Eckley & Associates Video ArticleTHE ONGOING REAL ESTATE DISASTER, PART IV: -

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DECEMBER 1, 2010

In my past several monthly Newsletters, I have discussed various aspects of the national and local “official real estate and economic recovery programs” and found them resembling nothing of the kind. I have usually concluded that “Black Holes” would be a better description for the programs and “Culprits” would be a better name for those running them.  I stand by that notion today and I feel vindicated when the AGs of most states have now started prosecuting the Fortress Five Banks for some pretty egregious lawlessness against, well, all of us.  Even the Establishment is finally catching on….or as least it is getting embarrassed into a response by the rising din of public outrage.  Alas. The Fortress Five are not “nice guys.”  Handing to them the mandate and sole power under the HAMP, HAFA, 2MP, HOPE and other recovery programs to do “justice” for us in sorting out this mess as they see fit has for them come to mean, once again,  “Just Us.”   It was the “Just Us” theory that got us here in the first place and more of it promises worse.  Indeed, it is high time to replace the silk suits of some boardroom bandits with striped pajamas.

That’s if we can get through the disinformation campaign they are now generating to try to protect themselves.  Right about the time the AGs announces criminal investigations into the Fortress Five, we are all suddenly being bombarded yet again with contrived “news” that “everything is really getting much better.”  It’s the worn out “prosperity is just around the corner” screed the Banking lobby’s payrolled press pundits, politicians, profiteers and apologists haul out each time they see the mob coming towards them down the street carrying a hangman’s noose. The same disinformation we have heard for four blundering years now.  Two recent weeks of fewer unemployment applications being made and a single national retail sales rise of a collective 3.3% over Christmas of last year is not the “’U-Turn Recovery” it is being touted to be.  As to the “rosy” unemployment statistics, that recent report only covers the so-called J3 level—the unemployment-insured population—and drops from it those who have run out of benefits or who have just gotten frustrated and simply stopped looking for work.  The J6 level, those employable but unemployed and not on unemployment compensation, still hovers around an actual 13.5%.  More unemployed people than ever in the history of this country.  So don’t pop those Champaign corks just yet. 
Instead….well……curb a Corona, as, barring a Wall Street collapse, there is going to be a modest real estate rise in 2011.  Not a big one.  But some palpable movement that will cause genuine asset appreciation before the end of 2011 that, if properly magnified through leverage, could line some of the smarter pockets rather nicely for as long as it lasts (see last month’s “Double-Dip” Newsletter).  That’s worth a high-grade beer, at least.  And, no, it’s not the banks that will make it happen.  It is in spite of their incompetence, book-juggling, lies and scofflawry.  It’s much about soft money, hardening commodities and some about rising confidence.  I will have a lot to say about that rise in coming Newsletters.
To be ready for 2011, though, we need more methods for equity to be generated than traditional institutional finance (which is getting harder to get and which rarely pencils for investors who need to turn over property regularly to release and realize accumulated equity and thus make money).  In this Newsletter, I will discuss an alternate vehicle for equity and equity redemption in 2011 by resurrecting and describing a sale method which has almost been forgotten:  The “owner-carry” where, in fact, almost any deal can be possible and where the not-so-insignificant “friction costs” of double appraisals, double loan points and huge down payments enables leverage and does not rob net equity.
What is holding many potential fair-market transactions back (residential and commercial) is the unavailability or costliness of finance through the usual mechanics, means and methods.
A flash for those many among us who may not even have been alive then (let alone in business): owner-carries are not a three-headed aardvark in the industry.  “Owner-carries” of one type or another were 50% of the 80s marketplace in many western and southwestern markets!  We simply forgot about it when the (now known to be misbegotten) bank-only financing boom started.  THERE IS A REASON THAT EVERY RESPONSIBLE REALTOR ASSOCIATION OFFICE STILL SELLS “OWNER WILL CARRY” and “LEASE/OPTION” SIGNS!   We used those signs and did those contracts in a major number of our deals.  For the above reasons, the 2011 market is certainly ripe to do so again!  It behooves us to relearn the technology of these deals.

There are three main present markets to handle owner-carried finance:  Owner-carries, themselves, i.e. the sale and purchase agreement between the principles--they are a hard asset and a cash flow asset;  then there is a private secondary market for owner-carry paper resale (the note buyers out there—quite a large group, actually, and buying like crazy);  then there are private, non-conventional lenders who will make an equity-removal loan (seller obtains the loan on seller’s own property for cash to seller immediately prior to the sale to buyer) which is “wrapped” into an owner-carry by which the buyer’s payments are channeled by an escrow first to servicing the underlying pre-sale loan with any balance to the seller.  In some cases, the owner-carry is PRIMARY, meaning directly between seller and buyer; in others it can be SECONDARY, or “THIRD PARTY” such as owner selling to an investor who then leases (many times with option) or sells back to the buyer on an “owner-carry.”  In some cases it can be a combination where owner sells to buyer and agrees to lease back from buyer.

