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How To Transfer a Non-Assumable Mortgage
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BY ROBERT J. ABALOS; Robert J. Abalos, a Boston lawyer and investor, is president and chief executive officer of the Cerberus Corp., a Massachusetts venture capital and investment firm. Distributed by AM-LAW News Service
The greatest barrier to buying or selling commercial real estate is the need to secure financing. While mortage money is generally easy to find these days, the placing of a mortgage or deed of trust on a property is expensive and time-consuming.
The problem lies with lenders. Most are notoriously slow in processing paperwork. All demand from the buyer, or mortgagor, exorbitant fees, ranging from minor annoyances, such as credit check and courier charges, to heavier burdens, such as points and loan origaniation fees.
For purchasers of real estate, the world would be an infinitely simpler (and cheaper) place if only they could "assume" the mortages that already encumber most conveyed property -- thus avoiding the need to obtain new financing, with new fees, from a lender. In fact, freely assumable mortgages do exist, but they are becoming more and more rare. So-called quasi-assumable loans are more widely available, but aren't really assumable at all. They require lender consent for the buyer to assume -- and, of course, the lender requires all sorts of fees, points, and paperwork for permitting the assumption. Most loans, then, are not assumable and contain the dreaded words "due on sale" somewhere in the mortgage agreement and promissory note.
The meaning of this expression is clear: If there is any transfer or attempted transfer of title to the property, the entire mortgage balance becomes immediately due (called demand and acceleration), and the original mortgagor/current seller is on the hook for a huge sum of cash. Such a draconian approach works well for lenders, as few mortgagor/sellers are willing to risk being obligated for the entire note balance in one fell swoop.
Due-on-sale clauses (DOSCs) have been widely attacked for many years in many quarters for being an unreasonable restraint on real estate transfers. But they have held up very well under the onslaught. Nonetheless, innovative lawyers and purchasers have developed ways to circumvent DOSCs -- much to the chagrin of mortgagees everywhere. Some of these methods have been protected by statute to guarantee their viability as alternatives to new mortgage financing.
Why would a purchaser/transferee want to beat a DOSC and risk the wrath of an angry lender? Some of the better reasons are:
* To avoid the fees, points, and charges attendant on transfers, called the transaction costs or the closing costs.
* To get the benefit of a below-market interest rate on an outstanding loan. Lenders always are looking for reasons to rewrite loans with low interest rates, and any title transfer gives them a convenient rationale.
* To save time. There is no need for an investigation, credit and income checks, title insurance, etc. The title transfer can take place overnight without the lender's involvement.
* To overcome an inability to qualify for a new loan. A buyer who is able to afford the monthly payments may still be denied a loan based on arbitrary qualifying rules. Consider a businessman who has faithfully paide more than $1,000 a month in rent for years, but is told by a mortgage company that he cannot "afford" a $750-per-month
mortgage payment because his income is too low. This problem arises particulary where newly established (less than two years in existence) corporations cannot get credit, regardless of their income, or where persons or businesses with a history of bankruptcy cannot secure loans, regardless of their current income or the reason for their past financial difficulty.
* To secure financing when mortgage money is tight.
* To avoid contract contingencies with respect to financing. In buyer's markets, the seller can instantly be assured that the prospective buyer will get financing if the seller himself provides it. The alternative is to take the property off the market for a number of weeks and, if the prospective buyer cannot get a mortgage, refund the earnest money deposit and start the search for a buyer anew.
A LENDER'S REVENGE
There are two major disadvantages to beating, or attempting to beat, a DOSC. First, the buyer may end up dealing with an angry lender who feels bested by a legal technicality. If the sale is structured properly, the lender will have no legal recourse but may be unwilling to make loans to the buyer in the future.
Second, the seller (who is also the original mortgagor) may have difficulty escaping underlying liability for the debt. The transfer contract may give the seller legal recourse against the buyer, but the lender almost always has recourse against the original mortgagor. The seller's solution is to qualify the buyer almost as closely as would the lender, make the buyer liable to the seller for any buyer default, and communicate frequently with the buyer to receive the slightest hint on any impending default.
Assuming a DOSC exists and the loan was originated by a federal savings-and-loan institution, the Garn-St Germain Depository Institutions Act of 1982 says the DOSC is legally enforceable when title is transferred. The date of the loan's origination is immaterial. However, if the S&L did not hold a federal charter at the time of origination and later converted to federal status, the Garn-St Germain law makes all such DOSCs legally unenforceable. This amounts to a straightforward exemption from the constraints of the DOSC.
If the DOSC was written by a non-federal lender (such as a bank, finance company, mortgage company, or individual investor), in some states the DOSC is unenforceable if the loan was made during certain "window periods." The limits of a window period are unclear in many jurisdictions, but codified in others. Although tricky, these periods provide legitimate barriers against the enforceability of DOSCs.
If the mortgage contains an enforceable DOSC, the question then turns to how to circumvent the clause lawfully. A number of approaches exist, but great care must be taken.
In one method the prospective buyer "loans" the seller money and places a mortgage on the property to secure this loan. The loan usually represents the seller's equity in the property. The seller deliberately does not make any payments, and the buyer "forecloses" on the property. At the foreclosure sale, the buyer takes legal title "subject to" the old loan, which, in most states, the first lender is unable to call.
One disadvantage is that at the foreclosure sale, an outsider might bid more than the amount the buyer has loaned to the seller. Then the buyer just gets the original loan back, plus interest. To avoid this the seller can turn over to the buyer a deed in lieu of foreclosure – which may give the buyer all the same rights with respect to the DOSC,
although the issue is not as well settled as with a foreclosure sale.
Another possible complication is that some title insurance companies will not insure properties obtained by foreclosure for a period of time, usually six to twelve months, or until after the mortgagor's right to redeem has passed. A buyer should consult with the prospective title insurer before using this technique.
