I recently had an email exchange with a client and her investment advisor. The client wants to buy a house and expects to resell it using a “wraparound” mortgage. She first sent me her question on Facebook, and I replied by email. The issues we covered come up often, and would be of interest to others. The text of that conversation (with names changed) follows:
Mary,
We should talk. As I said, any transfer of the property after you buy it, or any agreement to transfer the property, will trigger the due on sale clause. I have never found a way around that. I don’t think there is one. Gurus who claim to have a way are always missing something.
That being said, I’ve had clients (including myself) who transferred property to an entity that they own and control, and who tell the lender about it, and that has worked. The theory there is you have a legitimate reason for doing it (asset protection, estate planning, etc.) and you own the entity that owns the house, so there’s no real change. The reason I advise them to come clean about that is that it sets the client up for a potential defense if the lender doesn’t object at the time, but tries to call the loan due a long time down the line. If they don’t exercise the right, they could eventually lose it (if a court agreed with that idea.) It’s not a great protection, but it’s something.
HOWEVER, if you were to do that with the intent of selling the beneficial interest in the entity to someone else, and then you did do that, it would be fraud. I could not, and would not, counsel a client to commit fraud. Fraud is an all-around bad idea.
The entity idea probably wouldn’t work anyway, because a commercial bank would foresee that strategy, and would make it a prohibited transfer to sell or otherwise transfer all or a controlling interest in the entity.
It’s an insoluble problem, but people decide to do it, and probably a lot more are doing it now than before the market crashed last year. It’s important to have a “plan B.” If the lender calls the loan due then the buyer is going to have to refinance really quickly. If they can’t do that, then you, as the holder of the second, would have a right to redeem, which means you’d have to be in a position to refinance really quickly. Also, of course, you have to carefully underwrite the loan you’re making, and be able to keep up the payments on the first if something happens to your buyer’s ability to pay. A second mortgage (which is what the wraparound is) isn’t really such great security. It’s close to useless if you don’t have the credit and/or liquidity to respond to issues that might come up. That’s why second mortgages command higher interest than first mortgages. (And, with a wraparound, the higher interest is calculated on both the first and second loan amounts, which makes it a really good yield—as long as all goes well.)
I hope that helps.
Amy
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MARY ASKED HER INVESTMENT ADVISOR, “BOB,” WHAT HE THOUGHT. HE FORWARDED HIS ANSWER TO ME WITH AN INVITATION TO COMMENT
I agree with her almost completely the only difference I have with her is that the selling of the beneficial interest is fraud. Using her scenario of creating an entity, if the seller and the buyer are both members of an LLC and the buyer buys out the seller’s interest, I would say that is not fraud. Much if this depends on intent. If the intent is to take away someone’s rights through misrepresentation, I would agree that it is fraud. The scenario of creating an entity has a myriad of exit strategies and timeframes in which to implement them, so I would say that if done correctly no fraud takes place. But we are splitting legal hairs that I don’t think need to be split. Besides, Garn-St. Germain (the act that gives lenders the right to call the note due) addresses the issue. First, Garn-St. Germain does not provide for an entity other than an inter vivos trust as an exemption to the lender’s right to call the note due. Transferring into an LLC would give the lender that right. Furthermore, also based on Garn-St. Germain, the lender can call the note due on a lease option as well. The only leasehold grant that would not give the lender the right to call the note due would be a lease of three years or less that does not include an option to buy.
I say the best strategy is to do everything in the open – in front of God and everybody. Make sure the buyer understands the transaction well and signs appropriate disclosures. The likelihood that the lender will call the note due is very low as long as their note is getting paid on time. And, like I said on my previous email, have a plan B in the event the lender gets squirrelly and calls the note due.
By the way, I especially agree with her comments on the gurus and their “secret formulas.”
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Dear Bob,
Thank you for sharing your thoughts. I agree with you that we are on the same page about most of these issues.
Fraud is defined as either (a) lying or (b) withholding a material fact when the other side is relying on the facts being what they appear to be, and not what they really are (with the addition of the concealed material fact.) Concealment of a material fact is no different from actively misrepresenting a fact. Both are fraudulent. There is a venerable body of law acknowledging the right of a lender to restrict the “deal” it makes in a loan to the particular borrower to whom the loan was made, that is to say, the lender has an enforceable right to insist that the privileges afforded the borrower are and should remain personal to that borrower. Garn-St. Germain gives federally insured lenders the right to call a loan due on sale, whether or not state law supports that right. In Colorado, state law makes due on sale and due on encumbrance clauses enforceable. Applying the definition of fraud to the situation I proposed, it would be fraud to tell the lender that I am transferring the property to an entity owned by me, and that I am doing it for estate planning or asset protection purposes, and then to transfer the beneficial interest in that entity to a third party. As I said in my note to Michelle, commercial loans to entity borrowers also invariably define “transfer” as the sale of a controlling interest in the borrower, if the borrower is an entity. I agree with you that having an entity provides some good exit strategies, but I do not agree that these strategies would always be non-fraudulent.