There are four types of owner-carried finance last seen most routinely as the principal finance up to the late ‘80s, the last time the markets plummeted like this and institutional finance evaporated.  They are (1) lease-to-equity (2) lease/option; (3) all inclusive deed of trust or all-inclusive mortgage (4) installment land agreement or land sale contract.  The disposal method for the resulting paper is (1) owner-hold or (2) owner resale of the resulting paper to a holder who is more a paper investor than a real estate investor (this provides product to those who are tired of their .010% to .075% bank returns on money but who still do not want to directly invest in real estate).  As noted, in some cases, the seller removes equity prior to the sale by taking out a loan and wrapping it.
In this edition of the Newsletter, one of the least understood but most powerful owner-carried finance methods is examined:  The “lease-to-equity” and lease/option—good for use when the seller needs to sell, the buyer is a good candidate to buy but is hesitant to commit to a full purchase, or when soft terms or a “test drive” can make the deal or when the parties want to do the deal, but also to buy a few year’s time to see where the market might go—a “market hedge.”  Later Newsletters will cover other owner-carry methods, such as the all-inclusive deed of trust (“AITD”)—good for when the parties want to do the deal, low downs or other soft or flexible terms are needed to make it happen and when soft or flexible terms can get a better price and also when there is no due-on-sale problem with underlying finance.  Since they are kin and the principals are the same, for purposes of this explanation, both lease-to-equity and lease/options will be treated as one, the collective lease-option.

Under a lease-option, the seller both leases to buyer and sells them an option to buy as an installment sale of the option.  Note that an option to purchase is not immediately granted and that it must be purchased.  It is the purchasing of it that gives the parties the tax affects they are looking for and can assist in how the instrument is viewed under the various due-on-sale and anti-alienation clauses contained in various underlying encumbrances in the marketplace.  The parties elect usually to give the buyer the tax-treatment/benefits of a purchaser on an installment method (and of course the seller must accordingly account it as an installment sale).  As a sale of an option to purchase, and “in effect” a present sale financed by an owner-carry, the agent is entitled to a full commission, immediately, at closing. 
The seller, in addition to a “sale,” and without letting the title to the property pass until paid in full, gets a marketable interest rate which readily beats what the seller has made in the historically tiny rates paid on money markets and savings these days.  He gets his price as the initial commitment, knowing full well that either the future market will support that price and rise to it, in which event he over-sold today at tomorrow’s recovered price and made out like a bandit if it is (very likely) exercised, or even the future market does not support his price and so what he got instead was what often calculates out to triple-net lease income, his underlying paid, his property-holding costs, taxes and insurance paid,  and the house back in good condition to try again.
The buyer gets the use of the property, a marketable finance rate, tax benefits and all without the large and permanent financial commitment that a straight purchase requires.  The buyer is often very willing to pay more money for the purchase price if and when he elects to exercise it (in his discretion) because with the option he gets a chance to “play the market” (wait and see if it will stay flat, go down, go up—and if it goes up he really made out) while with the lease he enjoys the actual use of the property.
Consumers have lease-optioned much of what they most desired for years.  Airplanes, high-end automobiles, telephone and computer equipment, furniture, tools and equipment were and are still common items.  For businesses, it allows capital retention while the use is accessed (usually the most important for profits) and allows generous tax benefits.  It is no different with real estate.

Here are some lines being used in a current luxury home real estate publication out there in the market both for lease/options and, where applicable AIDTs:

Are you ready to get out from under the mortgage payments on your home, but are afraid to sell in today’s market?  Want to get a competitive advantage on the marketplace and get a better price by offering something few are?   READ ON!Have a home or building to sell but buyers are reluctant in this marketplace to buy at anything other than at a giveaway price?Getting no bites on your listing to sell but don't want to give the property away to a lowball offer or reduce the price again?Earning next to nothing on your savings and would like a steady 5% to 6% cash flow without further investment than your own equity?Like to unleash the earning power trapped in your home or building for a steady cash return, payable by a platinum-level buyer?Tired of waiting for the moment to place your home or building on a market that seems only to be endlessly spiraling down?Like to have real ownership of your home or building still in your hands AND a high return on the value locked into it?Would you like to sell but seem to have too much mortgage and too little (but still some) equity for this distressed marketplace?   Would you like to land even more equity by offering a better deal to a buyer?
This is YOUR CHANCE TO SELL YOUR HOME or other property which other methods or a bad economy is otherwise denying you.  This is not a gimmick.  Handled by a quality luxury real estate agent, licensed escrows and experienced attorneys for quality sellers and buyers!

