Dealing with the "Due On Sale" Clause
by Attorney William
Bronchick (legalwiz.com).
For more information go to
legalwiz.com .
The “due–on–sale” clause is probably the most talked about, feared
and misunderstood topic in real estate. This article will dispel any
misunderstandings you may have about the due–on–sale and suggest a
simple, yet effective strategy to get around it
What is the Due–on–Sale Clause?
Before we discuss how to get around the due–on–sale, we must
understand what it is and where it came from. The due–on–sale (a.k.a.
"acceleration clause") is a provision in a mortgage document which gives
the lender the right to demand payment of the remaining balance of the
loan when the property is sold. It is a contractual right, not a law.
This means that if title to the property is transferred, the bank may
(or may not), at its option, decide to "call the loan due."
An "assumable" loan is one which is secured by a mortgage which
contains no due–on–sale provision. FHA–insured mortgages originated
before 12/89 and VA–guaranteed loans originated before 2/88 contain no
due–on–sale provisions. Nearly all loans originated today contain a
"standard" due–on–sale clause which usually reads something like:
"If all or any part of the property herein is transferred without the
lender’s prior written consent, the lender may require all sums secured
hereby immediately due and payable."
Where Did the Due–on–Sale Dilemma Come From?
Banks began inserting due–on–sale clauses in their mortgages in the
1970s when interest rates rose dramatically. Home buyers were assuming
existing loans rather than borrowing new money from banks because the
interest rates on existing loans were lower. The banks used the
due–on–sale as a way to kill their own worst competition. They argued
that the reason for the restriction was to be able to police who was
living in the property, the collateral for their loan. This argument
holds little water, since most banks haven’t been enforcing due–on–sale
violations since the early 80’s when interest rates were high. In fact,
Black’s Law Dictionary defines the due–on–sale clause as a device for
"preventing subsequent purchasers from assuming loans with lower than
market interest rates." This idea was also confirmed by the Court in
Community Title Co v. Roosevelt Savings & Loan 670 S.W.2d 895 (Mo.App.
1984): “The due–on–sale clause was a way of eliminating these low
yielding loans as soon as the property was sold, so that it could
re–loan the money at current higher rates or negotiate a higher rate in
the event the purchaser assumed the existing loan.”
The homeowners fought the banks in court claiming that the
enforcement of the due–on–sale was "unfair trade practice" and an
"unreasonable restraint on the alienation of property." In state courts,
many homeowners were winning the argument. See, e.g., Wellenkamp v. Bank
of America, 21 Cal 3d 943 (1978). The banks ultimately won in a United
States Supreme Court case, Fidelity Federal Savings and Loan Association
v. de la Cuesta, 102 S.Ct. 3014, (1982). Congress thereafter passed the
"Garn–St. Germain Federal Depositary Institutions Act" (12 U.S.C.
1701–j) which codified the enforceability of the due–on–sale clause,
despite state statute or case law to the contrary.
There is No "Due–on–Sale Jail"
Many people are under the mistaken impression that transferring title
to a property secured by a "due–on–sale" mortgage is illegal. This is
because most lay people confuse civil liability with criminal
liability.To be "illegal," you must be in violation of a criminal law,
code or statute. There is no federal or state law which makes it a crime
to violate a due–on–sale clause. If the lender discovers the transfer,
it may at its option, call the loan due and payable. If it cannot be
paid, the lender has the option of commencing foreclosure proceedings.
So the real question is: are you willing to take a property subject
to a mortgage containing a due–on–sale clause with the risk of getting
caught?
