Article I Section 10 of the United States Constitution says: 'No State shall … pass any Bill of Attainder, ex post facto law, or law impairing the Obligations of Contracts . . .'
Promissory Notes are simply contracts between a lender and a borrower. Mortgage Notes are forms of the same kind of contract which are secured by a Mortgage instrument. Contract law binds them both and any disputes between borrower and lender are usually settled in Equity Courts. From time to time, lenders seek to impose limitations and restrictions upon borrowers that have the net effect of forcing borrowers to either renegotiate existing loans or to borrow new money under conditions more favorable to the lender.
Some 25 years ago Martha Wellenkamp wanted to sell a property which was mortgaged. The mortgage forbade anyone else taking title without the lender's approval. The mortgage balance was $1,100 or so, payable at 6%. The lender wanted an additional 1% in return for approving the new borrower's taking over Martha's loan. Martha hired a young attorney, Fred Crane, to fight back. The law suit went all the way to the Appellate Court in the 9th circuit – where Martha won.
The Wellenkamp decision spread like wildfire through the nation. It is estimated that the attempts by the lender to extract an additional $11 per year in interest from Martha Wellenkamp cost lenders some $2 Billion in California alone.
In July of 1982, after considerable ranting and raving by banks, the U.S. Supreme Court ruled that the Wellenkamp ruling didn't apply outside the 9th circuit. In the fall of 1982, the U.S. Congress passed the Garn/St. Germaine Bill (named after its authors) which more or less said that a loan contract could legally state that any change of ownership of all or part of a mortgaged property, or transfer of any interest therein, without prior acceptance in writing of the new owner by the lender, could be deemed to be a default. The payment in full of any loan balance would be 'due-on-sale', hence the name, 'due-on-sale' clauses. That made real estate a lot less liquid.
Additional exceptions and modifications to mortgage language were added over the years, as people attempted to get around lender contracts through a variety of ruses, and lenders fought back. Some of the exceptions permitted under the Act included the following:
1. Creation of a junior lien subordinate to the original loan. This is now allowed.
2. So is pledging of the property to secure a loan for household appliances.
3. Transfer by devise or descent upon the death of a joint tenant is exempt from the Act.
4. A lease for less than a 3 year term, not containing an Option is O.K.
5. Plus, there are other exceptions contained in the regulations.
Harking back to the U.S. Constitution's language, any legally enforceable contract which anyone writes need not contain due-on-sale language. Nor could the new law add due-on-sale language to any existing loan contract if it wasn't there originally. In the final analysis, the new law merely authorized lenders to call a loan at their option if a new borrower refused to come in and negotiate new terms on an old loan.
It did not make it unlawful for people to assume or take title subject to existing loans, or place wrap-around loans on properties they sold and not tell the lender about it. Buyers tried a lot of subterfuges over the years. Here are some of them:
1. Since the law related to loan assumptions only, new buyers simply took title 'subject to' the existing loans without releasing the original borrower.
2. When selling, the original borrower often 'wrapped' the loan and continued making payments out of the funds the new borrower paid him.
3. Properties were placed into Trusts, Partnerships, Limited Liability Companies and Corporations. Then shares of these entities were sold rather than the properties themselves. But in 1983, due-on-sale clauses were strengthened by stating that the transfer of control over the ownership of any borrower-entity such as a Trust, Corporation, Partnership, LLC, etc. would be deemed a transfer of the property.
4. Powers of Attorney were signed by a seller to legally empower the buyer to sign a deed. After completing his purchase of the house, albeit leaving the title in the original owner's name, the buyer moved in. When he was ready to eventually sell, he merely signed the deed and conveyed title to the next buyer in his capacity as the representative of the former owner.
5. Properties were deeded directly to the new buyer. Despite the existence of an insurance policy naming the lender as additional insured under the policy, the new buyer simply bought another policy in his own name as if the property were free and clear. The cost of an extra insurance policy was a small price to pay for getting access to existing low interest financing.
6. The seller signed a long term lease or a management contract with the buyer giving him permission to either occupy himself or rent the property to third parties so long as he paid all the payments and property expenses. A confederate also obtained an Option to buy the property at the same time, and this Option was sold to a subsequent buyer who repeated the process.
7. Elaborate escrow arrangements were set up through which title to a property was placed into a Trust with an Attorney named as Trustee. The Trust guaranteed to any buyer that title would be conveyed upon demand. The buyer paid the seller for his equity taking possession of the property. Upon subsequent sale or refinancing, the Attorney conveyed title to the ultimate buyer.