Do you want to live a luxury lifestyle but are reticent to pay or be encumbered by $2M or more in today’s declining market?  Unwilling to plunge into the market and take the chance that today’s price will be tomorrow’s down-spiraling calamity?
Want to hedge your investment bet with a purchase program that gives you the property and the finance and an option to exercise payoff if the market goes up or to conclude the contract and move on without further liability if the market goes down?
Want in-built finance at rates and terms you design rather than working with the inflexible traditional jumbo lenders?
Want the tax benefits of a sale without the mortgaging and paperwork hassle of it?
This is YOUR CHANCE TO BUY YOUR DREAM HOME or other property which other methods or a bad economy is otherwise denying you.  This is not a gimmick.  Handled by a quality luxury real estate agent, licensed escrows and experienced attorneys for quality sellers and buyers!

AGENTS!  We have sellers and buyers ready, willing and able to buy and seal on the NEW LEASE/OPTION AGREMENT, make significant down payments, finance at reasonable rates and pay full sales commissions at close.  SEND US YOUR OFFERS!
INVESTORS!  FINANCIERS!  We have top-grade, local, above-market-rate, 700-plus FICO real estate secured paper for sale.  Check us out for some buys!  We are also making high-end real estate sales with strong parties for above-market rates which need funding.  Check us out for some top fully-secured returns!

Some of the rules I will discuss here are national ones and since many real estate licensees are often dealing across adjacent state lines, I wanted to cover more than just Arizona in the following ethical discussions.
Real estate licensees owe a duty of honesty, good faith, fair dealings and full disclosure to ALL parties to a transaction.  In Arizona, see Ariz. Rev. Stat. § 32-2153 A and B, R4-28-503c and R4-28-1101, et. seq.  In California, see California Business and Professions Code; Disclosures in Real Property Transactions, 6th Ed. (2005), State of California, The Real Estate Transfer Disclosure Statement (TDS), and particularly Cal. Civ. Code Section 2079.13 et. seq. and Cal. Civ. Code Section 2956 et. seq., 12 USC Section 1701x, The Housing Community Development Act (1987).  For all California Disclosures, including important ones concerning owner-carries, log to 
Essentially, most state real estate and licensure rules, including Arizona and California, hold as follows concerning these transactions:
Agents owe a fiduciary duty to their clients to put the interests of their clients ahead of their own.  Realtors additionally owe the foregoing through the NAR Code of Ethics.  All of these financing methods pose risks to the owner/seller as follows:  (1) default of the lessee, optionee or buyer; (2) bank disapproval of the transaction; (3) some tax deduction shifts; (4) potentially unmarketable resulting paper.   All pose risks to the lessee, optionee, or buyers as follows:  (1) inability of the buyer to keep in good stead of the transaction due to economic changes;  (2) adverse bank action due to the transaction method, itself, (3) some loss of homeowner/buyer tax benefits under leases/options; (4) risk that the lessor/optionor/seller will not keep in good stead with the bank; (5) a potentially unmarketable resale position due to method of underlying purchase.  For both parties, tax risk questions and the ability or risks to “wrap” underlying encumbrances must be spelled out and they need to be advised to contact their own legal and tax counselors.  All of this must be disclosed in writing to the parties and be understood by them both by the real estate licensees but also from the seller to the buyer as a good faith transactional disclosure.  THERE IS NO SUBSTITUTE FOR DISCLOSURE AND INDEPENDENT CONTACT WITH AN ATTORNEY IN THIS ARENA FOR BOTH PARTIES.