Simply transferring property in violation of a due on sale provision is not illegal, and it’s not a tort. It’s just a breach of contract. On the other hand, lying about it could be found by a court to be fraud, subjecting the liar to tort damages. In an egregious-enough situation, it could also result in being barred from discharging the debt in bankruptcy, and even criminal fraud liability. I would advise clients against it simply on ethical grounds, but the “real world” consequences are also quite serious.
I agree that as a practical matter, as long as the lender is getting paid AND interest rates stay low, “creative” financing activities are probably low risk. There are enough actual defaults right now to keep lenders busy dealing with those things. That is one reason I stressed carefully underwriting the carryback borrower, and having a plan to make the payments if the borrower defaults. If the lender finds out about the transaction in the context of a monetary default on the loan, things could get pretty ugly. Also, when the market turns around and interest rates start to go up, lenders may very well start looking into who really owns their collateral, and start calling loans due. They have ways of finding out.
It occurred to me that investors might, these days, be able to find private or commercial lenders who are willing to consent in advance to a sale under certain circumstances—approval of the borrower, payment of a fee, etc. That is another possibility for financing this kind of transaction.
I agree with you that it’s best to be upfront about what is going on, and to have an exit strategy. If the transaction is properly documented and the buyer’s interest is of record, and if there is a viable exit strategy, then this kind of deal can be a good one for all involved, the investor, the buyer, and the lender. It’s always up to my clients whether to go forward with such a transaction or not. It’s not my job, or my intent, to talk them out of it. I just want to make sure they are doing it with their eyes wide open.
Amy
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BOB’S RESPONSE:
Amy,
I agree with you completely about lying about ownership being fraud. Unfortunately many investors who do “subject to” deals cross that line. That and the fact that they were not making the payments as agreed is why the North Carolina AG started cracking down on that particular practice. I also believe that any act in which the intended purpose is to conceal a transaction is also fraud. Again, the NC AG called Subject to transactions fraudulent based on the fact that they were putting the property into a land trust and transferring the beneficial interest in an attempt to hide from the lender the fact that the title had been transferred. Furthermore, investors were telling their sellers to tell the lender they still owned the property. In that case I think fraud is easy to prove. Personally that is an instance where I believe the thing speaks for itself.
In transactions where an investor is the buyer and the investor does not have his own funding, it is perfectly appropriate for him to bring in an equity partner and for the two of them to form an LLC which then purchases the real estate. In this case the it is the equity partner who will either bring cash, a loan he obtains, or both. In most of these cases it is the equity partner who retains the real estate and buys out the other partner if that is part of the exit strategy. In this instance there is no fraud and it provides for exit strategies that are limited only by the imagination of the parties involved. As Michelle can tell you, I always warn against using a sophisticated acquisition or exit strategy with an unsophisticated party with the exception of reasonable owner financing strategies on the sale to a retail buyer. In other words, I would never recommend forming an LLC with an owner occupant/retail buyer or seller.
In Mary’s case, she would purchase the property, fix it up and sell it to a retail buyer. If the buyer needs owner financing Mary could provide it in a seller second, or a wraparound mortgage. In either case she would provide proper disclosure of the transaction to the buyer, and follow all state and federal laws with regard originating and servicing the loan including RESPA, TILA, FCRA, FDCPA, etc. Furthermore, the recorded documents would properly reflect the transaction showing the buyer in title. In the case of a wraparound mortgage, the buyer would make the mortgage payments to Mary. Mary would be making the mortgage payments to the first mortgagee and banking the difference. In addition, Mary would have a backup plan b and c in the unlikely event the lender calls the note due.
While there is the risk of the lender calling the note due and the buyer defaulting, I don’t see a lot of exposure here. I also do not see any evidence of fraud. Is there something I am missing?
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MY COMMENT ON BOB’S REPLY:
I don’t agree that “Mary” would have to do all the same disclosures as a commercial lender, but I do agree there should be great care taken to make sure the “retail” buyer understood what she or he was getting into, and knew of the financial ramifications. I would also want to make sure the buyer had two or three months of mortgage payments readily available.
AS A POST SCRIPT:
Mary sent me a contract to review. It is a very short, very incomplete Contract for Deed (though it doesn’t call itself that.) It attempts to circumvent the due on sale clause by not having anything of record. Here’s what I told Mary about the contract:
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I didn’t need to spend much time looking at the contract before concluding that it is totally unsuitable for purchasing investment property in Colorado. Almost every paragraph has something of concern.
It’s an installment land contract with no protection for the buyer if: (a) the seller doesn’t keep the underlying encumbrances paid, (b) the seller gets a judgment lien against him or incurs any and all voluntary encumbrances, (c) the senior lender declares the underlying mortgage due on sale, (d) the seller dies, or (e) the seller decides to sell the property to someone else. It also does not comply with Colorado law concerning escrowing payments for taxes. The condemnation provision does not adequately protect the buyer. It provides for forfeiture of the contract as a remedy for buyer default. There are other issues. I don’t think you need more reasons not to use this.
As we have discussed at length, there is no way to get around the due on sale provision of the existing financing on the property. That being the case, a buyer should insist on getting a deed to the property at the time of purchase. Any carryback financing from the seller should be in the form of a note secured by a deed of trust. There is no other way to adequately protect your interests in the property. There is no good reason to use an installment land contract, especially this one.