Getting around the Due-On-Sale clause
Earl L. Huse, JD
September 03, 2008
Investors like buying homes when the loan can be assumed, then sell it on an installment land contract or other creative finance concept (a.k.a. "contract-for-deed). Payments collected from the sale usually are higher and creates good income for the investor. In this situation, the loan is not assumed or paid off; the investor collects the payments from the buyer and pays the financial institution himself. This was typical for investors of FHA and VA loans. This type of financing is commonly referred to as a "wrap" and the only problem with it is that there are not a lot of FHA and VA loans readily available with loan assumptions. All FHA and VA loans originated after 1989 are not freely assumable.
The presentation and structuring of a creative financing tool called a "land trust" will be used at various times throughout these writings and the following will be a guideline for you to see how properties are incorporated into various scenarios.
During the early 1970´s real estate loans were being assumed when property was sold or transferred at an alarming rate. One of the reasons for the vast amount of loan assumptions was the favorable lower interest rates that were on some of the mortgages. As a result of the assumptions, homebuyer´s were not borrowing new money. One way the lending institutions began to prevent the loan assumption was to use the due-on-sale clause. This was a sure way to end their own competition.
The due-on-sale clause is a clause in a mortgage note, which provides that the entire loan amount is due and payable to the lender upon the sale of the mortgaged property. The bank has the option to call the loan which is due if they wish. It is a contractual right and is not a law. It is an effective wedge for the lender to renegotiate the interest rate, and perhaps points in the event of sale on the mortgaged property.
Such clauses have been referred to variously as "due-on-sale," "alienation," or "acceleration" clauses. The validity of a due-on-sale clause was subject to conjecture for a time, but the courts and Congress have sustained it. A typical due-on-sale clause reads:
Should trustor sell, convey, further encumber, or alienate said property, or any part thereof, or any interest therein, or agree to do so, or be divested of his title or any interest therein in any manner or way, whether voluntary or involuntarily, Beneficiary may declare the entire indebt-ness secured hereby immediately due and payable.
The due-on-sale clause is a hindrance to almost everyone who tries to find a way around it only because it is so misunderstood and so many people have tried ways to avoid it and have ended up loosing their property. In case, during the mid 1980´s in Palm Springs, California, a realtor had sold hundreds of home with an AITD but failed to recognize that there were "due-on-sale"} clauses on each of the properties. He did not know or understand the significance of the clause, as a result, some months later, lenders were calling the notes due exercising the due-on-sale clause. Most of the buyers (vacation home buyers) ended up loosing their property due to no fault of their own.
There was little, if any equity in the properties and when the "owners" tried to refinance the loans. Lenders were looking at the original purchases as "second homes" with little or no money down which the loan-to-value ratio´s were not acceptable to them (the lenders) and most buyers (borrower´s) could not come up with adequate down payments or qualify financially for new financing. As a result, lenders foreclosed on the properties.
There is an effective way of getting around the "due-on-sale" clause. When several cases were brought to court claiming that the due-on-sale clause was an unfair trade practice, the consumers won the battle. The banks, not happy with the decision, went to Washington and lobbied Congress to pass a federal law, which would supercede the courts. The banks ultimately won and the act passed which created the "Garn-St. Germain Federal Depositary Institution Act of 1982". This act allowed the banks to enforce the due-on-sale clause. There are a few exceptions to the act in which the lender cannot enforce the due-on-sale clause, and one of them is a homeowner may transfer his title and interest to a living trust for his own benefit.
Because federal laws preempt state laws, because of the Gam-St. Germain Depositository Institution Act, the Act controls sales "subject to" today. The Act applies to all "due-on-sale" clauses whether it be by commercial lenders, private lenders, or a loan secured by both real and personal; property, and to loans secured by mobile homes.
A land trust is a form of a revocable, living trust and despite the fact there seems to be an ignorance of land trusts, the fact is that anyone who resides in, is making payments on a property owned by a revocable, beneficiary directed, inter vivos (between the living. From one living person to another. Where properties pass by conveyance) title-holding trust, need only be made a co-beneficiary in it, in order to receive the benefits of homeownership. For the resident beneficiary, this trust/lease arrangement actually provides pride of ownership, use, occupancy, equity build-up, and appreciation and income tax write-off benefits.
There are several elements in the creation of a trust, which include, but are not limited to:
1. A declaration by owner of property that he holds it as trustee for another person;
2. A transfer inter vivos by the owner of property to another person as trustee for the transferor or for a third party;
3. A transfer by will by the owner or property to another person as trustee for a third person;
4. A promise by one person to another person whose rights are to be held in trust for a third person.
A land trust is created by two legal documents called a Trust Agreement and a Deed from the creator of the trust to the trustee. The Trust Agreement is between the creator (called grantor) of the trust and the trustee, which defines the trust arrangement, and a deed from the creator (grantor) of the trust to the trustee.
With this creation, the trustee then holds the title for the benefit of the creator (grantor) who, in this case, is also the beneficiary. With your property incorporated into the land trust the due-on-sale clause has not been violated and the lender cannot call the note due and payable. The land trust creation allows a passive, typical seller-carry-back transaction to carry a trust deed (seller carry back of a 2nd, 3dr, etc. trust deed) without risk of any attachments to the property latter on by the other party´s creditor judgment, tax lien, bankruptcy or marital dispute.
