Q. What exactly is a land sales contract and what are the risks to the buyer and seller?
I have signed a contract with a friend to buy one of his investment properties -- a single-family house -- as an investment. Originally his lender had verbally offered 11.5 percent, 30-year financing, although my friend now has a 9.5 percent loan on the property. Once I became more interested, the quoted interest rate went to 11.75 percent plus three points. I am beginning to think the lender is trying to take advantage of me.
My friend has suggested a land sales contract to avoid the points and to permit me to keep his 9.5 percent rate. He will take back a second trust to cover his equity. This sounds like a good deal to me.
A. If you are buying this property with little or no money down, the land contract may be a good deal for you.
While land contracts are very common in the western part of the United States, there are many problems and uncertainties with this kind of transaction. I urge extreme caution before finalizing your sale. It is clear that your seller would like to use this procedure to get around the nonassumability of his existing loan -- and you, of course, would like to take advantage of the lower interest rate.
Oversimplified, the land contract -- also referred to as a contract for deed or installment contract -- is a legal transaction where the buyer makes a down payment and the balance of the purchase price is paid in monthly or quarterly installments.
Title to the property does not turn over to the buyer until a set time, generally agreed upon between the parties. This time could be a period of years -- for example three or five years -- or could be based on a percentage or equity put into the property. It could also be negotiated that title will not transfer until such time as the buyer obtains new mortgage financing, thereby relieving the seller of the outstanding loan obligation.
In the absence of a specific statute, the parties are free to enter into any contractual agreement they want, as long as they do not violate public policy.
Generally speaking, the seller is obligated to convey title in accordance with the terms of the contract. As we have indicated, this could be when the buyer either pays the entire purchase price in full or reaches a certain point in the transaction.
Needless to say, this raises many serious legal problems. Let us look at it from the seller's point of view first.
The seller wants to make sure that real estate taxes will be paid when they become due. If there is a mortgage, the seller wants to be satisfied that the mortgage payments are kept current to avoid foreclosure. After all, until the deed is transferred to the buyer, the seller still holds legal title.
Generally speaking, the buyer makes the necessary monthly payments to the seller, who in turn continues to make the first mortgage payments to the existing lender.
Additionally, the seller must be concerned about the condition of the property. Adequate safeguards must be spelled out in the contract giving the seller the right to inspect the premises periodically and requiring the buyer to maintain insurance in the event of a fire or other hazard.
The buyer has problems also. What guarantee does the buyer have that the seller will not sell the same property fraudulently to other purchasers? It is absolutely imperative that a memorandum of the land contract sale (or the land contract itself) be recorded in the jurisdiction where the land is located.
Many states require recordation of these transactions. Nonetheless, it is strongly recommended that the world be put on notice -- through recordation -- of the existence of this sale.
What arrangements will be made for the actual conveyance of the deed, when the terms of the contract have been met? If a transfer is not to take place for a number of years, it is conceivable that the seller could die, or otherwise be incapacitated.
It's advisable to require the seller to put the deed in escrow with a public institution or an attorney, so that the escrow agent will have the absolute authority to record the deed in favor of the buyer when the conditions of the contract have been met.
In effect, the seller is treated as having made the conveyance on the date of contract, although title will not transfer until a future date. In law, while the seller retains bare legal title, the buyer has an interest known as "equitable title."
For Internal Revenue Service purposes, the tax laws treat the land sales contract as a sale, thereby creating a taxable consequence for the seller even before the deed is transferred and also permitting the buyer to deduct real estate taxes and interest, where appropriate.
Finally, we have perhaps the most serious problem, namely dealing with the existing mortgage.
The reason you and your seller want to enter into this kind of transaction is to get around the language in the standard deed of trust (mortgage) that states: "If all or any part of the property or an interest therein is sold or transferred by borrower without the lender's prior written consent ... the lender may ... declare all the sums secured by this deed of trust to be immediately due and payable."
This is known as the nonassumability clause, also referred to as the "due on sale" clause. That clause has been determined to be against the public policy of many states. However, the majority of the states in the nation have upheld the validity of these clauses.
You have to look to the language of the existing mortgage. It is my opinion that under the Standard Deed of Trust Clause, a land contract will in fact trigger the due on sale clause.
No one knows for sure whether a lender will attempt to exercise the due on sale clause. By so exercising it, the lender accelerates the mortgage and calls it immediately due.
Thus, from the buyer's point of view, unless you are able to come up with alternate financing or cut a deal with the lender, you may find that the property will be put up for foreclosure sale. From the seller's point of view, if a foreclosure takes place, the seller could lose his entire equity in the property.
Buyers and sellers should recognize that consequences of a land sales contract.
It is a very valuable legal tool and where the mortgage is freely assumable -- such as with Federal Housing Administration and Veterans Affairs-insured loans -- it will assist in making the deal.
However, as with any kind of creative financing, buyers and sellers should go into this type of arrangement having received independent legal advice. Benny L. Kass is a Washington attorney. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.