The "Trust–Assignment Trick"
The game for us is how to transfer ownership to the property without
getting caught by the lender. You could simply get the owner to sign you
a deed and not record it, but this method is problematic (for example,
what if the seller gets a judgment against him?). Enter the "trust
assignment trick…
The Garn St. Germain Act carves several exceptions in which the
lender may not enforce the due–on–sale:
Exemption of Specified Transfers or Dispositions
With respect to a real property loan secured by a lien on
residential real property containing less than five dwelling units,
including a lien on the stock allocated to a dwelling unit in a
cooperative housing corporation, or on a residential manufactured home,
a lender may not exercise its option pursuant to a due–on–sale clause
upon –
(1) the creation of a lien or other encumbrance subordinate to the
lender’s security instrument which does not relate to a transfer of
rights of occupancy in the property;
(2) the creation of a purchase money security interest for
household appliances;
(3) a transfer by devise, descent, or operation of law on the
death of a joint tenant or tenant by the entirety;
(4) the granting of a leasehold interest of three years or less
not containing an option to purchase;
(5) a transfer to a relative resulting from the death of a
borrower;
(6) a transfer where the spouse or children of the borrower become
an owner of the property;
(7) a transfer resulting from a decree of a dissolution of
marriage, legal separation agreement, or from an incidental property
settlement agreement, by which the spouse of the borrower becomes an
owner of the property;
(8) a transfer into an inter–vivos trust in which the borrower is
and remains a beneficiary and which does not relate to a transfer of
rights of occupancy in the property; or
(9) any other transfer or disposition described in regulations
prescribed by the Federal Home Loan Bank Board.
(The Federal Home Loan Bank Board, which was disbanded in 1989 and
replaced by the Office of Thrift Supervision, takes the absurd position
that the Act only applies to owner–occupied homes.See 12 C.F.R. 591.
However, the clear language of Garn Act specifically states that it
applies to residential one–to–four family homes. There is no mention
that it must be "owner–occupied." Although never enforced or challenged,
such a direct conflict with the meaning of the Congressional statute
would probably be struck down in court as being "ultra vires". See,
Sheldon, J. Repossessions & Foreclosures, Sec. 13.4.2.3.3).
The Land Trust.
A land trust is form of a revocable, living trust which is exempted
under the Garn Act. A land trust, like a living trust, is create by two
legal documents:
1) A trust agreement between the creator (called "grantor" in legal
terms) of the trust and the trustee which defines the trust arrangement;
and
2) A deed from the creator of the trust to the trustee.
The trustee holds title for the benefit of the grantor (in this case,
the grantor is also the "beneficiary"). If you place title to your
property into a land trust, you have not violated the due–on–sale (so
long as there is no change in occupancy).
Let’s say that you come across a seller who is willing to give you
title to his property. The only "glitch" is that the loan is not
assumable because the mortgage has a due–on–sale clause. Here’s the
process for getting around it:
STEP 1: Sammy Seller signs a trust agreement with you as trustee of
his trust. Sammy is named as the "beneficiary" of the trust.
STEP 2: Sammy Seller transfers title to the trustee (no violation of
the due–on–sale clause)
STEP 3: Sammy Seller quietly assigns his interest under the trust to
you (similar to a transfer of stock in a corporation). This assignment
is not recorded in any public record. Sammy moves out and you move in.
STEP 4: You are now the beneficiary of the trust. Your trustee makes
payments to the lender.
Keep in mind that the assignment of Sammy Seller’s interest under the
trust to you does trigger the due–on–sale, but who is going to tell the
lender? In reality, the lender will discover the transfer of an interest
in real estate in one of three ways:
1) Change of name on the deed. Not likely, since lenders don’t
readily have "spies" at the clerk’s and recorder’s office;
2) Different name on the check received for payment. Not likely,
since the bank officers are far removed from the clerical workers who
process payments; or
3) Change of hazard insurance beneficiary. This is the most common
way a lender discovers a transfer of interest in the borrower’s
property.
If you notify your insurance carrier of a change in insurance
beneficiary, the lender, who is also a named beneficiary, receives a
copy of the change. However, if you transferred title into a land trust,
the new beneficiary under the insurance policy will be the trustee of
the land trust. The lender will probably not object, since it will
assume the seller has implemented an estate planning device.If the
beneficiary of the trust is assigned, the lender will not be notified
since the insurance beneficiary (the trustee) has not changed.
This strategy is not much different than simply transferring title
directly from seller to buyer (called taking a deed "subject to").
