This article discusses the use of alternative financing arrangements in lieu of a trust deed to mask the sale of real estate.
Creative financing vs. creative chaos
The “creative financing” of real estate between a seller and a buyer begins and ends with the terms necessary to establish carryback financing. The variables of carryback financing include:
the amount of the debt;
the interest yield on the debt;
the schedule of installment payments; and
the due date for final payoff.
Seller financing allows the buyer of property to defer payment of a huge portion of the purchase price. The seller accepts a promissory note as partial payment of the purchase price for the property sold, called an installment sale.
An installment sale is a practical financial arrangement between buyers and sellers born out of:
high prices, tight credit policies and high long-term interest rates; or
the seller’s desire to defer the payment of profit taxes.
The variables of any financing make up its “creative” aspect, such as the amount, rate, payments and due date.
Two sets of forms are used to document the terms of carryback financing which will be junior to an existing trust deed lien:
a note and trust deed, to evidence and secure the balance of the seller’s equity remaining to be paid after the down payment; or
an all-inclusive note and trust deed (AITD), to evidence and secure the balance of the price remaining to be paid after the down payment.
All other forms for documenting the terms of carryback financing offer not creative financing, but creative chaos, both legal and financial.
Seller financing consists of arranging the financing of real estate. It does not include the creation of alternative documentation, sometimes called masked security devices.
Creating new forms or using forms which serve a different purpose (lease-options) or have outlived their once useful purpose (the obsolete land sales contract) is the root of creative chaos.
Documents developed for otherwise legitimate business purposes are occasionally substituted for notes and trust deeds to set up a smoke screen in an attempt to avoid due-on enforcement, reassessment for property tax purposes, profit reporting and the buyer’s right of reinstatement or redemption on default.
Alternative documentation for a carryback sale includes such instruments as:
land sales contracts, sometimes called contracts for deed [See first tuesday Form 165];
long-term escrows with interim occupancy;
unexecuted purchase agreements with interim occupancy, sometimes called lease-purchase agreements;
lease-option sales contracts [See first tuesday Form 163]; and
reverse trust deeds coupled with one of the above.
During periods of rising interest rates and decreased sales, when the frequency of lender due-on enforcement also tends to rise, these alternative financing techniques share a common strategy of creating trappings that mask the existence of a sale in order to avoid due-on enforcement. In the process, reassessment for property tax increases does not automatically occur.
Federal legislation allows the lender to call or recast the loan on the transfer of any property interest, including a sale, transfer of any possessory interest, further encumbrance or foreclosure, whether or not recorded. [12 Code of Federal Regulations §591.2(b)]
Notable exceptions allow leases of three years or less on any property (without a purchase option), and further encumbrance of owner-occupied, single-family residences (SFRs) to escape due-on enforcement.
Since an attempt to hide a sale from the lender (and the county assessor) involves the use of alternative security devices, financial disadvantages exist from the outset of the transaction.
In addition, by changing the use of legitimate documents, the legal rights of the parties to the transaction become different from the rights permitted by the use normally intended for the document.
With most alternative security arrangements, the new owner/buyer fails to become the owner of record or to exercise the benefits of ownership, such as interest/depreciation deductions and the right to sell or further encumber the property.
Hiding the purchase from the lender hides it from everyone, including the Internal Revenue Service (IRS), Franchise Tax Board (FTB), assessor and creditors.
Other common threads between all alternative carryback devices used in lieu of a note and trust deed include the lack of recording and the loss of the benefit extended to recorded documents, as well as the lack of title insurance. If a carryback transaction is to go unrecorded, unescrowed and uninsured, at least the proper documents should be used – a grant deed, trust deed and note – to avoid compounding the failure to record or obtain a title insurance policy by using chaotic documentation.
Contract for deed: the land sales contract
The land sales contract was used widely from the late 1960s until the late 1970s as the preferred method for avoiding due-on enforcement by lenders.
