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How to Beat the Due on Sale Clause

by William Bronchick, J.D.   
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The "due on sale" clause is probably the most talked about, most feared, and most misunderstood topic in real estate investing.

This article will dispel any misunderstandings you may have about the "due on sale" clause 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 it, we must understand what it is and where it came from.

The "due on sale" (aka "acceleration clause") is a provision in a mortgage document that 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 that is secured by a mortgage which contains no "due on sale" provision. FHA-insured mortgages originated before Dec. 1989 and VA-guaranteed loans originated before Feb. 1988 do not contain such 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 clause 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 1980s 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 home owners 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 home owners 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" clause:

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 that 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 Congressional statute would probably be struck down in court as being "ultra vires."

Enter: the land trust

A land trust is a 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 that defines the trust arrangement

  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 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 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?

From a legal standpoint, an 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 Official 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 and the New York State Land Title Association), contains a specific paragraph contemplating the buyer taking "subject to" an existing mortgage.

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 also concluded that "the breach of the contract of sale in contravention of the 'due on sale' clause is not a crime." [See Advisory Opinion No. 728.]

The Virginia Bar reached a similar conclusion in Opinion 471 (1983).

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 this clause to all parties involved in the transaction so that they are aware of the risk.

Utah Rule R162-2f-401a states, "Real estate licensees have an affirmative duty to disclose in writing to buyers and sellers the existence or possible existence 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 a 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 web site for the National Association of Realtors, 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 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 "wrap around" 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, are hundreds of thousands of investors, borrowers, agents, title company employees, and attorneys breaking the law 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 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.

In theory, a lender could sue you, the buyer, for inducing the seller/borrower to breach his mortgage agreement (called "tortious interference with contract"). This case would be pretty hard to make, since the standard mortgage agreement does not state that the borrower has to notify the lender if he transfers title or any other interest in the property.

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 that advocated, educated, and performed closings using a contract-for-deed. Some of the properties that were closed had Roosevelt's mortgages, which contained "due on sale" provisions.

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.)

Likewise, it would be just as easy for you to prove that the borrower was inclined to walk away from the property and default on the loan...Why else would he hand you a deed subject to his mortgage?

Of course, all of this discussion of "fraud" requires a material misstatement of fact in the first place. If anyone made a misstatement, it was the borrower. (OK, so it was your idea--so what?)

If the borrower and you simply transferred title without making any statements to the lender (as I described above), then there can be no fraud.

The United States Supreme Court recently declared that is not fraud to violate a "due on sale" if the borrower simply transfers title without saying anything to the lender. [See Field v. Mans, 1995.S.Ct.207 (1995).]

Furthermore, the court in Medovoi v. American Savings & Loan, 89 Cal.App.3d 875 (1979) 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.

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 today's 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 can 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. As 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.

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About the Author:

william bronchickWilliam Bronchick, J.D. is an author and attorney who regularly presents workshops and do-it-yourself seminars at real estate and landlord associations around the country. He is the president and co-founder of the Colorado Association of Real Estate Investors.

Bill specializes in all forms of asset protection and is the author of several great home study courses:

 
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