However, the chances of the lender discovering the change of ownership
are greatly reduced.This is especially true where the lender has
contracted to use a "servicing" company to deal with most facets of the
loan. If you have had any experience with servicing companies, you may
know that most are so poorly managed that they don’t know which way is
up (I would wager that a survey of 100 servicing company employees would
reveal that 98 of them wouldn’t know the meaning of a due–on–sale
clause).
But, but… isn’t It is Unethical or Fraud?
Note: This discussion is limited to the legal analysis of "ethics"
rather than the moral one, namely whether you think it’s "right or
wrong" to try and get around a due on sale without telling the lender.
I’ve found that such a discussion is pointless – only you can decide
what’s "right" for you.
From a legal standpoint, a real estate agent who does not disclose
the transfer to the lender has committed no breach of ethics.In fact,
some of the standard contracts approved by the California Association of
Realtors contain provisions contemplating a "subject to" transfer (see,
e.g., form LRO–14, Residential Lease with Purchase Option). The Offical
Utah Division of Real Estate forms also contain provisions for transfers
in the face of a due–on–sale provision (see Seller Financing Addendum to
REPC). Form 3248, the "official" real estate contract used by New York
Attorneys (jointly prepared by the New York State Bar Association, the
New York State Land Title Association), contains a specific paragraph
contemplating the buyer taking "subject to" and existing mortgage. There
is a law in MI (Sec 445.1628) that does make it a crime for a licensed
agent to help someone evade a due on sale, but it only applies to the
long–gone "window period" loans (originated between January 5, 1977, and
ending on October 15, 1982).
The state bars have no problem with lawyers helping clients conceal a
transfer either. In Matter of Sabato, 560 N.E.2d 62 (Ind. 1990), the
court found no ethical problem with an attorney helping a client
circumvent a due–on–sale provision using a land trust as described
above.
In Alaska Bar Association Ethics Opinion #88–2, the Committee
declared
"circumventing a contract term under these circumstances is not fraud
or fraudulent conduct. The attorney’s participation would amount to
concealing a breach of contract."
The Illinois Bar in Advisory Opinion No. 728 also concluded that an
attorney helping a client evade a due on sale is not a crime, noting
that:
"The economic survival of a client may well depend upon failing to
fulfill a contract."
The Virginia Bar reached a similar conclusion in Opinion 471 (1983).
"There is no duty on the part of an attorney to advise the holder of
the first deed of trust, who is not his client, that a violation of the
terms of the deed of trust have occurred in a subsequent closing."
Thus, if it is not illegal or fraud for an attorney or broker to
conceal a transfer of ownership, it is certainly not for a lay person.
It is not a bad idea, however, for any party or real estate agent to
disclose the existence of a due–on–sale clause to all parties involved
in the transaction so that they are aware of the risk. Utah Rule
R162–6.2.14 states "Real estate licensees have an affirmative duty to
disclose in writing to buyer and sellers the existence or possible
esistence of a "due–on–sale" clause in an underlying encumbrance on real
property, and the potential consequences of selling or purchasing a
property without obtaining the authorization of the holder of the
underlying encumbrance" (note that the rule does not prohibit such
transactions). In Ethics Opinion No. 96–2, the Alaska Bar ruled that an
attorney has no duty to disclose the existence or the implications of a
due–on–sale to parties to a transaction whom he was not representing
(personally, I disagree with this ruling; I think an attorney should
disclose, even if it runs him the risk of giving out unsolicited legal
advice).
"Federal" Fraud?
Some title company representatives and attorneys have refused to
close "subject to" transactions, quoting 18 United States Code Section
1001, which generally states that:
"whoever, in any matter within the jurisdiction of the executive,
legislative, or judicial branch of the Government of the United States,
knowingly and willfully –
(1) falsifies, conceals, or covers up by any trick, scheme, or device
a material fact;
(2) makes any materially false, fictitious, or fraudulent statement
or representation; or
(3) makes or uses any false writing or document knowing the same to
contain any materially false, fictitious, or fraudulent statement or
entry; shall be fined under this title or imprisoned not more than 5
years, or both.
