner-financed transaction 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., there is no balloon); the seller must determine that the buyer has the ability to repay the loan (and this must be supported by verifications and documentation); 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. See our article The Dodd-Frank Law in Texas for more details.
The Balloon Problem
As mentioned above, Dodd-Frank prohibits balloon notes in residential owner-financed transactions. So what can be done in lieu of a balloon to provide a borrower with incentive to refinance? Notes may be structured so that the interest rate adjusts upward after, say, the 5 year minimum specified in Dodd-Frank (Title XIV Subtitle B Sec. 1418 requires a 6 month notice to the borrower before the rate adjusts). It is also our view that owner financed notes may include a statement on the part of the buyer/borrower that it is his or her goal to refinance the note within a certain period of time. The buyer/borrower may, if appropriate, also agree in the note to engage in credit repair by taking part in a credit repair program approved by seller. This may add some "weight" to the buyer/borrower´s intentions without being a requirement.
Texas Property Code Sec. 5.061: Statutory Requirements for Executory Contracts
Texas Property Code Sec. 5.061 et seq. applies to "executory contracts," which can be defined as transactions that are incomplete or unfinished in some material respect, usually the delivery of a deed (legal title to the property). The Property Code was extensively amended in 2005 to remedy what were perceived as abuses by sellers in using contracts for deed – e.g., collecting a large down payment and then, if the buyer fell behind, using the eviction process to repossess the property as if the buyer were no more than an ordinary tenant. This approach unfairly confiscated any equity that had been deposited and accumulated by the buyer in the property.
Because of this dark history, burdensome rules and restrictions now apply in transactions where title is not immediately conveyed. Such contracts must be recorded, a through financial disclosure must be given to the buyer at closing, and the seller must provide an accounting statement every January. Buyers also have a right to convert to a deed, note, and deed of trust. Other requirements:
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.
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.
5.069(b) states 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.
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.
Failing to comply with the above may constitute a deceptive trade practice and result in treble damages. Accordingly, contracts for deed and other executory contracts have fallen into disuse – which was exactly the legislature´s intent.
Note that even if a seller is willing to endure the various restrictions and potential liability involved in engaging in a contract for deed, the S.A.F.E. Act licensing requirement would still apply.
The executory contract rules of Prop. Code Sec. 5.061 do not apply to commercial transactions.
The Seven-Day Notice Requirement
This is an odd law that became effective on January 1, 2008. Prop. Code Sec. 5.016 requires the following: (1) 7 days notice to the buyer before closing that an existing loan is and remains in place; (2) giving the buyer this same 7 day period in which to rescind the contract to purchase; and (3) also that the 7 day notice be sent to the lender. These notices are the obligation of the seller and must be in the form prescribed by the statute. Actual lender consent, however, is not required. Sec. 5.016 notices, often sent to the loan servicer (who is not generally equipped to handle such communications), usually produce no response.
Note, however, that Property Code Sec. 5.016(c)10 provides an exception to the notice requirement "where the purchaser obtains a title insurance policy insuring the transfer of title to the real property." Thus if you are able to get a title company to insure your owner-financed deal, you can dispense with the 7 day notice. Few title companies will insure "creative" transactions such as wraps and land trusts, however, so this exception may not be of much help.
This is a law that "has no teeth" to speak of and, as a result, compliance is erratic. Watch for future legislation that may add penalties. For now, Sec. 5.016 has not become a significant impediment to owner-financed transactions.
PART TWO: OWNER FINANCING TECHNIQUES
Contracts for Deed
As a result of Prop. Code Sec. 5.061, contracts for deed (sometimes called "land sales contracts" or just "land contracts") are all but dead in Texas residential transactions. This is a far cry from the old days when contracts for deed were common, particularly in rural areas, where it was literally the "wild west" in terms of deals of this type.
Lease-Options in Residential Transactions
Although not technically a form of owner finance, lease-options were a traditional way for investors to get less-than-qualified buyers into a home. These too are now considered to be "executory contracts" and are subject to Prop. Code Sec. 5.061. Note that there is an exception for lease-options shorter than six months and, of course, commercial transactions are not covered.