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In recent years, FHA and VA loan language has also prohibited the transfer of property without the new buyer qualifying for a new loan. Let's place this into perspective. FHA doesn't lend money. It merely insures a lender who does. As a result of the RTC debacle, FHA has been attempting to shore up weak lenders so there wouldn't be a repeat disaster. They've discovered that the largest incident of loan defaults occurs among non-owner/occupants. The VA followed suit for the same reasons.
While the language in the instruments used by FHA and VA lenders is less comprehensive than that under the Garn/St. Germaine Act these loans usually fall under that Act too, so any evasive tactics would have to not only avoid FHA/VA restrictions. but also the usual due-on-sale strategies, some of which were outlined above.
Here's a bullet-proof step-by-step way for a transaction to be completed without any problems. We'll look at it from the buyer's point of view:
1. The buyer doesn't buy the property. Instead, he makes the seller a 100% loan, based upon the equity they negotiate between themselves. The buyer tenders the seller a combination of money and Promissory Notes in the amount of his equity. Since there has been no sale, no taxes are due on the part of the seller at that time.
2. The seller signs a non-recourse convertible demand wraparound note at the maximum legal rate, secured by a mortgage containing an assignment of rents to the buyer, and requiring the buyer to pay all underlying liens, including any non-assumable loan. The 'devil' in any creative loan details should be contained in the Note, which is normally a private document known only to the principals; not recorded in the public records. The Mortgage should be a plain vanilla FNMA/FHLMC model.
3. The buyer records the mortgage in the public records and has the seller instruct his casualty insurance company to name the buyer as an additional insured lender to protect his security interest in the property.
4. The owner gives the lender a 3 year lease, with the right to sub-lease, thereby giving him the right to occupy and possess the property, and to collect the rents and to apply them to the loan balance, retaining any excess for himself.
5. The seller further secures the buyer by signing all documents required to close an eventual sale, including a deed and closing statement reflecting the total cash and notes previously advanced by the buyer. He also signs a Power of Attorney and Assignment of Insurance Proceeds which authorize the buyer to claim under any insurance policy, sign any new deed, lease or other real estate document so long as it creates no liability for the seller.
6. Finally, escrow instructions are signed by both parties, lodged with a mutually selected escrow agent. These require the escrow agent to transfer the property to the buyer, or to his assigns, without further action anytime the buyer demands payment on his 'loan', unless the total sum loaned including interest is paid in full within 30 days. A copy of the demand for payment is to be sent by certified mail to both the escrow agent and the seller. Further, in the signed escrow instructions, both seller and buyer both indemnify the escrow agent for carrying out these instructions.
Here's how those instructions might read, subject to any modifications you might want to include to make your deal work better.
'To Aardvark Escrow Company, 1234 Main Street, Anytown, Anystate, USA, the following escrow instructions are hereby given regarding the transaction between John and Jane Doe of 101 Maple Street, Anytown, Anystate, 49620, hereinafter called borrower, and Richard Roe of 5678 University Place, Anytown, Anystate, 49634, hereunder called lender:
1. To further secure his loan, borrower will deliver unto you a signed and Notarized Warranty Deed to the property described as (legal description and street address) which you will hold in a place of safe keeping, subject to the following terms.
2. Lender will deliver unto you copies of a Note and Mortgage signed by the borrower, and, a signed and notarized full release of liability indemnifying the borrower against any negative credit report and estopping the lender from any further legal action, should he exercise his rights below.
3. At anytime henceforth, the lender may, by sending a letter to the last known address of said borrower, with a copy sent by certified mail to you, demand full payment of the unpaid balance of the above described Note together with all accrued, unpaid interest, which shall compound at the highest rate allowed by law, calculated to the date of repayment.
4. At the option of the holder thereof, full payment for said Demand Note may be made 'in kind', by his accepting, in lieu of payment by certified check of all amounts due, delivery of an acceptable deed of conveyance from the Maker to the Holder or his assigns, subject to the then existing liens, encumbrances, restrictions, covenants and easements of record.
5. By delivery of and acceptance of the said conveyance, the Holder and the Maker hereof mutually release each other, and parties acting for or through them, from all future obligations on the said Note and Mortgage, and the debt together with all accrued interest is thereby fully satisfied. Both parties, their representatives, assigns, agents or nominees are thereafter estopped from any further claim against the other with regard to this transaction.
6. This escrow instruction comprises the complete agreement between all parties. Both Borrower and Lender agree to indemnify the above named escrow agent and its employees from any liability stemming from strict adherence to these instructions,
7. By affixing their signatures below, the lender, borrower and escrow agent agree to be bound by this agreement unless all parties mutually and voluntarily agree to a signed modification thereof.
Benefits: The Seller gets tax free cash. The Buyer gets control without ownership. Property Exchanges can be timed to qualify for tax-free treatment under IRC Section 1031. No due-on-sale clause can be invoked.
