These laws were initially introduced as a means to protect low-income buyers and immigrants along the Texas-Mexico border as the practice of lease-options by unscrupulous builders and developers are what is traditionally blamed for the creation of ‘colonias’ (identifiable unincorporated areas located within 150 miles of the Texas-Mexico border that lack infrastructure and ‘decent’ housing), however; their effect on real estate investors extends far beyond the state’s border regions.
SB 629 and its companion HB 1823 both enter into simultaneous effect on September 1, 2005. The result of these combined new laws is to effectively eliminate the many reasons that investors use lease-options in the first place and the unintended consequence is that, while introduced to protect low-income buyers, immigrants, and unsophisticated buyers, these new laws will actually make it much harder for these individuals to purchase housing due to the fact that they, in many cases, are unable to qualify for traditional mortgage financing and builders and investors will now be less inclined to offer lease-options or ‘rent-to-own’ scenarios as a purchasing alternative under these new laws.
SB 629, introduced as an amendment to another law passed in 2001 which revised part of the Texas Property Code (Chapter 5, subchapter D) and governed installment land contracts, is a silver bullet for many investors.
Under the previous law passed in 2001, installment land contracts are now considered ‘executory contracts’ and, as such, the seller is required to provide several disclosures. In and of themselves, most of these disclosures are not too great an issue for most sellers; however, the law also stipulates mandatory penalties (which are ridiculously disproportionate to the supposed harm suffered by the buyer) for non-compliance on the part of the seller. The obvious liability for the seller is the fact that any buyer looking for a payday may enlist the services of an attorney for the sole purpose of exploiting a seller’s technical non-compliance with disclosure requirements that the seller may not even have known existed at the time the contract was signed.
With the introduction and subsequent passing of SB 629, the effect is that lease-options, which were not addressed in the previous 2001 law, are now also considered executory contracts along with the installment land contracts already mentioned. This is where things get bad.
One of the primary issues with this change is the fact that investors no longer maintain the benefits of ownership in regards to taxation (as was previously possible) nor are these investors able to take advantage of the capital gains tax rates due to the fact that these lease-options are now legally considered an actual sale of real property instead of a traditional rental scenario with the option to purchase. Because lease-options are now considered a sale, there is a negative tax implication for sellers desiring to defer profits through the use of a 1031 exchange when (and if) a tenant/buyer exercises his option to purchase the property. The sale is deemed to happen as soon as the lease-option is signed and not, as has previously been the case, some time in the future when the tenant/buyer actually chooses to exercise his option to purchase.
As if this isn’t bad enough, very few investors are ‘cash heavy’, meaning that few people actually hold the property that they are selling ‘free and clear’ and that most have some sort of underlying mortgage on the property.
However; under SB 629, a potential seller cannot enter into an executory contract with a potential buyer if the seller does not own the property in fee simple, free from any liens or encumbrances. In addition, the seller also has to maintain fee simple title for the entire duration of the contract. The exception to this requirement (Section 5.085) is that it does not apply to a lien or encumbrance placed on the property that is placed on the property by the seller prior to the execution of the contract in exchange for a loan used only to purchase the property if the seller, not later than the third day before the date the contract is executed, notifies the purchaser in a separate written disclosure of the terms of the seller’s underlying loan.
In short, a buyer could agree (but is not required to do so), before the contract was executed, to accept property that was not held in fee simple if the encumbrance on the property resulted from the seller obtaining a loan in the past to purchase the property. The caveat to this is that the seller must inform the buyer, in writing, as to (a) how much the seller paid, (b) the remaining balance on the current mortgage note, (c) the seller’s monthly payment amount, (4) the seller’s mortgage loan number, and many other traditionally confidential pieces of information that seller’s would never normally release to a prospective buyer. Furthermore, a buyer also could agree (at his discretion) after the contract was executed, that an encumbrance may be placed on the property in order to obtain a loan to make improvements to the property.