The great advantage fo the "friendly" foreclosure is that the buyer quickly receives title to the property. But the buyer must be careful that the seller, while withholding payment on the buyer's note, continues to make payments on all senior encumbrances.
A note to sellers: This technique generally will not produce a negative entry on credit reports. As long as the first (and usually reported) mortgage is kept current, it is doubtful whether a foreclosure by a second mortgagee (here, the buyer) will make it into the files.
Indemnification works well when dealing with (1) a mortgagor/seller who is having problems meeting monthly obligations and is delinquent on mortgage payments; (2) a mortgagor who is terminally ill; or (3) a period of time when foreclosures are on the rise (such as the present), and lenders are unwilling to risk further damage to their balance sheets by taking in more REOs (real estate owned).
Indemnification occurs in one of two ways. The first is to contact the lender prior to title transfer and, after pointing out the continued delinquency of the mortgage or the mortgagor's terminal state, offer to take title to the property subject to the existing loans. The lender gains a healthy new borrower and avoids foreclosure proceedings. Some
lenders will also try to kick up the interest rate and charge assumption fees. In that case, they are not desperate enough to allow the transfer without writing new financing.
A second variation is for the buyer to take title subject to the existing financing and to sign an indemnification clause in the sales contract. The clause provides that if the lender calls the loan, the buyer will indemnify the seller for the costs involved (namely, the amount of the loan and the attorney fees). Once title has been transferred and recorded, the buyer can contact the lender and work out a deal.
The advantage, again, is that the buyer receives title to the property in his or her own name very quickly. All the techniques that follow require that title be placed in someone else's name.
TITLE IN TRUST
A common approach is for the seller to convey title into an inter vivos (or living) trust and the buyer to purchase the beneficial interest under the trust. A specific exception in the 1982 Garn-St Germain act makes DOSCs unenforceable in these circumstances. The trustee's responsibility is simply to hold legal title to the property. Once the transfer into trust has taken place and the ned deed listing the trustee as legal owner has been recorded, the trust instrument should be forwarded to the lender. Then a separate contract can be executed to transfer the beneficial interest under the trust to the buyer. This document does not have to be recorded, nor does it have to be sent to the lender.
The main advantage here is that the lender is legally barred from enforcing the DOSC. The lender knows of the transaction, and there is no risk of lender backlash about an attempted transfer in violation of the DOSC.
The main disadvantage is that the buyer cannot hold title in his or her own name. Another possible problem is that a lender might attempt by court order to obtain the names of the beneficiaries under the trust. But this is unlikely as long as the loan payments are current and buyer, seller, and trustee are happy with the arrangement.
PARTNERSHIPS OR CORPORATIONS
A variation on the trust technique is to transfer title to a partnership or corporation and then to sell the interests under the entity to the buyer. Both steps require the lender's consent, but lenders agree if the standard closing costs are paid.
There are many potential disadvantages here, aside from the payment of lender fees. The transfer of the mortgage liability to the corporation can be a taxable event. Incorporation is costly: The annual fees paid to the state of incorporation can be burdensome, as can the paperwork attendant to managing a corporation.
Some buyers may not be up to these responsibilities, and sellers must always be on their guard. A buyer could sell interests in the corporation or partnership, diluting the seller's recourse in the event of a buyer default. A restriction on the transfer of shares in the articles of incorporation solves this problem with respect to legitimate buyers, but
the more nefarious may neglect to disclose these restrictions to third parties.
On the other hand, this technique can be effective if there is a preexisting relationship between the parties, especially a business relationship where a corporate or partnership arrangement would make sense. The corporate or partnership form of holding title is also
valuable because it allows for "off the balance sheet" debt financing. If the buyer
defaults, it's easy for the seller to recover: Instead of going through the time and expense of a foreclosure, the seller simply demands return of the corporate shares or partnership interests.
WHAT NOT TO DO
Two common procedures that are inappropriate for beating DOSCs are the land contract and the wraparound, or all-inclusive, mortgage.
Under a land contract (also known as a contract for deed, agreement for sale, contract of sale, or uniform land purchase installment contract), the seller retains legal title to the property while receiving monthly payments from the buyer. When the contract price is fully paid, the seller conveys title to the buyer.
This can be a disaster for the buyer. The seller might jeopardize the buyer's clear title by indurring a tax lien and judgment, going bankrupt, or simply selling the property to a third party. Or the seller might overburden the property with debt by placing other mortgages on it.
Moreover, the seller generally does not tell the lender of the contract. If the buyer records the contract, as any rational buyer should to protect further alienation of the seller's interest, then the lender will be alerted to the transfer and can call the mortgage.
The land contract is no bargain for sellers either. For example, evicting a defaulting buyer in many states requires a full or partial refund of the buyer's "equity" in the property before a court will order title quieted in the seller's name. Nor does the land contract circumvent a DOSC. It just tries to avoid the DOSC by not telling the lender about the transfer.
Using the wraparound-mortgage technique, the seller makes the current financing part of the prearranged package offered to the buyer. The seller earns money on the spread between the lower interest rate on the original loan and the higher rate charged the buyer on the entire note. But a wraparound mortgage only works where the original mortgage has (1) a below-market interest rate and (2) no DOSC. If there is a DOSC and the loan is called by the lender, the wraparound mortgagee (the seller) can not only lose the original low-interest loan but also be completely wiped out by foreclosure.
Remember: It is not illegal to circumvent a DOSC. Smart investors do it all the time. It is profitable to do so when you can. Taking advantage of one's legal rights is always proper (especially when dealing with mortgage lenders). But great care must be taken in beating a DOSC. Otherwise, you may have a called loan, legal fees, and an angry lender on your back.