By William Bronchick, Esq.
This article is for real estate investors and my real estate clients. 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?
But, but . . . isn’t It is Unethical or Fraud?
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. 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” an 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.
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 has 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 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 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 the 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 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 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 simply 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
The late Attorney Robert Bruss, a well-respected nationally syndicated real estate columnist, advocated the practice of 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 advocates the use of a land trust to avoid alerting 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.”
Laches
An equitable defense to the acceleration of the due on sale clause by the lender is called, “laches”. Essentially you argue that the lender waived its right to enforce the due on sale by waiting too long. Remember, the due on sale is not automatically triggered – the lender must choose to enforce it, and by failing to do so for a long period of time, they may lose their right to enforce it. There’s no particular “statute of limitations” for laches, but it is rather an equitable defense that can be argued and hopefully granted by a court in the case of a long wait for the lender to enforce the due on sale.
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. This can also be true of other forms of Creative Financing.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 percents 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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