The financing arrangement is deceptively simple. A buyer and seller enter into a contract for the sale of property. The buyer takes possession of the property and makes payments according to the terms of the contract. The transaction lacks a formal escrow, title insurance and disclosures of property conditions.
Title does not pass until the buyer pays the seller in full.
One might argue the existing lender of record has no cause to call the loan since record ownership of the property does not change until the contract is fully performed. However, this argument fails since equitable conversion of ownership does occur – the seller is only entitled to money, not a return of the property except by foreclosure – and the buyer becomes the equitable owner of the real estate with the right of redemption to pay all sums due the seller and get clear title. [Tucker v. Lassen Savings and Loan Association (1974) 12 C3d 629]
However, as uncomplicated as the land sales contract may sound, it has proven to be an extremely fragile affair, both economically and legally.
Although a land sales contract with a power-of-sale provision has been accorded the same statutory treatment as a trust deed, courts have given the defaulting buyer under a land sales contract that does not contain a power-of-sale provision unequal treatment. Most land sales contracts provide no such power and must be judicially foreclosed on a default.
In the past, some courts treated the defaulting buyer as an owner/mortgagor, entitled to the reinstatement rights of mortgage and trust deed law. Other courts viewed the buyer’s default as a forfeiture, transforming a would-be owner into a tenant who must pay rent, give up possession, or face eviction.
Now, a defaulting buyer who has built up a “substantial equity” under a land sales contract has an unconditional right to complete the purchase by paying the remaining balance – a redemption – but no right to reinstate on a default unless the contract provides for the terms of a reinstatement or includes a trustee’s power-of-sale provision. [Petersen v. Hartell (1985) 40 C3d 102]
The trend is to regard the land sales contract without a power-of-sale provision as a mortgage, bearing no legal difference from a carryback trust deed, except for the lack of a power-of-sale provision and the accompanying right to reinstate on default. [Perry v. O’Donnell (9th Cir. 1985) 759 F2d 702]
A basic land sales contract is an agreement to convey title to the buyer when the buyer fully satisfies the amount remaining unpaid on the purchase price, sometimes called a contract for deed. [See first tuesday Form 165]
Also, to fit within the statutory definition of a land sales contract, the agreement to convey title must not call for the transfer of title until more than one year has passed after possession is given to the buyer. [Calif. Civil Code §2985]
The seller, also called a vendor, retains legal title under the land sales contract as security for the buyer’s promised payment of the balance of the purchase price. The buyer, called a vendee, receives possession of the property and becomes the equitable owner of the property.
Although the unrecorded land sales contract is often used to mask the sale of real estate, a sale is actually completed when the land sales contract is signed by the parties and delivered to the seller in exchange for the transfer of possession of the property to the buyer. A small payment to the seller usually accompanies the transaction.
Conveyance of title to the buyer usually occurs years later when a formal sales escrow is opened to complete the seller’s performance of the land sales contract, which is no different from reconveying a trust deed lien from title.
The conveyance escrow is not a “sales escrow” at all. It is merely the means used to “pay off and release” the seller’s security interest in the property under the land sales contract, since the seller retained title to the property as security for the balance remaining on the credit sale.
The contentious contract
The buyer and seller should determine and analyze the risks and benefits accompanying their use of an unescrowed, unrecorded and uninsured land sales contract before either:
signing and delivering an offer to purchase on a land sales contract [See first tuesday Form 167]; or
signing and delivering the land sales contract and transferring downpayment funds and possession. [See first tuesday Form 165]
Typically, when a land sales contract is used, the formal aspects of an escrowed sale of real estate are incorrectly deferred until a “sales escrow” is opened to handle the buyer’s payoff and the seller’s transfer of record title to close out the land sales contract.
The “sales escrow” also will fail to reflect the fact that the actual sale occurred years earlier when the buyer and seller entered into the land sales contract.
What actually takes place when a “sales escrow” is used to close out the land sales contract is a refinancing of the property – a payoff of the carryback debt and a release of the seller’s security interest by the further conveyance of title to the buyer.