Reading in much the same manner, HB 1823 was the companion bill to SB 629 above and it, in effect, allows individuals who purchase homes under traditional contract-for-deed or rent-to-own scenarios the same rights as other buyers using any other method, including use of the standard Texas homestead exemption, the right to pass the home to a family member if the purchaser dies, and right to take advantage of tax exemptions and deductions (which the seller subsequently loses). Under this new law, lease-options and contract-for-deed purchasing arrangements are now considered ‘executory contracts’ to convey real property and, as such, it takes many advantages away from sellers and gives them to the buyer.
According to John Henneberger, co-director of the Texas Low Income Housing Information (TLIHIS) Service, a non-profit entity whose goal is to assist low income Texans; “After more than 40 years of abuse, the contracts-for-deed system has finally been fixed once and for all. For more than ten years, we have worked with Senator Lucio to curb the predatory practices of those who would take advantage of low-income residents. With this bill, Senator Lucio has ensured that residents of ‘colonias’ and low income neighborhoods all along the Border will no longer be subject to arbitrarily losing their homes under the old contract-for-deed system.”
Senator Lucio, sponsor of the bill and author of SB 629, also stated that “The Texas Senate sent a strong message to those who would prey on the innocence of our low-income Texans with this unanimous vote that we will not let the unscrupulous take advantage of our constituents.”
Under HB 1823 (similar in large part to its parent bill SB 629), some of the key points affecting investors and other sellers who may want to use a lease-option are that:
- lease-options and other contract-for-deed arrangements are now clarified and considered as ‘executory contracts’ which entitles buyers with certain protections;
- purchasers now have the option to convert their lease-options or contract-for-deeds into traditional mortgages; <
- sellers are required to keep the property free of liens during the term of the contract although it allows certain prior mortgages liens with certain protection for the buyer;
What this means: If the seller already has a preexisting mortgage lien on the property (regardless of whether it contains a Demand Clause or not), the seller must notify the purchaser in writing before the third day that the new lease-option contract is executed of the lien holder’s contact information, the outstanding loan balance, the loan servicer, payment amounts and due dates, etc. which means that the purchaser will know both the seller’s monthly and overall profit – which the purchaser may use as a negotiating tool against the seller.
- a purchaser, at any time and without paying penalties or charges of any kind, is entitled to covert the purchaser’s interest in property under an executory contract into recorded, legal title.
What this means: Per HB 1823, a seller must give the purchaser legal title to the property if the purchaser provides an appropriate promissory note that contains the same interest rate, due dates, and late fees as the contract. Also, on or before the tenth day after the date the seller receives the aforementioned promissory note, the seller shall either schedule a mutually-agreeable date to execute the deed and deed of trust or otherwise deliver to the purchaser a written explanation that legally justifies what the seller refuses to convert the purchaser’s interest into recorded legal title.
In other words, if you as a seller have an underlying mortgage on the property and the purchaser provides a Note and you must then give the purchaser legal title, the ‘Due on Sale’ or ‘Demand’ clause in your mortgage loan will probably be triggered and you must pay off this underlying debt. However; as indicated in both bills, sellers are prohibited from refinancing the property (to pay off the aforementioned mortgage loan) since the seller is required to keep the property free of additional liens unless the new lien is obtain for the sole purpose of improving the property and it is authorized by the purchaser.
- sellers may not impose any provision that forfeits an option fee or other option payment paid under the contract for a late payment;
- sellers may not impose any provision which increases the purchase price, imposes a fee or charge of any type, or otherwise penalizes a purchaser leasing property with an option to buy for requesting repairs or exercising any other right under Chapter 92 of the Texas Property Code;
- property sold under contracts for deed are required to be legally platted/subdivided and contract for deed owners are now enabled to obtain information in order to determine whether their property has been properly platted;
Due to the enactment of these new laws, lease-options in Texas, which have long been a source of debate and varying legal opinion, have become even more convoluted. Because of this, low-income and credit-challenged buyers will probably find it more difficult to realize the dream of home ownership and investors, along with other sellers of real property, may be well served to invest in markets that do not generally require lease-option alternatives for buyers while actively searching for less-complicated and more mainstream sales techniques such as wraparound mortgages, seller-financing (with the subsequent sell of the mortgage note), and traditional mortgage financing.