GENERALLY:  Many properties have an underlying encumbrance which purports to restrict all or certain kinds of transfers.  Arizona and California law had long histories conceptually AGAINST the restrictions against transfer that the so-called due-on-sale clauses represented.  After the Wellencamp and Dawn InvestmentCalifornia cases in 1978 and 1982, respectively, effectively prohibited lenders in those states (and had great influence in other states like Arizona) from arbitrarily enforcing these clauses, two legal developments came about.  One was the passage by the Federal Home Loan Bank Board (followed by other federal regulatory agencies) of a rule which validated the clauses in debts issued by federally-chartered savings and loans (and later followed by the U.S. Comptroller of the Currency for federally-chartered banks), later validated by Fidelity Federal Saving and Loan v. de la Cuesta case of 1982 to overrule California law and some Arizona statutes which appeared not to permit due-on-sale enforcement on the basis that a federal rule “pre-empted” state law under the federal supremacy clause of the U.S. Constitution and other rationales.  The other was the passage of the federal Garn-St. Germaine Act in 1982 which upheld certain enforcements of the due-on-sale clause for state-chartered banks and thrifts, which contended again, that it pre-empted state law to the contrary.  The Garn Act excluded some transactions (prohibited restriction of them) that would thus be allowed under the California and Arizona law against restrictions:  (1) the creation of a subordinate lien (2) transfers by death of a joint tenant (3) grant of a leasehold of no more than 3 years (4) transfers to certain relatives; (5) transfers to an inter vivos trust in which the borrower remains the occupant of the property.  Arizona restrictions against restraints of alienation and contract penalties have not been repealed. 
In many cases, the clause is not a “due on sale clause” at all.  A true due on sale clause states that the entire loan balance becomes “due on sale or other (lawfully restricted) transfer, as the option of the holder.”  Many debt instruments—commonly found in non-bank-drawn documents or private owner-carried documents which are not regulated by the due on sale laws—have only an anti-assignment clause which is distinctive and is NOT a due on sale clause and thus not covered by the laws enforcing due on sale clauses.  These clauses usually covenant that “in any sale, transfer, assumption or assignment of the contract or the property covered by it, the consent of the (lender/owner, etc.) must be first had and obtained.”  Case law will not let requests by the debtor for those transfers be unreasonably, arbitrarily or capriciously declined.   The test is usually this:  “Does the proposed transfer, method and transferee impose a greater risk of default or damage to the (lender/owner) than is posed by the original debtor?”   If not, then the transfer, method and transferee is a reasonable one and the transfer can take place.  Applications for this kind of transfer typically are made in writing to the creditor or owner, explain the transaction, provide a proposed copy of the transfer documentation showing terms, the name for the transferee and a financial statement and credit report showing the transferee to be at least as creditworthy as the original borrower and giving the creditor/owner an opportunity to make comments and approve or disapprove and state the reasons for any disapproval.  These kind of transfers are by assignment or “wrap around” agreement and are almost always “non-novating,” meaning that the original borrower stays in the chain of liability and could, if the transferee does not perform, be co-claimed against in any enforcement action by the owner/holder.  If the owner/holder does not answer after a deadline date given or declines for no stated reasons or for unreasonable, arbitrary or capricious reasons, it is deemed an unreasonable decline and the transferor and transferee normally close the transaction.

SECOND ANALYSES:  If you have concluded that it probably is a “real” due-on-sale clause, that does not end the analyses or the options.  One option of course is to get lender consent.  In this environment, many of them will be more receptive to it than they once were, as long as the original borrower stays on the loan until it is paid off.  Don’t try too hard for a “novation” (seller released from the loan and the new buyer assumes the loan) as the paperwork on that for the lender to accommodate is too complex and virtually amounts to issuing a new loan.  Besides, if the buyer was that qualified, he could get his own finance.  Where consent is given, it is often “go ahead and do it, just tell the seller to keep up those payments and provide us with a copy of the finished contract.”

THIRD ANALYSES:  Some lenders will not consent as their only knee-jerk response, whether they have the right to or not.   The next analyses then turns to whether there are any defenses to the enforcement of the clause brought on by facts particular to the transaction.  The lenders hands are often not clean and none of the due-on-sale laws and regulation will permit or excuse bad lender conduct or a borrower’s pure contract defenses.  Has the lender violated any consumer protection laws, violated RESPA, Truth-in-Lending, engaged in mortgage fraud or other acts or omissions of false appraisal practice which strike at the heart of the loan enforcement, waive the clause or which should otherwise stop the lender from enforcement.  Has the lender acted at all times in good faith?  For example, in California and Arizona  each party to a contract owes the other the implied covenant of good faith and fair dealing.   In Arizona,Wagonseller v. Scottsdale Mem. Hosp., 147 Ariz. 370, 383, 710 P.2d 1025 (1985) and the approximately 103 cases thereafter citing it with approval holds that all contracts impliedly contain a non-disclaimable covenant to act in good faith.  The covenant of good faith requires that each party to act fairly towards the other and prohibits each party from doing "anything that will injure the right of the other to receive the benefits of their agreement.”  Enyart v. Transamerica Ins. Co., 195 Ariz. 71,  985 P.2d 556, P14 (1998) (citing Rawlings v. Apodaca, 151 Ariz. 149, 725 P.2d 565 (1986)).  Often, there have been oral agreements and understandings made by the lender (“..go ahead and do the deal..,” later retracted..) which even contract integration clauses (disclaiming oral agreements) cannot trump.   "Boiler plate" clauses will not change the "actual deal" which the parties bargained for or could anticipate, including warranties implied by law and promises on which the other relied.  Borrowers are entitled to their "dickered deal" and the reasonable expectations of their bargain.  In Arizona, See e.g Darner Motor Sales, Inc. v. Universal Underwriters Insurance Co., 140 Ariz. 383, 682 P.2d 388 (1984).  An attempt to exculpate the deal actually made likely violates the good faith and fair dealing covenant implied into all Arizona contracts. defendants which made it impossible for the plaintiffs to reach their contractual expectations.  More specifically:  The covenant of good faith requires that neither party do "anything that will injure the right of the other to receive the benefits of their agreement" and the duty not to act in bad faith or deal unfairly is part of contract, and remedy for its breach generally is on contract itself. 
Under Darner,  parol  evidence (evidence outside of the contract, including an oral consent to transfer or oral promise) is admissible to establish that actual deal.  Claims like this are valuable trading stock in reaching compromises with the lender that allow the deal.