The sales escrow opened to close out the land sales contract transaction is for the purpose of either:
a full conveyance and refinancing of the property with a new lender who provides funding for the payoff of the debt owed the seller on the land sales contract; or
a seller “rollover” of the remaining contract debt into a note and trust deed, executed by the buyer and received by the seller on transfer of title to the buyer.
All costs of a conventional closing incurred in a formal sales escrow, also called transactional costs, are avoided at the time of entering into a land sales contract. A seller and a buyer choosing to use a land sales contract usually do not formally escrow the land sales contract transaction or obtain title insurance, local government occupancy or retrofit certificates.
The closing costs are actually deferred until a sales escrow is opened to complete performance of the land sales contract and convey title.
Closing costs include escrow fees, recording costs, title insurance premiums, a beneficiary statement and assumption or loan fees. Reassessment and income taxes follow.
Often the payment of brokerage fees is in large part deferred as a lien on the land sales contract until the seller is paid in full through the “sales escrow”.
Due-on-sale and reassessment
Consistent with their rationale for not recording the land sales contract, the buyer and the seller do not request a beneficiary statement from the lender or a waiver of the lender’s right to call or recast the loan on transfer of equitable ownership.
Thus, a seller and a buyer often mistakenly believe an unrecorded sale of real estate (such as a sale on a land sales contract) that is not brought to the attention of the lender or the county assessor does not trigger the due-on clause or reassessment as a sale and change of ownership.
On the contrary, entering into a land sales contract triggers both the due-on clause in an existing trust deed as a transfer of an interest and reassessment as a change of ownership – even if the land sales contract document is not recorded.
Whenever the holder of a trust deed containing a due-on clause discovers the secured property has been sold on a land sales contract, the lender can enforce the due-on clause. Likewise, the county assessor can reassess.
Escrow companies have contributed to the creative chaos scene in the form of the “contract escrow”.
The contract escrow actually involves two escrows.
When the first escrow closes, the cash down payment is disbursed to the seller. However, all documents normally recorded (grant deed and trust deed) are placed in a second “holding” escrow. Nothing is recorded, but the proper documentation has been procured.
Actually, the property has been sold for purposes of reassessment, due-on-sale and income tax.
The second contract escrow holds the documents until a written request is received from the buyer or the seller to record the grant deed and trust deed.
Since both the seller and the buyer have an insurable interest in the property, two separate policies of fire and hazard insurance are frequently obtained – one for the seller and one for the buyer.
The carryback note is often placed on contract collection with the same escrow company.
Unexecuted purchase agreements, extended escrows
Similar in approach to the land sales contract is the transfer of possession to the buyer under an “unexecuted” purchase agreement, as a sales escrow will not be closed for an extended period of time.
Here, a marketing instrument is used, such as a standard form purchase agreement. The purchase agreement is turned into a security device characteristic of a land sales contract or lease-option, with a transfer of possession and the buildup of equity through payments to the seller.
For example, a buyer and a seller sign a standard purchase agreement.
An escrow is opened. A grant deed, a carryback note and trust deed, and the down payment are deposited into escrow within 30 to 60 days. However, the closing and disbursement of funds are delayed until after one to three years of timely performance by the buyer. During the extended escrow period, payments are made to the seller which include credit toward the down payment called for in the purchase agreement. Often, the buyer’s payments are sent to escrow, which receives the down payment.
Since the buyer wants to take possession of the property prior to closing escrow, he enters into an interim occupancy (lease) agreement with the seller. Neither the lease nor the escrow will extend beyond three years to avoid triggering any due-on clauses.
Should the seller enter into a lease for more than three years, or apply payments toward the purchase price, the transfer of possession will qualify as a sale, triggering reassessment, profit tax reporting, the lender’s right to accelerate the loan, etc. [12 CFR §591.2(b)]
To protect any increase in value of the property which has occurred by the end of the occupancy period, the buyer must:
close the long-term escrow;
renew or extend the lease at least every three years; or
find a buyer who will purchase his position.