Some sellers have attempted to continue to use lease-options by creatively re-writing the contract to call for a right of first refusal rather than an option – but be careful . . . as soon as a price is named, it becomes an option. Clever draftsmanship (including giving old documents new names) will not avoid Sec. 5.061. Courts look to substance over form – they will look at what a transaction actually is, not what the parties (or their lawyers) pretend it to be.
"Stacking" 6 month lease-options is a possible method of avoiding the statute. For instance, the documents can be written to provide that the option to purchase expires after, say, 179 days and then automatically renews for another 179 day term. This exploits a loophole in the law. The risk is that a disgruntled borrower may challenge the transaction in court, alleging that the true intent of the parties was to do a longer term deal – even though the written documents state differently. If the court agrees (and a liberal-minded judge might make this determination) then the various penalties contained in Prop. Code Sec. 5.061 et seq. could rain down upon the seller. In spite of this risk, a substantial number of investors are using the stacking method.
Lease-options continue to have a role in short-term residential transactions and in commercial deals, but are otherwise less common given the substantial risk to the seller. For more information on lease options, see our companion article Lease-Options in Texas.
Traditional Owner Finance
A traditional owner-financed transaction involves conveying paid-for property to a buyer by warranty deed, with the seller taking back a real estate lien note secured by a deed of trust. There are no worries about an existing lien-holder; therefore the deed of trust put in place by this seller financing becomes a first lien against the property. If the buyer defaults, the seller can foreclose in the usual manner. Since Texas has a swift non-judicial foreclosure statute, the seller is in a good position to enforce his rights in event of default.
Traditional owner-financed transactions often close in a lawyer´s office without title insurance – although it is prudent for a buyer in such transactions to at least obtain a title report that indicates what liens, lawsuits, and judgments may exist that affect the property.
So long as the property is the seller's homestead or is being sold to a family member, the S.A.F.E. Act licensing requirement does not apply.
The first point to realize is that wraparound transactions are a form of owner finance. Wraps (sometimes referred to as subordinate-lien financing) have become more popular since the 2005 changes to the Property Code limited the utility of lease-options. A wrap is a creative device that leaves the original loan and lien in place when the property is sold. The buyer makes a down payment and signs a new note to the seller (the wraparound note) for the balance of the sales price. This wraparound note, secured by a new deed of trust (the wraparound deed of trust), becomes a junior lien on the property.
Money flows as follows: the buyer makes monthly payments to the seller on the wraparound note and the seller in turn makes payments to the original lender. The original lender´s note is referred to as the "wrapped note," and it remains secured by the "wrapped deed of trust." Note that is possible to wrap more than one prior note (e.g., an "80/20").
In the usual case, the wraparound note to the seller exceeds the amount of the wrapped note payoff by the amount of the seller´s equity. Alternatively, the buyer may make a cash payment to the seller for the seller´s equity, and the wraparound note payment will then be structured to correspond – either closely or exactly – to the amount of the payment on the wrapped note (sometimes referred to as a "mirror wrap"). The interest rate on the wraparound note is often higher than that on the wrapped note, since seller financing usually carries a rate that is slightly higher than market.
When the buyer gets a refinance loan, the original, wrapped note is paid and released, and the seller keeps any cash that exceeds the payoff amount of this first lien. The main difference between a wrap and a conventional sale is that the seller must wait until the wraparound note matures in order to receive the full sales proceeds in cash. Remember: no balloons.
For more information on wraps, see our companion article, Wraparound Transactions in Texas. Included is suggested a wrap addendum to be attached to the TREC One to Four Family Residential Contract. At the end of the wrap article is a checklist of information that is needed in order to prepare wrap documents.