FOURTH ANALYSES:  Moreover, there are exceptions and allowed transfers even under the due-on-sale laws where no consent is needed.  For those or for other situations in which lender consent is not going to be actively sought, there may be other laws, rules and exceptions that still give you room for an owner-carry deal without running afoul of the clause.  Many times, the lease-option method clears those hurdles or runs the least risks.  Let’s look at some of those other laws, rules and exceptions.

FIFTH AND INESCAPABLE ANALYSES:  If the transaction results in Bank loan payments being made on time and the loan being ultimately paid off without a hitch, who really cares?  Who really would even investigate title when the loan is always current?  As long as the loan interest rate is equal to or higher than market—no one.  Right or wrong, the author of this Newsletter has seen well over several thousand owner-carries of one kind or another written right over the top of clear and enforceable due on sale clauses and of those the author has seen less than ten generate any issues and those were almost always triggered by a non-payment.  The well-written owner-finance anticipates the lender might want to get paid off early and builds that in by allocating between the parties how the burden of that will be handled.

In California, see Cal. Civ. Code Section 2924.6 which exempts enforcement of due-on-sale clauses in connection with a deed of trust on residential property if the loan was executed or refinanced on or after January 1, 1976, the following:  a transfer between spouses, a transfer resulting from a decree of divorce or separation, a transfer to an inter vivos trust of which the debtor is a beneficiary, the imposition of a junior lien or encumbrance on the property.  In California due-on-sale clauses have been held not to apply to purchase options.  Pacific Southwest Dev. Corp. v. Western Pac. RR (1956) 47 C2d 62, 301 P2d 825; Vierneisel v. Rhode Island Ins. Co. (1946) 77 CA2d 229, 175 P2d 63.   In Arizona, as well, a “sale” has not occurred simply by the issuance of a purchase option.  If that was the case, then the AAR residential resale agreement—certainly a functional “option to purchase”—would violate the existing underlying mortgage the moment it was signed by the parties.  Few residential mortgages do or can limit leasing and practically speaking the lenders will normally permit leasing if it is otherwise restricted by the loan.  Most commercial loans anticipate liberal and long term leasing.  The actual prohibitions of the debt instrument (especially the ones issued by federally-chartered institutions) need to be examined to determine their restrictions.  Some are not as pervasive as is commonly supposed and many are in a secondary market that now has control over them and would prefer them to be performing.  At the same time, all of the common law defenses are available, including “dirty lender” defenses, below.  In some cases, there are anti-predatory lender rules that prohibit all lenders from arbitrarily making a “call” on a loan.  In California see Fin C Sections 4970-4979.8 for residential loans under current FNMA limits (now $729,400).  See also Coast Bank v. Minderhout (1964), 61 C2d 311, 38 CR 505 (over ruled on other grounds in Wellencamp) indicated that flat prohibitions of any transfer might be an unlawful “disabling” restraint on alienation.  The lender can also “waive” the clause by accepting payments after the transfer, see Rubin v. Los Angeles Fed. Saving and Loan Ass’n (1984), 159 CA3d 292, 205 CR 455.  This is a matter always requiring consulting with legal counsel.