The lease-option sale
Buyers and sellers of real estate must understand and be aware that a sale structured as a lease-option is still a sale. The form used to structure the sale does not change the rights and obligations of the buyer and seller which are provided by mortgage and contract law.
Moreover, a seller seeking to disguise a sale as a lease-option creates risks that are eliminated by more conventional wraparound formats, like the AITD.
A sale documented as a lease and option to purchase typically lacks a power-of-sale provision allowing for a trustee’s foreclosure – the seller’s best remedy to recover the property (title and possession) should the buyer default.
The lease-option sale usually is not documented through an escrow, nor is there delivery of a grant deed or a note and trust deed. Instead, the buyer will lease the home with an option to purchase it at a predetermined price – not a price based on market value at the time of exercising the option.
The down payment, called option money, is applied toward the purchase price, should the option be exercised. Similarly, a portion of the monthly payment, called rent, will apply as principal paid toward the price on exercise of the option prior to its expiration. Of course, the expiration of the option is the due date for payment of the balance of the purchase price. [See first tuesday Form 163 §15]
However, when a tenant receives credit toward the price by his option money or rent, the lease-option is recharacterized as a land sales contract, mortgage or trust deed for all purposes. Also, the carryback sale structured as a lease-option will typically be devoid of a trust deed power-of-sale provision, prohibiting the seller from rapidly foreclosing by a trustee’s sale and wiping out the equity the buyer has paid for and built up in the property.
Except for the absence of legal documentation in the form of a grant deed, note and trust deed, the terms of the lease-option sale have all the economic characteristics of a credit sale. There is an agreed-to price, a down payment, monthly “rent” payments which apply in whole or in part toward principal (the balance being interest) and a due date for the final/balloon payment.
When a buyer in possession under an agreement receives credit toward the purchase price by a portion or all of his payments to the seller, he has built up and established an equity in the property. Thus, he has an ownership interest which carries with it the right of redemption (to pay off the seller and get clear title) which cannot be terminated except by a judicial or nonjudicial foreclosure or deed- in-lieu of foreclosure.
A lease-option agreement structured on terms economically consistent with a credit sale (a down payment or credit of payment toward the price) is neither a lease between a tenant and a landlord nor an option to buy. The lease-option sales agreement is a disguised security device for credit financing of a sale between a buyer and a carryback seller. [Oesterreich v. Commissioner of Internal Revenue (9th Cir. 1955) 226 F2d 798]
An actual lease coupled with a separate option to buy is the antithesis of seller financing. A borrower’s debt obligations and a lender’s foreclosure rights are diametrically opposed to a tenant’s leasehold obligations and the eviction rights of a landlord.
Also, all lease-options trigger due-on provisions in trust deeds encumbering the property.
Taxwise, lease-option sales are recharacterized by the IRS, the state FTB and the county assessor as carryback financing or land sales contracts – the sale of real estate.
To avoid tax burdens imposed on sellers is one reason to conceal property sales behind the format of a lease-option. Under an actual option agreement, any option money received by the seller is reported as either profit or income when, respectively, the option is exercised or expires, or the property is sold subject to the option.
The seller, disguised as a landlord, will also deduct the amount of the property’s annual depreciation to reduce income taxes – until the lease-option is recharacterized by the IRS as a sale.
For buyers, avoidance of property reassessment by the county is strong motivation to structure a sale as a lease-option. However, the use of a lease-option to mask a sale has property tax consequences as well, since economic characteristics of the transaction constitute a change of ownership, triggering retroactive reassessment when later discovered.
Reverse trust deed
The reverse trust deed is often used to provide recorded protection for the buyer’s investment in an otherwise unrecorded transfer, such as one involving the two-step contract escrow.
As the name suggests, the economic roles of the buyer and seller in the transaction are reversed.
The buyer documents the amount of the down payment on the property as a loan made to the seller.