It is a bit of stretch to apply this law to concealing a transfer
that triggers a due–on–sale clause. Taken to its illogical extreme, this
statute could land you in jail for saying "I’m next" while on line at
the post office when you really aren’t. In fact, criminal statutes are
always narrowly construed to protect the rights of citizens.
18 U.S.C. Sec. 1010 makes it a crime to make any false statement in
regard to a loan insured by HUD. This law has been used to prosecute
borrowers and their brokers who lie on their loan applications or
"fudge" down payments for FHA loans. It has never been used to prosecute
due–on–sale violators. In fact, the HUD–1 Settlement Statement (lines
203 and 503) that is used for virtually every loan closing has a blank
which states, "loans taken subject to." How could a HUD–promulgated
closing form contain such a blank if it were a crime to take property
subject to an existing loan?
Remember that the due–on–sale is triggered by "transfers" other than
a deed. A lease of three years or more or a lease with option to
purchase (of any term) also gives the lender the option to call the loan
due. Real estate agents routinely engage in lease/option transactions,
and generally make the lease/option a compensable part of their listing
agreements. In fact, REALTOR.com, the official website for the National
Association of Real Estate Investors, contains thousands of listings for
properties available by lease/option terms. It would be fair to assume
that the large majority of these properties have underlying loans that
would be triggered by the seller engaging in a lease/option transaction.
Thus, if a lease with option triggers the due on sale, and real estate
agents assist sellers in doing lease/options, then wouldn’t hundreds of
thousands of agents (as well as REALTOR.com) be engaging in fraudulent
transactions?
To take it one step further, consider that major title companies
routinely assist in closing "wraparound" transactions that also trigger
due–on–sale clauses on underlying loans. So, these companies, their
employees and their attorneys would also be guilty of conspiracy to
commit fraud. Furthermore, attorneys, escrow agents and other parties to
a transaction would also be guilty of conspiracy to commit fraud.
"Occam’s Razor" is a scientific precept that postulates a simple
theory: given two explanations, the simplest one is probably the right
one. People have been taking over properties subject to existing
mortgages for at least thirty years, and there have been no reported
cases of criminal prosecution for hiding the transaction from a lender.
So, have hundreds of thousands of investors, borrowers, real estate
agents, title company employees and attorneys breaking the law for all
these years and getting away with it, or is the practice of hiding a
transfer from the lender a perfectly legal transaction? You decide!
Civil Liability?
In theory, a lender could sue the borrower for fraud for deliberately
making a misstatement regarding the status of his loan. Of course, this
makes no sense, because a lender would do better simply calling the loan
due and foreclosing the property. Furthermore, a case for fraud requires
someone to lie in the first place; keeping your mouth shut is the
easiest way to avoid the issue. The case for fraud would be pretty hard
to make, since the standard FNMA mortgage agreement does not state that
the borrower has an affirmative obligation to notify the lender if he
transfers title or any other interest in the property.
What if the borrower simply keeps his mouth shut and transfers title
without making any statements to the lender? This issue was addressed in
a United States Supreme Court case, Field v. Mans, 1995.S.Ct.207 (1995).
Defendant Mans bought a development property from Field, who carried a
private mortgage on the property. Mans transferred title to an entity he
and a new partner owned, then contacted Field to see if it was ok. In
two written letters, Mans lied and told Field that he had not yet
transferred title. Field refused permission without $10,000
compensation. Years later the real estate market tanked, Mans filed for
bankruptcy and tried to absolve himself of the deficiency on the
mortgage debt owed to Field. Field claimed that the "fraud" exception in
the bankruptcy code would not allow the debt to be wiped out. The court
agreed.
However, Justice Ginsberg, in his concurring opinion suggested that
had the borrower kept his mouth shut, there would be no fraud and the
debt would have been discharged. Justice Ginsberg cited the oral
argument between the court and the lender’s (Field’s) attorney wherein
the lender conceded that had Mans said nothing, there would be no fraud.