Historically lenders have used due on sale or acceleration clauses to protect themselves from unanticipated risks by ensuring that a responsible party continues in possession of the mortgaged property in the event that ownership of the property is transferred.  Snow v. Western Sav. & Loan Ass'n, 152 Ariz. 27, 31; 730 P.2d 204, 2008 (1986).  Beginning in the 1970s, many states, including Arizona, began to invalidate due on sale clauses as illegal restraints on alienation.  See e.g. Baltimore Life Insurance Company v. Harn, 15 Ariz.App. 78, 486 P.2d 190, petition for review denied, 108 Ariz. 192, 494 P.2d 1322 (App. 1972)(holding that a due on sale clause is only enforceable if the lender’s security is threatened).
In response to extensive lobbying by lenders, the Congress and the Federal Home Loan Bank Board (“FHLBB”) promulgated regulations to preempt state statutory and common law restrictions on the use of due on sale clauses for federally-chartered institutions.  In Fidelity Federal Savings and Loan Ass’n v. De la Cuesta, 458 U.S. 141, 156 (1982), the United States Supreme Court held that any state laws restricting the enforceability of due on sale clauses for loans held by federally-chartered institutions were in direct conflict with the FHLBB regulations and were therefore void under the Supremacy Clause of the U.S. Constitution.
Following the De la Cuesta decision, Congress enacted the Garn - St. Germain Depository Institutions Act of 1982 (“Garn Act”), which made the state-chartered lenders subject to the FHLBB regulations as well.  In Scappaticci v. Southwest Sav. & Loan Ass'n, 135 Ariz. 456, 459 (Ariz. 1983), the Arizona Supreme Court acknowledged that Arizona state common law relating to due on sale clauses was preempted by the Garn Act.  Prior to the Garn Act, Arizona common law only permitted the enforcement of a due on sale clause when the lender’s security was threatened.  Baltimore Life Insurance Company v. Harn, 15 Ariz.App. 78, 486 P.2d 190, petition for review denied, 108 Ariz. 192, 494 P.2d 1322 (App. 1972); Patton v. First Federal Sav. & Loan Ass'n, 118 Ariz. 473, 578 P.2d 152 (1978).  Because the Garn Act represented a dramatic departure from state law, Congress permitted states to enact the restrictions gradually over what was known as the “window period.”  Following the 5-year “window period” ending on October 15, 1987, Arizona’s common law restrictions on due on sale clauses ceased to be enforceable.  Now, all due on sale clauses contained in loans and security agreements by federal or state regulated institutions are enforceable in accordance with Garn and its associated regulations, which essentially permit said clauses to be enforced according to their terms with few exceptions.
The Garn Act applies to due on sale clauses contained in real property loans and security agreements, including any “loan, mortgage, advance, or credit sale secured by a lien on real property, the stock allocated to a dwelling unit in a cooperative housing corporation, or a residential manufactured home, whether real or personal property.” 12 U.S.C. § 1701(j)(3)(a)(3). 
The Act states that “Notwithstanding any provision of the constitution or laws (including the judicial decisions) of any State to the contrary, a lender may . . . enter into or enforce a contract containing a due-on-sale clause with respect to a real property loan.  12 U.S.C. § 1701(j)(3)(b)(1).  “The exercise by the lender of its option pursuant to such a clause shall be exclusively governed by the terms of the loan contract, and all rights and remedies of the lender and the borrower shall be fixed and governed by the contract.”  Id. at § 1701(j)(3)(b)(2).
Despite permitting the lender broad ability to enforce due on sale clauses, the Act states that the lender “is encouraged to permit an assumption of a real property loan at the existing contract rate or at a rate which is at or below the average between the contract and market rates, and nothing in this section shall be interpreted to prohibit any such assumption.”  Id. at § 1701(j)(3)(b)(2).
According to Arizona statute, the Garn Act “applies in accordance with its terms to all real property loans” made after October 15, 1987.  Arizona state law prohibits a lender from increasing the interest rate on a loan assumption for a residence of 2 and ½ acres or less unless the original borrower is released from the indebtedness.  A.R.S. § 33-806.01 (2009).  Further, the lender cannot charge a fee for the transfer that exceeds 1% of the balance due on the secured obligation.  Id.
The Garn Act and the current Office of Thrift Supervision regulations contain several limitations on the enforceability of due on sale clauses:  THE FOLLOWING CANNOT BE RESTRICTED BY THE LENDER WHO IS UNDER THE GARN ACT:
(1) A lender shall not (except with regard to a reverse mortgage) exercise its option pursuant to a due-on-sale clause upon:
(i) 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: Provided, that such lien or encumbrance is not created pursuant to a contract for deed;
(ii) The creation of a purchase-money security interest for household appliances;
(iii) A transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety;
(iv) The granting of a leasehold interest which has a term of three years or less and which does not contain an option to purchase (that is, either a lease of more than three years or a lease with an option to purchase will allow the exercise of a due-on-sale clause);  NOTE HERE THAT IF THE PURCHASE OPTION IS CURRENTLY VESTED AND PART OF THE LEASE it can trigger the clause, but what if it is not “contained” in the lease and what if it is not a subsistent “option”   until purchased and the purchase of the property is simultaneously a purchase of the option, so it never becomes subsistent until a full payoff?  It also does not prohibit consecutive, rolling three-year terms on the lease to the same tenant.  This is so general as to by cryptic, but it is not the purpose of this Newsletter to go into “how to do it” as that is a three-hour course with lots of original documents.  Suffice it to say that there are some very sophisticated lease-finance documents out there that take advantage of these holes--if you know where those documents are and no, they are not in $5 pads at the Association store.
(v) A transfer, in which the transferee is a person who occupies or will occupy the property, which is:
(A) A transfer to a relative resulting from the death of the borrower;
(B) A transfer where the spouse or child(ren) becomes an owner of the property; or