The seller, disguised as an owner borrowing money, signs a note for the amount of the down payment and a trust deed in favor of the buyer. The trust deed will become a lien on the property the buyer is acquiring. Hence its name as a reverse trust deed.
When escrow closes on the sale, the buyer’s reverse trust deed is recorded (he is the beneficiary) and the seller receives the net proceeds from the down payment. The buyer takes possession under a lease signed by both the seller (as the landlord) and the buyer (as the tenant).
All other documents regarding the buyer’s actual purchase of the property – the executed grant deed and any carryback note and trust deed – are placed, unrecorded, into a contract or holding escrow. Escrow is instructed to hold these documents (together with the note and a request for a reconveyance of the reverse trust deed) until the buyer or seller requests they be recorded.
The end result is that the record will indicate the seller merely equity-financed his property.
Neither the lender nor the tax assessor are alerted to the transfer as long as the grant deed remains unrecorded and undisclosed. However, both the lender’s due-on clause and the assessor’s right to reassess have been triggered.
The reverse trust deed takes the place of the Memorandum of Agreement recorded in some contract escrow arrangements.
The reverse trust deed represents a degree of financial protection for the buyer. When recorded, it prevents the seller from defeating the buyer’s down payment by further encumbering or deeding out the property to a bona fide purchaser (BFP). [Miller v. Cote (1982) 127 CA3d 888]
Should the seller interfere with the buyer’s unrecorded grant deed interest, the buyer can foreclose on the trust deed and wipe out the seller’s position.
If this sounds too good to be true, it is! The reverse trust deed has several fatal flaws – some economic, some legal.
Economically, price inflation or value appreciation of the property will cyclically outstrip the buyer’s ability to protect his equity. Should the buyer ever need to foreclose to recover the amount of down payment, he will only become the legal owner if he is the successful bidder at the trustee’s sale.
Of course, there is the risk other bidders will appear at the sale and overbid. At a minimum, the buyer as the foreclosing beneficiary of the trust deed will get back the amount of his original down payment, plus interest.
Legally, the reverse trust deed is even more disenchanting than the lost inflation or appreciation. Even if the buyer could bid high enough at the trustee’s sale, he still stands to lose the property if the senior lender calls the loan, is unpaid and forecloses under its due-on rights.
If the property is an owner-occupied, one-to-four unit residential property, the owner (seller, not the buyer) can further encumber and avoid a call under the existing lender’s due-on clause only if he continues to occupy. [12 CFR §591.5(b)(1)(i)]
Thus, the very purpose for using a reverse trust deed (the transfer of possession without due-on-sale/reassessment) renders it legally useless, since it does not avoid a call or the recasting of existing financing or reassessment when discovered by the lender or the county assessor.
Taxwise, a reverse trust deed transaction, unless reported as a sale, exposes the seller to liability for tax evasion for deliberately restructuring a sale to appear as a non-taxable event (a loan).
The substance and function of the transaction (the sale of the property) supersedes its recorded form (the trust deed loan).
Also, concealing the sale from the county assessor results in the imposition of stiff property tax penalties by the county tax collector – to say nothing of the penalties for the seller’s failure to report profit to the IRS and California’s FTB.
Filing the IRS 1099-S
When a formal sales escrow is not used to handle documents and funds on a sale, the person arranging the sale – generally the broker – is required to report the transaction to the IRS on a 1099-S form. [Revenue Regulations §1.6045-4(a)]
The IRS recognizes the sales date to be the earlier of the dates on which:
title is transferred; or
the economic benefits and burdens of ownership shift from the seller to the buyer. [Rev. Reg. §1.6045-4(h)(2)(ii)]
Typically, reporting the sale to the IRS with a 1099-S form is incorrectly deferred until the title is conveyed to the buyer through escrow on payoff of the land sales contract, lease-option or other masked security device. Here again, escrow improperly collaborates with the seller, buyer and broker to prevent discovery of the previously masked sale by all persons or agencies – even when escrow closes and reports the closing as the date of the sale.