This article comments on the use of alternative financing arrangements in lieu of a trust deed to mask a sale of real estate.
Alternative carryback financing during recessions
The variables of any financing make up its “creative” aspect, such as its amount, interest rate, payment schedule and due date.
Two sets of forms are used to document the terms of carryback financing which will be junior to any existing trust deed liens:
- 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 used for documenting the terms of carryback financing offer not creative financing, but creative chaos, both legal and financial.
Seller financing consists solely of arranging the financing of real estate. It does not include the creation of alternative documentation, sometimes called masked security devices.
Creating new forms, using forms which serve a different purpose than a trust deed (such as a lease-option) or using forms which have outlived their once useful purpose (such as an obsolete land sales contract) is the primary cause of creative chaos and mistaken beliefs.
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 a default.
Alternative documentation for a carryback sale includes such instruments as:
- land sales contracts, sometimes called contracts for deed;
- long-term escrows with interim occupancy;
- unexecuted purchase agreements with interim occupancy, sometimes called lease-purchase agreements;
- lease-option sales contracts; and
- reverse trust deeds coupled with one of the above.
Masking the obvious sale
During periods of rising interest rates and decreasing 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 masking process, reassessments for an increase in property taxes do not automatically occur.
Federal legislation allows a lender to call or recast a loan on the transfer of any property interest, including a sale, a transfer of any possessory interest, a further encumbrance or a foreclosure of the property, whether recorded or not. [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 attempts to hide sales from the lender and county assessor usually involve the use of alternative security devices, inherent financial disadvantages exist from the outset of the transaction.
Additionally, by changing the intended use of legitimate documents, the legal rights of the parties to the transaction become different from the rights permitted by the use for which the document was originally drafted.
With most alternative security arrangements, the new owner/buyer fails to become the owner of record and often fails to exercise the full 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), assessors and creditors.
Other disadvantages exist for owner/buyers who use alternative carryback devices in lieu of a note and trust deed, such as the lack of recording the documents 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 the very least the proper documents should be used — a grant deed, trust deed and note — to avoid compounding the failure to record and obtain a title insurance policy by using chaotic documentation.
Contract for deed: the land sales contract
The land sales contract was widely used from the late 1960s to 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 typically lacks a formal escrow, title insurance and full disclosures of property conditions.
Title does not formally pass hands until the buyer pays the seller in full.
One might argue the existing lender of record has no cause to call the loan since the record of ownership of the property does not officially change until the contract is fully performed. However, this argument fails.
An equitable conversion of ownership does occur under a land sales contract since the seller is only entitled to money, not a return of the property except by foreclosure. Thus, 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 straight forward as the land sales contract may sound, it has proven to be an extremely fragile economic and legal affair.
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 devoid of a power-of-sale provision unequal treatment. Most land sales contracts provide no such power of sale and must be judicially foreclosed on a default.
In the past, some courts treated the defaulting buyer as an owner/mortgagor who was 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, and ultimately face eviction.
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. However, the buyer has no right to reinstate on a default, unless the contract includes the terms for a reinstatement or 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, which bears no legal difference from a carryback trust deed, except for the lack of a power-of-sale provision and the owner’s right to reinstate on a default which accompanies the trustee’s foreclosure process. [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 dollar amount remaining unpaid on the purchase price, sometimes called a contract for deed.
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 the buyer is given possession of the property. [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, also 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 a sale of real estate, the 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 downpayment 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, an event no different in legal and financial effect than the reconveyance of 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. The seller had retained title to the property as security for the remaining unpaid balance 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 they either:
- sign and deliver an offer to purchase on a land sales contract [See first tuesday Form 167]; or
- sign and deliver the land sales contract and transfer 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 later sales escrow, used to close out the land sales contract, fails 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 to 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 a transfer of the 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 to the buyer.
Closing costs on a sale include escrow fees, recording costs, title insurance premiums, a beneficiary statement and assumption or loan fees. Reassessment and income taxes are soon to follow these fees.
Often the payment of brokerage fees is in large part deferred as a fractional ownership in, or 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 a land sales contract, a buyer and 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, sellers and buyers often mistakenly believe an unrecorded sale of real estate (such as a sale on a land sales contract), which 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 on their discovery of the sale.
Contract escrows for delayed recording
Escrow companies have contributed to the creative chaos scene in the form of the contract escrow.
The contract escrow actually involves two escrows.
On the close of the sales escrow, the cash down payment is disbursed to a seller. However, all documents normally recorded, such as a grant deed and a trust deed, are placed in a second “holding” escrow. Nothing is recorded, but the proper documentation has been completed.
The sale of property has been closed for purposes of reassessment, due-on-sale and income tax.