(C) A transfer resulting from a decree of dissolution of marriage, legal separation agreement, or from an incidental property settlement agreement by which the spouse becomes an owner of the property; or
(vi) A transfer into an inter vivos trust in which the borrower is and remains the beneficiary and occupant of the property, unless, as a condition precedent to such transfer, the borrower refuses to provide the lender with reasonable means acceptable to the lender by which the lender will be assured of timely notice of any subsequent transfer of the beneficial interest or change in occupancy.
(2) A lender shall not impose a prepayment penalty or equivalent fee when the lender or party acting on behalf of the lender
(i) Declares by written notice that the loan is due pursuant to a due-on-sale clause or
(ii) Commences a judicial or nonjudicial foreclosure proceeding to enforce a due-on-sale clause or to seek payment in full as a result of invoking such clause.
NATIONWIDE - 12 C.F.R. § 591.5 (2009):  The lender is also precluded from imposing “a prepayment penalty or equivalent fee when the lender or party acting on behalf of the lender fails to approve within 30 days the completed credit application of a qualified transferee of the security property to assume the loan in accordance with the terms of the loan, and thereafter the borrower transfers the security property to such transferee and prepays the loan in full within 120 days after receipt by the lender of the completed credit application.”  Id.
The right to enforce a due on sale clause may be waived if “before the transfer, the lender and the existing borrower's prospective successor in interest agree in writing that the successor in  
interest will be obligated under the terms of the loan and that interest on sums secured by the lender's security interest will be payable at a rate the lender shall request.”  Id.  At that point, the lender must “release the existing borrower from all obligations under the loan instruments, and the lender is deemed to have made a new loan to the existing borrower's successor in interest.”  Id.
In most cases, where the transaction is structured to give the buyer a real stake in the property that is “owner-like” and have financial significance (not “token consideration”) and especially where the parties have specifically opted to treat the transaction as a sale, IRS and most state and local revenue departments will do so, as well.  Most of the IRS cases are in fact ones where the parties are trying to keep a transaction FROM qualifying as a sale, requiring gain treatment and, where applicable, installment sale reporting.  The Uniform Commercial Code has an assumption that a purchase option exercise price of less than 10% of the lease consideration is, per se, a sale.  Where the documents are often ambiguous, IRS looks at how much money is placed down or paid in one year or over several years for the overall transaction.  IRS will almost always respect the affirmative ELECTION of the parties to treat the transaction as an installment sale and will only look then to have seller and buyer each report it and pay taxes on it that way. 
For residential properties, see the deduction limits for interest in IRC 163(h)(3), i.e. interest on the first $1 million of principal, not to exceed $100,000.  For all transactions, see IRC 453c., Rev. Rul. 72-408 for installment sale treatment; IRC 1274 and 483 for ordinary income treatment of interest; IRC 1234(a)(1), Reg. 1.1234-1(a) for option financing; Bitker & Menikoff, Structuring Business Transactions for Federal Income Tax Purposes, 1978, Wis. L. Rev. 715 and Rev. Rul. 55-540 for classifying lease/option as a sale. 
Being reclassified as a sale, the residential owner-occupier “buyer” can deduct (if properly written) non-purchase-money rents as “functional interest” and property taxes, just as a conventional buyer might.  The “seller” accounts for rents as ordinary interest income—no differently than would be rents as both are ordinary income items.  Being reclassified as a sale, the investor or commercial tenant can depreciate and otherwise deduct rents and all other operational expenses.
Personal guaranties—an agreement in writing whereby one assures the performance of another—can enhance the credit of an otherwise unattractive buyer.  If the buyer is not as financially solid as the seller would like, he can ask that a guarantor step up to the plate who does have the financial strength to guaranty the performance of the buyer throughout the whole loan or some period of the loan.  This is not he same as a “co-signer” who simple signs his or her name beside the borrower’s on the contracts.  A genuine and the best Guaranty is entirely a separate instrument. 
Guaranties are enforceable to some degree in all states, even in some cases where the primary debtor would not be personally liable, such as in an “anti-deficiency” residential foreclosure state like Arizona.  Absent some defenses provided by common law, they are 100% enforceable in Arizona.  In California, guarantors are not clearly liable for debts which are regulated by the “one-action rule” of CCP 726(a) and can raise that defense.
See more about debts, deficiencies and debt liabilities under real estate debts under “FAQS”. 
Many E & O carriers for real estate licensees will not cover deals which do not use the approved Realtor® forms for their areas.  It is easy to use these forms even with seller-carries and lease/options.  Here is how it is done:  In all states, there is a residential sale or resale agreement and a seller finance section or addendum to the sale agreement that is part of the official Realtor® forms.   Use these and on the finance addendum indicate the method of finance and if it is lease/option so state in the area for written inserts.  Note that the “final finance documents are to be prepared by an attorney and placed in escrow.”  This is no different than Bank finance, which has also always prepared their own finance documents which are not Realtor® forms and placed them in escrow for closing as the final documents in the deal.  Thus, the normal “Realtor® documents “have been used for the deal” and your E & O carrier should cover and it maybe unlawful interference with the contractual relations of sellers and buyers or an anti-trust violation for it not to.  Always check to be sure.  And of course it should go without saying:  Get an attorney and CPA involved in this deal who knows something about this complex area of practice!