There are three basic types of land trusts used by real estate investors: (1) an "anonymity trust" (our term) designed to hold property without disclosing the names of any principals; (2) an "entry trust" (our term) used as a tool to acquire and then transfer real estate by means of an assignment of beneficial interest (sometimes called an "Illinois Land Trust"); and (3) an "exit trust" (our term again) designed to hold title to real estate while a credit-impaired buyer does credit repair until able to obtain a conventional loan to take the property out of trust. We will examine each in turn.
(1) The anonymity trust is usually established as part of a broader asset protection plan. It is a relatively simple document that is executed along with a warranty deed conveying real property into the trust. The traditional way for a trust to hold property is in the name of "John Jones, Trustee for the 123 Oak Street Trust;" however, it is just as feasible to hold title in the name of the trust alone – e.g., the "123 Oak Street Trust." County clerks have no problem recording a deed into the name of a trust so long as the trustor´s/grantor´s signature is acknowledged. In fact, this method may be preferable since no individual names are disclosed (the trust agreement is not a recorded document).
Title companies do not like this arrangement, however. They generally decline to insure title in the name of the trust without the trustee being expressly named; and if a title company is handling the subsequent sale of property that is currently in an anonymity trust, they will ask to see and approve the trust agreement (which is not a problem so long as a properly drafted trust agreement exists, as it should). The strictest title companies will require that a new deed be executed into the trust naming the trustee – an action that does not usually trouble investors, since their anonymity has nonetheless been maintained during the term of the trust.
Most trust transactions are handled and closed in an attorney´s office without the participation of a title company. If the buyer/trust beneficiary wants to know the status of title, a title report can always be purchased at a reasonable cost.
(2) In the case of the entry trust, an investor coaxes a distressed seller into transferring property by recorded deed into a trust, after which the seller then executes an unrecorded assignment of beneficial interest to the investor. This is usually done in anticipation of a foreclosure. However, these trusts do not delay or stop foreclosure unless the investor is willing to reinstate the loan and/or continue to make payments until the property is sold.
Drafting the trust is critical. Certain types of these trusts also allow the original seller to retain a beneficial interest (always a bad idea) that allows the original seller to a share of the profits when the property is flipped. Others permit the original seller to have a "power of direction" over the trustee – an even worse idea.
A significant risk, from the investor´s point of view, is that the original seller may still be able to transfer the property to someone else, in defiance of the unrecorded assignment of beneficial interest that has been given to the investor. For this reason, depending on the circumstances, a "subject to" deed may be a simpler and better solution than an entry trust. If asset protection is important, then the grantee on the subject to deed should be the investor´s LLC.
(3) In the exit trust, the trustor/investor is the seller. Property is conveyed into a land trust that acts as a temporary "parking place" for the property while a credit-impaired buyer (the trust beneficiary) takes immediate possession and works to obtain conventional financing in order to purchase the property outright at a specified price. Sound similar to a lease-option? It is, except that beneficial interests in a trust are personal property, not real property, and therefore arguably do not fall under the executory contract provisions of the Prop. Code Sec. 5.061 et seq.
For more information on land trusts, see our companion article, Land Trusts in Texas. Another article, Asset Protection in Texas, may also be of interest.
PART THREE: DUE ON SALE ISSUES
What if the property to be conveyed still has a lien on it? Owner financing while an underlying loan is in place is neither illegal nor a breach of contract. It does not "violate" the due-on-sale clause in the underlying deed of trust. If you look carefully at the typical lender's documents, you will see that they usually do not prohibit a transfer of property without the lender's consent. They generally state that if the borrower transfers the property without the lender's permission then the lender may, if it so chooses, declare the loan due. Look at paragraph 18 of the Fannie Mae/Freddie Mac Uniform Deed of Trust:
If all or any part of the Property or any interest in the Property is sold or transferred (or if Borrower is not a natural person and a beneficial interest in Borrower is sold or transferred) without Lender´s prior written consent, Lender may require immediate payment in full of all sums secured by this Security Instrument.
This is not prohibitory language. It says the lender may accelerate the note if it wants to. When an investor transfers the property without consent from the lender, the investor makes it possible for the lender, if the lender so chooses, to accelerate. It is not a breach of the deed of trust. It is not fraud. As attorney Bill Bronchick puts it, "There is no due on sale jail."
