The truth about getting around due-on-sale clauses

I discuss this subject in two of my books:

 and 

There is great demand for ways to get around due-on-sale clauses in mortgages for four reasons:

• to preserve a below-market interest rate
• to avoid a credit check when the prospective buyer has poor credit or inadequate cash or income to afford the property
• to use the Stonecrest line of Tax Court cases to avoid paying income tax on excess mortgage relief over basis.
• to lease-option a one- to four-family house (which generally relates back to the second reason).

Reason for the due-on-sale clause

Real-estate investors who are not too bright tend to believe lenders want due-on-sale clauses because they are greedy. They then use that notion to rationalize illegal or immoral behavior toward the lender.

In fact, the main reasons for due-on-sale clauses is lenders want and need to know to whom they are loaning money and they need to be able to predict roughly when a mortgage will be paid off. If you loaned your car to a friend, who agreed in writing not to let anyone else use it, then you saw it going down the street with some stranger at the wheel, you'd be upset, and rightly so. By the same token, lenders do not like to loan one guy $100,000 to buy a house then find that someone else now has the house, especially when the new guy has lousy credit and/or inadequate equity or income. Neither can lenders tolerate making mortgage loans which will likely last seven years on average because of the due-on-sale clause, only to find that those mortgages are being passed onto subsequent buyers, thereby extending their terms which gives lenders negative spreads between their cost of funds and interest income during periods of high interest rates.

If you think making assumable mortgages is a smart idea, I dare you to go into that business. The fact that no one is in the assumable-mortgage business any more proves it is intelligence and experience, not greed, that motivates lenders to include due-on-sale clauses in their mortgages. Actually, the vast majority of lenders have no choice. The due-on-sale clause is required by the various federal agencies.

History of the due-on-sale clause

History lessons sometimes help real-estate investors understand what they need to know. Due-on-sale clauses are prime examples.

Due-on-sale clauses were common and believed to be enforceable twenty-five years ago. Then a nutty group of California Supreme Court justices decided the Tucker v. Lassen Savings & Loan Association (12 Cal. 3d 629, 1974) and Wellenkamp (Wellenkamp v. Bank of America, 21 Cal 3d 943, 8/25/78) cases. Those decisions said that due-on-sale clauses were not enforceable unless the lender could show impairment of security. Other state courts subsequently made similar decisions.

de la Cuesta U.S. Supreme Court decision

That unleashed a torrent of subject-to purchases, especially during the high-interest-rate early '80s. The savings-and-loan industry was hurting big time and subject-to purchases had the effect of extending the duration of below-market interest rates, which, in turn, bankrupted federally-insured S&Ls. The federal government pursued a lawsuit to get the Wellenkamp line of cases "overturned." They were soon successful in the U.S. Supreme Court de la Cuesta decision. (Fidelity Federal Savings and Loan Association v. de la Cuesta et al., 458 U.S. 156) On June 28, 1982, the U.S. Supreme Court said federal savings and loans could enforce their due-on-sale clauses even in states where state courts said otherwise.

Garn-St. Germain Act

The de la Cuesta decision gave Congress the courage to pass the Garn-St. Germain Depository Institutions Act of 1982 on October 15, 1982. The Garn bill pretty much said due-on-sale clauses were enforceable, period.

At his Web site, guru William Bronchick said that by passing the Garn Act, the Congress "usurped" the authority of the state judges who previously said due-on-sale clauses were not enforceable. Excuse me. According to Black's Law Dictionary, "usurp" means, "To seize and hold any office by force, and without right." At what law school did Bronchick learn that Congress has no right to pass laws related to federal mortgages? And what about de la Cuesta? Was the U.S. Supreme Court also "usurping" the power of state judges when they overturned lower-court decisions in that case? Referring to United States Code provisions pertaining to federally-related mortgages as usurpation of state court decisions is real-estate demagoguery.

FHA and VA assumable mortgages

The de la Cuesta decisions and the Garn-St. Germain Act made due-on-sale clauses enforceable. But what about mortgages which had no due-on-sale clauses? The most common examples were FHA and VA mortgages. On December 1, 1986, FHA began requiring credit checks before they would approve assumptions.

Starting 2/29/88, new VA mortgages were not assumable unless the VA approved the new borrower. Same reason as the FHA change. On 12/15/89, FHA put a number of strict assumption-and-subject-to-related rules into place.