Let’s count the blessings that owner-carries give everyone and bank financing does not.
With the owner-carry and particularly the lease/option, the seller moves the property in this miserable market where every edge is needed because he does not have to “get it all up front” and “go hard” on an “all cash today price” from the buyer.  The property is thus usually moved for a better price, and gets a return on the sale price as either rents or interest that is better than what seller’s money market is making.  The interest rate is usually at a better rate than bank loans—5% to 6%--about 8 to 10 times better than common money market rates--is not uncommon.  The buyer is usually happy to pay it as he gets other softer terms and no hassle like he gets from the banks. 
On the other side, the seller turns his “dead asset property” into an active source of income.  He holds the title until it is cashed out.  And he might get that better purchase price in the future as property recovers over the several year period of the financing, but even if the “buyer” does not ultimately purchase it, at least the “seller” made some income, got his payments made for him for a number of years, and has the property back with more equity than he started with.  He is now free to go to the market to do it again if necessary until a strong-enough recovery comes around that makes his sale price attractive. 
Back to the other side again:  The “buyer” gets a softer, more manageable deal, often some significant leverage due to typically low down payments, and some tax deductions that help bear the costs and which encourages him to offer a higher ultimate purchase price.  In addition, the buyer gets the no-risk option of waiting out the market to see if it rises over the period of the lease to meet his price.  If it doesn’t, he is free to conclude the lease and move out.  Both parties get the “sale” done, the mutual objectives met and with all of the tax advantages.
And the best news for last:  This is a TRUE SALE and real estate licensees should collect a FULL SALE COMMISSION!
So now, query:  How would all licensees NOT have the responsibility to introduce his or her clients and customers to one of the 4 owner-carry options like these EVERY time in this kind of market?   Who would one not put “potential owner carry” as an acceptable finance mechanism in every MLS listing?  Nothing ventured, nothing gained. 
Owner-carries are a “WIN-WIN” alternative that cannot be left gathering dust in the dark.  We who care about curing the malaise have to get these “trieds-and-trues” back out of the closet and bring them and the talent to use them back to the marketplace!
No.  The real estate and economic mess is not over yet and will not truly be over for many years.  But you have two choices when the economic ship sinks as ours has:  drown or straddle some flotsam and paddle like hell until landfall!  Owner-finance is not always a sure landfall and a dry bed, but it is one of the better currently available oars to try to get there. 
‘Nuff said.


J. Robert Eckley is a multi-state real estate, agency and banking law attorney, successful litigator, popular writer, educator, economist, past Realtor and national speaker with an immense personal and professional involvement in forefront issues over the past three decades. He has established precedent at the Supreme Court and co-founded transactional laws, rules and forms that guide practitioners today. He has been a real estate licensee and a former Realtor for three decades, was named to numerous Commissioner's Advisory Committees and Governor’s Agency Advisory Committees, received a host of leadership and instructor awards, is a CCIM Affiliate, testified in Congress against the due-on-sale clauses in 1982, fought the clause in state and federal courts, fought against all and defended a half dozen state and nationally chartered banks and thrifts, and has received leadership awards and honors from U.S. President Reagan and former Arizona Governor Napolitano, to cover just a few of the miles he has gone.  Often as entertaining as he is practical and enlightening!  See more at