Creation of a land trust allows almost all loans that may be defined or have a due-on-sale clause of any type to be assumable including FNMA (FANNIE MAY. The Federal National Mortgage Association (FNMA). This is a federally charted, public company, which purchases mortgages from lenders. It has specific standards with respect to mortgages it will purchase (i.e., concerning loan to value, maximum loan limits, buyer creditworthiness, etc.). Most lenders sell or intend to sell the mortgages they make to FNMA. Loans and mortgages meeting FNMA have become known as "qualified" or "conforming" loans. GNMA (GINNI MAE. Government National Mortgage Association. A federal association, working with F.H.A., which offers special assistance in obtaining mortgages, and purchasing mortgages in a secondary capacity), VA, FHA (FHA. Federal Housing Administration). A federal agency which insures first mortgages, enabling lenders to loan a very high percentage of the sales price of real property) and FHLMC (FREDDIE MAC. Federal Home Loan Mortgage Corporation. A federal agency purchasing first mortgages, both conventional and federally insured, from members of the Federal Reserve System, and the Federal Home Loan Bank System. The exceptions are loans to business entities and land sales contracts loans.
There are certain transfers that do not allow financial institutions to call the loan due where the loan is secured by real property consisting of 4 or less residential units, and the transfer is:
1. To create a junior lien (2nd, 3rd, or 4th trust deed);
2. To create a purchase money loan for household purposes;
3. Based on the death of a joint tenant;
4. A lease for 3 years or less without an option to purchase;
5. Certain intra-family transfers;
6. To an inter vivos trust; or
7. The transfer is allowed by the FHLBB (Federal Home Loan Bank Board) Regulations.
There are sellers who are willing to sell their home with little or no money down but are hesitant because their loan is non assumable and the mortgage has a due-on-sale clause or other terminology meaning the same thing included in the language.
Let´s review some of the steps to the process to avoid the due-on-sale clause:
1. The seller must be willing to keep his existing loan in his name while a land trust is created in his own name and places the property into; i.e. Earl and Lily Goodguys vest the property with "The Earl and Lily Goodguys Trust." The trust is now a inter vivos (living) trust; and because it is directed solely by Earl and Lily; and since no sale of Real Estate has taken place; and since the trust is in the borrower´s name only; there are no income tax consequences and the lending institutions due-on-sale clause is not violated.
a. Sign a trust agreement with trustee of your choosing. This could be your mother, father, brother, attorney, etc. You are named the beneficiary of the trust.
2. The seller must define the property´s use, occupancy and possession; a co-beneficiary interest in the trust (50%, 75%, 90%, etc.) is assigned to a second party. Although the interest can be forfeited at termination, the seller should always retain at least 10% beneficiary interest in order to conform to the IRS´ 10% rule (i.e., no land trust beneficiary may hold less that a 10% interest); to discourage the due-on-sale clause.
a. Title is transferred to the trustee with no violation of the due-on-sale provisions.
3. The seller creates an agreement for Use and Possession between the trustee and the new "co-beneficiary" whereby the IRS characterize the resident beneficiary as an owner of an "IRC" 163 Qualified Property even though the real estate has itself been converted by the land trust to personality. (See IRC 163 (h) 4(D) pertinent to real property held in estates and certain trusts, in which ownership is characterized as personal property.
4. Seller sends a letter to the financial institution, which states:
To: ABC Mortgage Company
1234 Pretty place
Your town, USA 55555
Re: Loan number: 123456
Please be advised as of this 22nd day of September 2001, I have been advised by my attorney to transfer title to my property located at 1234 Your street, My town, USA, 12345, into a revocable, living trust for estate planning purposes.
The below named trustee shall make all future payments on behalf of the trust.
Earl Goodguy Lily Goodguy, Trustee
The seller assigns his interest to the property to you, the buyer, through the trust. The trust is not recorded as a public record. The buyer is now the beneficiary of the trust. Your trustee makes the payments to the lender.
There are three distinguished methods that a lending institution can detect when a transfer of real estate has taken place, and they will discover it in one of those ways, they are:
1. When the name on a deed is changed it then becomes public information but the lending institutions usually do not request copies of deeds unless they are suspicious about miss-dealings between the original borrower and the lender. The other time a request for a deed may be implemented is in case of intentional fraud, miss-representation (in the future once loan has closed) or by warrant. This, however, rarely if ever happens.
2. Sometimes there is a name change on the checks sent to the lending institution (usually if the lending institution is a small portfolio lender). This happens occasionally when the original borrower acquired property as a single person using her maiden name for the mortgage then got marriage. Once the marriage was consummated, the borrower had new checks issued with her married name and used these for her mortgage payments. A bank officer whom was "hand" posting the accounts because the banks computer system was down for the day noticed it, and the bank officer could not locate the name. As a result, the "due-on-sale clause was executed by the bank, and the borrower had to provide verification as to who she was. This however, is a rare situation and rarely happens because it is usually clerical workers in the financial institutions who process payments, not bank officers.
3. Normally when real property is transferred the hazard insurance beneficiary is transferred. When this happens, the lender is notified of the transfer. This is the most common way financial institutions discover a transfer of a borrower´s interest in real estate. When the insurance carrier is notified of a change in insurance beneficiary, the lender, who is also named as beneficiary, receives a copy of the change.
a. When title to property has been transferred through the land trust, the named beneficiary under the insurance policy will most likely be the trustee of the land trust. If the property is sold by transferring the beneficial interest in the trust, the lender will not be notified since the insurance beneficiary (the trustee) has not changed.