The actual wording of the clause

It's paragraph 17 of the standard "Single Family FNMA/FHLMC UNIFORM INSTRUMENT Form 3005 9/90 Amended 8/91" which is used almost universally on one- to four-family mortgages in the U.S. Paragraph 17 reads as follows:

17. Transfer of the Property or a Beneficial Interest in Borrower. If all or any part of the Property or any interest in it is sold or transferred (or if a beneficial interest in Borrower is sold or transferred and Borrower is not a natural person) without Lender's prior written consent, Lender may, at its option, require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if exercise is prohibited by federal law as of the date of this Security Instrument.

If Lender exercises this option, Lender shall give Borrower notice of acceleration. The notice shall provide a period of not less than 30 days from the date the notice is delivered or mailed within which Borrower must pay all sums secured by this Security Instrument. If Borrower fails to pay these sums prior to the expiration of this period, Lender may invoke any remedies permitted by this Security Instrument without further notice or demand on Borrower.

The original post-Garn FNMA/FHLMC due-on-sale clause said:

"If all or any part of the Property or an interest therein is sold or transferred by Borrower without Lender's prior written consent, excluding (a) the creation of a lien or encumbrance subordinate to this Mortgage, (b) the creation of a purchase money security interest for household appliances, (c) a transfer by devise, descent or by operation of law upon the death of a joint tenant or (d) the grant of any leasehold interest of three years or less not containing an option to purchase, Lender may at Lender's option declare all the sums secured by this Mortgage to be immediately due and payable."

The current clause lets the underlying federal statute and regulation deal with the details which previously were spelled out in the mortgage clause. I suspect the lenders decided it was better to claim the broadest possible right to accelerate the loan and to force people who wanted to learn of the limitations on enforcement to look up the law.

Not just ‘sales’

To understand the clause, you have to break it down into small parts. When you do, you immediately find that "due-on-sale" is a misnomer. A better name would be “due-on-transfer-of-any-interest clause.” The list of actions covered by the actual clause is far broader than just “sales.” The federal regulation (12 C.F.R. 591.2) says the due-on-sale clause is triggered by:

“...transfers of real property subject to a real property loan by assumptions, installment land sales contracts, wraparound loans, contracts for deed, transfers subject to the mortgage or similar lien, and other like transfers.”

A great many exceedingly ignorant investors think that all you have to do to get around a due-on-"sale" clause is a transaction that is not a "sale" per se. As the regulation shows, that is not true.

Land contracts

Note that the first sentence covers transfers of "an interest." That, and the regulation, make the clause cover not only sales, but land contracts. Many investors erroneously think that because the deed does not change hands in a land-contract sale, it is not a "sale" that triggers Paragraph 17 of the FNMA/FHLMC mortgage.

Lease options

Many gurus say you can get around the due-on-sale clause by doing a lease option instead of a sale. Wrong. Subparagraph (d) of the longer clause covered that. Now you have to look at the law itself [§1701j-3(d)(4)] to learn that the due-on-sale clause is triggered by any lease longer than three years. And it's triggered by any lease that contains an option to purchase the property, regardless of the length of the lease.

In the mortgage (Paragraph 6), you promise to "...occupy, establish, and use the Property as Borrower's principal residence within sixty days after execution of this Security Instrument and shall continue to occupy the Property as Borrower's principal residence for at least one year after the date of occupancy..." The lender is prohibited from "unreasonably withholding" permission to not occupy during that period and "extenuating circumstances beyond Borrower's control" are an exception to the occupancy promise. In the absence of lender unreasonableness or extenuating circumstances, you may not do any kind of lease until you have lived in the property for a full year. If you habitually buy properties and immediately lease-option them, you will not be very credible arguing extenuating circumstances.

Land trusts

Another guru gimmick is for the current owner to transfer the property to a trust, then sell the beneficiary interest in the trust to the guy who wants to take over the mortgage.

The statute [12 USC 1701j-3(d)(8)] and the federal regulation [12 C.F.R. 591.5 (b)(vi)] say transfer of a home into an inter vivos trust does not trigger the due-on-sale clause.

Statute

"...a transfer into an inter vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property;"

Regulation

"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"

Their purpose was to enable people who wanted to make use of the probate-avoiding aspects of those trusts. Note that the regulation exception does not cover subsequent sales of the inter vivos trust to someone else, only transfer of the home to an inter vivos trust owned by the same people as the original mortgage borrowers. The regulation's purpose most definitely was not to open up a loophole for avoiding due-on-sale clauses.

Remember also the title of paragraph 17 in the mortgage document: "Transfer of the Property or a Beneficial Interest in Borrower."

