There's No "Due on Sale Jail"

There's No "Due on Sale Jail"
by William Bronchick, Esq.
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; ( 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