The second contract escrow holds the documents until a written request from the buyer or the seller is received by escrow instructing them 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 another for the buyer. Alternatively, an agreement is entered into by the buyer and seller giving the buyer an interest in the proceeds of the insurance policy.
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 regular purchase agreement form. 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 the buyer’s equity through payments to the seller, called a lease-purchase sale.
For example, a buyer and a seller sign a standard purchase agreement.
An escrow is opened. A grant deed, a carryback note, a 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 of a portion of the amount toward the down payment (or price) called for in the purchase agreement. Often, the buyer’s payments are sent to the same escrow company that received the down payment and documents.
Since the buyer wants to take possession of the property prior to the close of 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)]
For the buyer to protect any increase in the property’s value which occurs by the end of the occupancy period, the buyer must:
- timely close the long-term escrow;
- renew or extend the lease; or
- find a buyer who will purchase his position.
The lease-option sale
Buyers and sellers of real estate must understand that a sale structured as a lease-option is still a sale. The form used to structure the sale does not change a buyer’s and seller’s rights and obligations which are provided by mortgage and contract law.
Moreover, a seller seeking to disguise a sale as a lease-option transaction creates risks that are eliminated by more conventional wraparound formats, like the all-inclusive trust deed (AITD).
A sale documented as a lease and option to purchase typically lacks a power-of-sale provision which allows for a trustee’s foreclosure — the seller’s best remedy to recover the property (title and possession) should the buyer default. [See first tuesday Form 163 §19]
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 of the property, 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 legal equivalent of a due date for payment of the balance of the purchase price. [See Form 163 §§14 and 15.2]
However, when a tenant receives credit toward the purchase price on payment of his option money or rent, the lease- option is recharacterized as a land sales contract, mortgage or trust deed for all purposes.
Additionally, a 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 of property under an agreement with the seller receives credit toward the purchase price for 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. The buyer’s redemption rights can only be terminated by a judicial or nonjudicial foreclosure, or a deed-in-lieu of foreclosure.
A lease-option agreement structured on terms economically consistent with a credit sale (a down payment or credit of payments 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 arranged by 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 which encumber property.
Tax aspects of a sale
Taxwise, lease-option sales are recharacterized by the Internal Revenue Service (IRS), the state Franchise Tax Board (FTB) and the county assessor as carryback financing or land sales contracts.
One reason sellers conceal property sales behind the format of a lease-option is to avoid added tax burdens on a change in ownership. Under an actual option agreement, any option money received by the seller is reported as either profit or income when 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.
Buyers are motivated to structure a sale as an unrecorded lease-option to evade property reassessment by the county. However, the use of a lease-option to mask a sale has property tax consequences, since the economic characteristics of the transaction constitute a change of ownership, triggering retroactive reassessment when later discovered.
Reverse trust deed disguises facts
The reverse trust deed is often used to provide recorded protection for a 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 becomes 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 (naming him as the beneficiary) and the seller receives the net proceeds from the down payment. The buyer takes possession of the property 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 notes or trust deeds — are left unrecorded and placed into a contract or holding escrow. The escrow agent 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.
As a result, the record indicates 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.
However, the reverse trust deed presents a degree of financial protection to 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.
Risks outweigh the benefit
However, the reverse trust deed is imperfect since it has several fatal flaws, both economic and legal.
Economically, price inflation or value appreciation of the property will cyclically outstrip the buyer’s ability to protect his equity (due to the historical monetary policy of the Federal government). Should the buyer ever need to foreclose to recover the amount of his down payment, he will only become the legal owner of the property if he is the successful bidder at a trustee’s sale.
Of course, the buyer runs the risk of being overbid by other bidders who appear at the sale. 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 lost inflation or appreciation. Even if the buyer could bid high enough at the trustee’s sale to acquire title, he still stands to lose the property if the senior lender calls the loan, and if unpaid, forecloses.
If the property is an owner-occupied, one-to-four unit residential property, the owner (meaning the 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 the property. [12 CFR §591.5(b)(1)(i)]
Thus, the very purpose for using a reverse trust deed (to transfer possession without the risk of the due-on-sale/reassessment) renders it legally useless, except to foreclose on the property, since the reverse trust deed does not avoid a call or the recasting of the existing financing or a reassessment when the transaction is 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. The seller is also faced with penalties for his failure to report profit to the Internal Revenue Service (IRS) and California’s Franchise Tax Board (FTB).
Filing the IRS 1099-S snitch sheet
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 Internal Revenue Service (IRS) on a 1099-S form. [Revenue Regulations §1.6045-4(a)]
The IRS recognizes the sale 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.