How often does a lender declare an otherwise performing loan due? They may not like the fact that the property has been sold to someone else, but – so long as payments continue on a timely basis – the risk that a lender will do anything about it is small. Some lenders now write threatening letters but generally do not follow through. It would appear that lenders have their plates full with loans that are in monetary default.
Owner finance, though more limited and regulated than ever before, is nonetheless alive and well in Texas. Greater consumer protection has been achieved by Texas Property Code Sec. 5.061, the S.A.F.E. Act, and Dodd-Frank, but these measures have also had the effect of significantly raising closing costs, particularly if an RMLO intermediary agent is involved. Consult a qualified real estate attorney before entering into a sales contract calling for owner finance and never use forms off the internet to set up a wrap or land trust. Liability under the revised Texas Property Code is just too great to take the risk.
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.
DAVID J. WILLIS ATTORNEY
Tel. (713) 621-3100
Fax (832) 201-5321
OWNER FINANCE CHECKLIST
Instructions to the Attorney for Document Preparation
Owner Finance: A straight owner-financed sale of property presumes that the property is currently paid for (i.e., there are no liens against it). If this is not the case, then do not use this checklist, since the appropriate format would instead be a wraparound. Use the checklist for wraparound transactions.
Attach a copy of the seller´s deed along with a copy of the earnest money contract, if any.
Legal fees (excluding recording costs) are $750 payable in advance.
1. Whom does the attorney represent? This question must be answered.
_____ Seller´s Broker
_____ Buyer´s Broker
2. What is the name and mailing address of the seller? (Note: the seller´s name should be exactly the same as shown on the deed into the seller).
Mailing Address: ______________________________________________________________
3. What is the street address of the property to be sold?
4. What is the legal description of the property (i.e., lot, block, subdivision, and county – check the deed)? Note: you need to answer this only if a copy of the seller´s deed is not attached. Please do not use the abbreviated form of legal description lifted from tax records
5. What is the name of the buyer, exactly as it will be shown on the deed to the buyer?
6. DOWN PAYMENT: $ ________________
7. AMOUNT OWNER FINANCED: $ ________________
8. SALES PRICE: $ ________________
9. TERMS OF OWNER-FINANCED NOTE:
Annual Interest Rate: _________ % Default Rate: _________%
Monthly payments of $ ______________ principal plus $ _____________ interest for a total P&I payment of $ ______________
Payments are amortized over __________ years.
Will the owner be collecting an escrow for taxes and insurance?
Initial deposit to escrow, if any: $ _________
Monthly escrow amount: $ ______________
When is the first payment due? ____________
Will the note provide for a late charge?
_____ Yes, $ ______ per day after _____ days.
If there will be a guarantor on the note, what is the guarantor’s name and address?
10. As to the deed of trust that secures payment of the note, who will be the seller’s trustee?
_______ Name and address: ___________________________________________
_______ David J. Willis Attorney (for this option add $25)
330 Rayford Rd., Suite 401
The Woodlands, TX 77386
11. If there are real estate brokers involved in this transaction, give name(s), address, and commission(s) payable.
12. Special Provisions (anything else the attorney should know?): ________________________
13. Client’s Instructions after Closing:
______ Ship the completed documents to me by email and we will get them signed and notarized ourselves without further assistance from you. We will then file the deed and the deed(s) of trust with the county clerk in the county where the property is located.
______ Ship the completed documents to me by email. We would like to schedule a “remote” closing with you by conference call. We will then file the deed and deed(s) of trust ourselves with the county clerk.
______ We request an in-office closing (limited local availability). We understand that fees are significantly higher for in-office services. Preferred dates:
First choice of date: ______________________________
Second choice of date: ____________________________
Thank you for taking the time to fill out this checklist!
Name of person issuing these instructions:
Phone: __________________ Fax: __________________
These instructions may be emailed to LoneStarLandLaw@aol.com or faxed to (832) 201-5321.