Due-on-Sale Clause – Understanding Land Trusts

This article is Part 3 of a four-part series on Land Trusts.  You can find Part 1 here: Understanding Land Trusts

Now you may be asking — how is the land trust going to help me with my lender?

The answer lies in why the land trust was created, and why it’s perfectly legal. It’s basically a compromise between two opposing forces.  On one side is the bank which is interested in generating income from loans and at the same time protecting itself through a security interest in real property — on the other side is the borrower (real property owner) who desires to transfer title to his property without fear of foreclosure or forced refinancing.  The bank acts as the protagonist by incorporating a “due-on-sale clause” into most, if not all, mortgages its writes.

The due-on-sale clause means essentially that the bank can decide to “call in” or “accelerate” its loan if the title of the property is ever transferred to another person or entity.  This is important to real estate investors who desire asset protection or freedom of contract.  If an investor wants to purchase property from a distressed seller subject to an existing mortgage, or to transfer his three properties into a limited liability company for asset protection, he does so at the risk that the lender discovers the transfers and subsequently accelerates the loans on the properties.  Many investors are troubled by this potential outcome and, thus, elect not to protect their encumbered investment real estate.

Now in reality, I’ve met thousands of investors at my workshops, and in all the years I’ve done them I’ve only heard of one or two instances where the bank used the due-on-sale clause to force a person to refinance their loan.  In these instances, the problem was simply that the owner was behind on his payments. But the due-on-sale clause has more ramifications than refinancing.

The bank’s decisions are influenced primarily by economic forces, so it doesn’t matter to them whether they are forcing you to refinance or not.  Furthermore, the bank is probably not going to hold on to your mortgage.  In the typical scenario, the bank will sell and resell mortgages to other banks as they need to.  Of course, they won’t allow homeowners to buy residences in entities or agree to the sale of real estate subject to an existing mortgage without first paying the mortgage in full.  Why?  Because if the bank attempts to sell the mortgage, a purchaser is not going to be willing to pay top dollar if they have to investigate who owns the property or the owners’ credit rating.  If the homeowner is forced to use his own name, then the bank and the potential purchaser of the mortgage have no problem doing business, since all the information is right there.

But from the homeowner’s perspective, this is horrifying — and rightfully so. Not only is the homeowner forced to borrow money from a faceless lending corporation, but he has no control over whom they sell the deed to, and who might enforce that due-on-sale clause. Even worse than that, he can’t protect himself in terms of liability by purchasing his real estate investment with a limited liability entity, because most commercial lending institutions refuse to do business with entities unless the buyer agrees to pay commercial interest rates.

This nightmarish scenario is averted with the Garn St. Germain Act. This 1982 legislation had many goals, including making home mortgages available to a large number of people. The Garn St. Germain Act addresses the basic conflict between homeowners looking to protect their assets, and the bank’s insistence that the homeowner buy the property in their own name. The Garn St. Germain Act prevents lenders from enforcing the due-on-sale clause when residential properties are transferred into a revocable trust and there is no change to the rights of occupancy. The key word here is revocable. Remember that a land trust is a revocable grantor trust that, as such, is covered under the Act.

Thus, under the Garn St. Germain Act an investor can create a land trust to hold title to his rental real estate without fear of his lender calling the mortgage due and payable.  Once the property is held by the land trust, an investor has the flexibility to assign his beneficial interest to a limited liability company or another purchaser without alerting any third parties to the fact there has been a transfer.  There are limits to the Garn St. Germaine Act.  If you have a property with more than four housing units, or have a loan that is not federally backed, then the Garn St. Germain Act does not apply.

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In part 4 of this series on Understanding Land Trusts we will complete the discussion by explaining the privacy of ownership, avoiding county transfer taxes, and wholesaling property or purchasing property “subject-to” an existing loan.