The exception to the due-on-sale enforcement only applies to owner-occupied homes. If you put the property into a trust then sell the beneficial interest in the trust and move out, you have triggered the due-on-sale clause.

Finally, the regulation says with regard to the inter vivos trust exception that the borrower must not refuse "to provide the lender with any reasonable means acceptable to the lender by which the lender will be assured of timely notice of any subsequent transfer of the beneficiary interest or change in occupancy..."

Triggering is dangerous, but not illegal or immoral

Taking an action that triggers the due-on-sale clause is neither illegal nor immoral. It simply gives the lender the right to call the loan, that is, to make you pay it off completely right now. If you cannot afford to do that, and most people cannot, that is a financially dangerous situation. Entering into a deal where the due-on-sale clause has been triggered puts a Sword of Damocles over your head.

Concealment is illegal or immoral

Triggering a due-on-sale clause may not be illegal or immoral, but concealing the fact that such a clause has been triggered could possibly be both. Various gurus urge different methods of concealing the transfer of ownership and/or occupant. Each of those methods probably requires one or more parties to the deal to breach ethics or to commit crimes or violate common laws like fraud or breach of contract.

People who are prosecuted in mortgage matters are typically charged with one or more of the following federal felonies:

Note that virtually all institutional (e.g., bank, credit union, savings and loan) mortgages are federally related because of federal deposit insurance, federal mortgage insurance, government backed bonds, federal charters of the lender, etc.

State statutes and common law

States also have similar criminal laws which are also violated in the typical mortgage scam. Common laws may also be violated. For example, if the borrower promised to inform the lender if the ownership, occupancy, etc. changed, and fails to do so, they have committed breach of contract. Persuading someone to commit breach of contract could be illegal interference on your part. Violations of common law are civil, not criminal, matters. That means you cannot be imprisoned for committing them, but you could be made to pay damages or forced to take some action.

For example, you getting the previous owner to keep the insurance on the property in his name to conceal the change in ownership from the lender is arguably conspiracy (two or more persons), mail fraud (something related to the insurance will go through the mail either from you or to you), concealment of a material fact, and false statement (to the insurance company about who is the current owner). If you do two such deals within a ten-year period, you have arguably violated the racketeering law.

If you cannot disclose it, it's probably wrong

In general, you should never do anything that cannot stand the full disclosure test. That is, if the deal could not be done if everyone involved, including all lenders, knew everything that was going on, the deal is probably unethical and illegal. The typical lease-option acquisition cannot be done unless the existing lender is kept in the dark about the change in control and occupancy of the property.

The bottom line here is that breaking laws or contracts is a serious thing.

Not many prosecutions or suits

Some gurus respond by saying they have never heard of anyone being prosecuted or sued over a due-on-sale clause. First, note that they are not saying I am wrong, only that you probably won’t get caught.

Secondly, there clearly have been such suits, most notably the de la Cuesta decision itself. A 1999 case, Friery v. Sutter Buttes Savings Bank, 61 Cal. App. 4th 869, involved two sales. The lender sued and forced the owner to assume (become personally liable for) the mortgage and agree to move the balloon up by five years. The Wellenkamp case and its similar successors in other states all involved lenders suing borrowers over refusal to comply with due-on-sale clauses. William Bronchick says, “I have spoken to thousands of people across the country and every time I ask ‘how many people got a loan called for violating the due on sale?’ virtually no one raises his hand. Of the dozen or so people who have had a lender call it, they simply ignored it and the lender went away.” Note that he does not say no one raised their hand. I would also note that there may be some people in his audiences who should raise their hands, but do not because they do not want to go against the speaker.

The borrowers won the Wellenkamp case and some pre-1982 cases in the other states. However, those victories were short-lived from the perspective of real-estate investors in general because the de la Cuesta decision and Garn-St. Germain Act removed all doubt about enforceability of due-on-sale clauses.

Why don't they get a letter ruling?

For another thing, the gurus are not interested in finding out what the law really is on lease-options. I have long urged them to obtain an IRS private letter ruling on the income-tax legality of their lease-option agreements. The cost of such letter rulings was just drastically lowered. But not a single lease-option guru has ever requested such a ruling, in spite of the fact that it would help his clients and help the guru market his material. The fact is they know what they advocate is probably illegal and they are afraid to get a ruling.

Laches, waiver, and statutes of limitations

I make a similar dare regarding whether due-on-sale clauses are enforced. If they are almost never enforced, why not tell the lender what you are doing at the outset? From everything I’ve heard, the lender probably won’t do anything. If that’s the case, and the lender belatedly tries to enforce the due-on-sale clause later, the investor might be able to invoke the legal doctrine of laches or waiver as a defense. Black's Law Dictionary offers many definitions. Here is one for each doctrine.

