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 and 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 Company 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;
(8) 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 Congressional statute would probably be struck down in court as being “ultra vires”).
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 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 (see Seller Financing Addendum to REPC). According to the New York Department of Real Estate, it is not improper for an agent to suggest a lease/option or contract-for-deed, both of which trigger the due-on-sale.
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 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 esistence 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).
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 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, a lease/option of any term, a contract for deed (except on VA guaranteed loans), moving out of the property within the first year and other transactions also give the lender the option to call the loan due. Thus, hundreds of thousands of borrowers across the country could be subject to prosecution. Furthermore, their real estate agents, attorneys, insurance agents, title companies and others could be indicted for conspiracy – LOL (laughing out loud).
There have been no reported cases of criminal prosecution for violation of the due-on-sale. In fact, the Federal Tax Court recently reviewed a case in which the taxpayer had taken title to 10 properties “subject-to” existing mortgages. If ever there were a case for federal prosecution, it would have been in a federal forum!
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 Company 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” which was published in the Chicago Bar Record in 1981. 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 the Marketplace
In most cases, lenders today are not concerned with violations of due-on-sale clauses on performing loans. There is no financial incentive for a lender to enforce a due-on-sale provision on a performing loan if market interest rates aren't any higher. A lender does not want non-performing loans in its portfolio – it simply looks bad. This trend will probably continue so long as interest rates remain within a few percentage points of existing loans.