In theory, a lender could sue you, the buyer for fraud. In one such
case, Medovoi v. American Savings & Loan, 89 Cal.App.3d 875 (1979) the
court declared a lender could not sue the buyer for fraud for
deliberately concealing a transfer, since he has no legal obligation to
tell the lender of the transfer. Another theory is called "tortious
interference with contract," that is, inducing the seller/borrower to
breach his mortgage agreement. Oddly enough, I did find one reported
case in which the lender tried to make such an argument: Community Title
Co v. Roosevelt Savings & Loan 670 S.W.2d 895 (Mo.App. 1984).
In that case, a lender (Roosevelt Savings) sued a title company
(Community Title) that advocated, educated and performed closings using
a contract–for–deed. Some of the properties were encumbered by
Roosevelt’s mortgages, which contained due–on–sale provisions. The
lender claimed that Community Title’s actions "tortiously" interfered
with the borrower’s contractual obligation to Roosevelt. Roosevelt lost
the case.
The court correctly reasoned that the title company was not liable,
since the borrowers could have found some other means of violating the
due–on–sale. In legal terms, there was no "but for" causation.The court
noted that the lender could not prove that in a financially–distressed
situation, the borrower was likely to pay off his mortgage in full
rather than simply default . That’s the reality of the business – why
would someone hand you a deed subject to his mortgage if he could simple
sell the property for all cash and pay off his loan? The reality is, a
seller who does hand you over his property is out of options!
Another interesting point the court made in the Community Title case
was that the lender had no standing policy on the enforcement of due on
sale clauses. These days, most lenders will not call in loans because of
the low–interest rate environment. Thus, a lender would have a very hard
time proving damages, as in the Community Title case. The lender’s only
remedy is simply to call the loan due and foreclose on the property. A
lender cannot seek a deficiency judgment against a borrower who takes
subject to an existing loan and does not assume liability for it.
Esplendido Apartments v. Metropolitan Condominium Assoc of Arizona, 778
P.2d 1221 (AZ 1989).
Don’t Just Take My Opinion
Attorney Robert Bruss, a well–respected nationally syndicated real
estate columnist, advocates the practice transferring properties
"subject–to" existing loans without notifying the lender. In his 1998
article, "Nothing Down Home Purchases," Bruss says, "I buy subject to
the existing mortgage and do not notify the lender of my purchase . . .
In today’s market . . . a lender would be crazy to push the issue and
put the loan into default." In his article, "The Six Pillars of
Assumption," he also advocates the use of a trust to "dupe" the lender.
Attorney Jeffrey Liss, J.D., LLM, a Harvard Law School Graduate and
well–respected member of the Illinois Bar, wrote an excellent article
called "Drafting Around the Mortgage ’Due on Sale’ Clause in the
Installment Sale of Real Estate" that was published in the Chicago Bar
Record. In this article he points out that "the mortgage does not
prohibit the [transfer], but merely gives the mortgagee an option to
accelerate. There is no duty upon the seller/mortgagor to report such a
sale. The attorney, therefore, is not counseling any breach of contract
or breach of a business relationship."
The Reality of the Marketplace
Buying a property subject to the existing mortgage loan is a risk
versus reward gamble. The reward is that you avoid loan costs, personal
liability for the note and conserve your cash. You can also take
advantage of favorable interest rates, since an owner–occupied loan is
likely going to have a lower interest rate than if you originated an
investor loan. You can also get away with a lower down payment.
The legal risk was addressed above, but what is the practical risk?
That is, what is the real risk of the lender calling in the loan?
Nowadays, the risk is pretty slim. So long as the interest rate on the
existing loan is within a few percent of market interest rates, the
lender is not likely to accelerate a performing loan. The reason is
simply profit; it costs money in legal fees to foreclose a mortgage, and
the lender would rather get paid than have another non–performing loan
on its books. Of course, if interest rates rose dramatically, lenders
may start enforcing the due–on–sale clauses again. Interest rates don’t
jump several points overnight, so pay attention to the market if you
have several properties acquired in this fashion. Consider refinancing
the loans or selling the properties if market interest rates move
upward. 
by Attorney William
Bronchick (legalwiz.com).
For more information go to
legalwiz.com .
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