Laches
omission [by the lender] to do what law requires to protect one’s rights under circumstances misleading or prejudicing adverse party [new property owner in subject-to purchase]; unconscionable, undue, unexcused unexplained or unreasonable delay in assertion of right

Waiver
The intentional or voluntary relinquishment of a known right, or such conduct as warrants an inference of the relinquishment of such right, or when one dispenses with the performance of something he is entitled to exact or when one in possession of any right, whether conferred by law or by contract, with full knowledge of the material facts, does or forbears to do something the doing of which or the failure of forbearance to do which is inconsistent with the right, or his intention to rely upon it. [emphasis added]

Delay alone is not enough to invoke laches. The property owner may also have to show that his situation now is different from when the deal was first done and that enforcing the clause after so much delay will therefore harm him in ways that were not true had the lender enforced the clause promptly.

Keeping the transaction secret prevents the laches or waiver “clocks” from starting. It’s hard for you to claim the lender waited too long to call the loan if you took steps to conceal from the lender the fact that the due-on-sale-clause-triggering event occurred.

Concealment would probably also enable the lender to accuse you of “unclean hands” if you tried to invoke laches or waiver. “Unclean hands” is a legal doctrine that says you cannot win by claiming the other side is being unfair if you, yourself, were unfair to them.

Statutes of limitations are time limits on when a prosecutor or civil plaintiff may start a court proceeding. Once the statute of limitations has ended, no prosecution or civil suit may occur. But as with laches and waiver, concealment of the transaction may delay the start of the statute-of-limitations “clock.” The law may say that the statute of limitations does not start to run until the lender learns of the due-on-sale-clause-triggering transaction. To the extent that you may want to rely on laches or a statute of limitations, it is in your interest to have the “clock” start as soon as possible.

Your enemies

There are a number of reasons why there are not more prosecutions or lawsuits regarding due-on-sale clauses. Prosecutors are busy with more serious crimes. Lenders are reluctant to be the bad guy in a public suit.

At his Web page, Bronchick admits that his technique triggers the due-on-sale clause (actually, he says “violates”), but then he asks the rhetorical question, “...but who is going to tell the lender?”

How about your enemies? The fact that you have lease-options which have triggered due-on-sale clauses is known by or knowable by your enemies. They could raise a stink and possibly thereby get your due-on-sale clauses enforced. Who might do that? Your ex-spouse, current spouse who has filed for divorce, former business partner, tenants or former tenants, buyer or seller who did business with you, anyone in or about to be in litigation with you, neighbors who are feuding with you, current or former disgruntled employees, etc. Talk about living in a “glass house.”

John Beck says he knows a guy whose business is to search for living-trust due-on-sale clause defaulters. Mortgage lenders tell him when properties have been placed into an inter vivos trust. He then monitors the payment of the water bills to see if the person paying the bills changes. If so, he reports it to the lender and they take whatever action they want to investigate further and possibly call the mortgage.

Beck also knows of an attorney who, before de la Cuesta, guaranteed his clients that he would defend, for free, any challenge to his scheme to get around due-on-sale clauses. He teamed up with a southern California escrow company. When the de la Cuesta decision came down, lenders deliberately went after every single deal this guy had set up. The escrow company was forced out of business and the attorney was forced to renege on his guarantee when he was overwhelmed by multiple foreclosure actions.

Beck says Dataquick advertises its services to lenders, in part, as a way to detect borrowers in default on due-on-sale clauses. Dataquick believe their sales to lenders are up as a result.

In June of 1998, I attended a conference run by Fair, Isaac, the high-tech company that produces the now ubiquitous FICO credit scores. One of the topics being discussed was high-tech ways to detect “silent second” mortgages. Efforts to get around due-on-sale clauses are generally belated “silent second” mortgages or land contracts or “silent assumptions.” Most single-family lease options are, in substance and therefore in law, wraparound land contracts, which are a type of second lien.

There is also the possibility that a news organization like 60 Minutes or 20/20 will do a story about people getting around due-on-sale clauses, thereby inspiring lenders and regulators to crack down.

Rise in interest rates would likely increase enforcement of due-on-sale clauses

The Wellenkamp and de la Cuesta cases, both of which involved lenders aggressively enforcing their due-on-sale clauses, occurred in the early ’80s. At that time, mortgage interest rates were at record highs---about 18% at the peak. In contrast, the interest rates on the Wellenkamp and de la Cuesta mortgages were much lower. The lenders have a fiduciary duty to put that money back out at current rates.

Other lawsuits to enforce due-on-sale clauses during that period were Patton v. First Federal Savings & Loan Association (578 P 2d 152) in AZ, Nichols v. Arbor Federal (250 NW2d 804) in Michigan, Bellingham First Federal Savings & Loan Association v. Garrison (553 P 2d 1090) and Morris v. Woodside (682 P 2d 905) in WA.

A conversation among three investors might go like this during a period of increased interest rates.

Investor A: Boy, I'm sure glad I have fixed-rate mortgages with that run-up in rates last month.

Investor B: I don’t have fixed rates, but my lifetime caps are below the current rates so I’m partly protected.

Investor C: I may be in trouble. I have all fixed-rate mortgages, but they are all in technical default because I did lease options. The lenders could call every single one of them.

In his article on the subject, William Bronchick says that lenders don’t care about enforcing due-on-sale clauses these days because market interest rates are low. He says, “This trend will probably continue so long as interest rates remain within a few percentage points of existing loans.” That may be true, but it implies an unspoken corollary: “This trend will probably NOT continue if [market] interest rates rise more than a few points above existing loan [interest rates].”

I found an interesting, albeit legally meaningless, clause in the law. Section 1701j-3(b)(3) says:

In the exercise of its option under a due-on-sale clause, a 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.

That means would you lenders please go easy on the borrowers.

‘Guts’

William Bronchick sent a brochure that promises to tell seminar attendees “How to Dance Around the ‘Due on Sale’ clause (sic).” But in an email to me he said, “‘Get around’ is not really what I am saying. The land trust trick DOES violate it, but it reduces your chances of getting caught. If you get caught, you refinance or pay it off. If you can’t, suffer the consequences. No crime. No fraud.”

At his Web site, he says “...the real question is: do you have the guts to take...the risk of getting caught.” Oh, so doing a real estate deal that triggers the due-on-sale clause in the underlying mortgage is a way of proving your manhood. Real men don’t eat quiche, but they do put themselves in situations where they might have to pay off all their mortgages on 30-days notice.

There are enough risks in real estate without your unnecessarily adding another huge one.

Ethics

In his discussion of getting around due-on-sale clauses, Bronchick says, “‘Ethics’ is a matter of opinion.” Actually, he uses a much cruder phrase. Ethics are usually a set of rules promulgated by some authority, like the Ten Commandments, the Golden Rule, or the Bar Association Code of Professional Responsibility. In many cases, like the Bar Association, the promulgater has authority to discipline or expel members who violate the pertinent code of ethics. Even when the person in question is not subject to organizational discipline, most people like to behave in an ethical manner. I have never heard a real estate guru admit to being unethical or to advocating unethical practices.

The core ethical code that I suggest is

• Tell the truth
• Keep your promises
• Treat others as you would like to be treated

If Bronchick or anyone else wants to dismiss that set of principles as merely my opinion, they should do so explicitly rather than shrug off “ethics” in the abstract. Conspicuous by its absence in Bronchick’s dismissal of ethics is the ethical code he recommends. By saying everyone has an opinion on ethics, he implies that his opinion differs from mine. But he makes no statement about what he thinks the appropriate code of ethics is.

Many lawyers seem to regard ethics as a “gnat” which they learned to “swat” in “word parsing” class in law school. The ethical code of many lawyers appears to be that whatever you can get away with is OK. I agree with Shakespeare when it comes to those lawyers.

People who are trying to get around due-on-sale clauses often lie to lenders or insurance companies, or ask others to do so. A borrower who promised to notify his lender of a change in ownership or a change in occupancy other than a straight less-than-three-year lease must violate that promise to keep a lease-option secret. In general, getting around a due-on-sale clause is a behavior pattern that few would want done to them if they were the lender, a behavior pattern that few would do to their best friend or a close relative. If you wouldn't want it done to you and wouldn’t do it to a friend or relative, how can you claim to be ethical when you do it to someone else? In fact, people who try to get around due-on-sale clauses rationalize their behavior by claiming lenders are evil and therefore deserving of unethical behavior on the part of the investor. That's bogus.

Violations of pertinent codes of ethics

Real estate agents and attorneys who are involved in such a deal might lose their license if the facts came out. They have an extra duty of disclosure and must comply with professional codes of ethics above and beyond what the average Joe must do. Here are some pertinent passages from the Realtor® and Bar Codes of Ethics: