We get many calls from buyers, sellers, and real estate brokers, asking us to prepare either an installment land contract, called an "ILC" or a "contract for deed," or a lease with an option to purchase. Most of these inquiries stem from the inability of the buyer to obtain financing for the purchase, whether due to a poor credit rating, a recent bankruptcy, or an insufficient down payment.
Either of these methods is risky for a buyer, for a number of reasons. One risk is that during the pendency of an unrecorded ILC or lease, the seller's title could become compromised by a lien (either consensual, like a new deed of trust, or non-consensual, like a tax, judgment or mechanics lien), making it difficult or impossible for the seller to eventually perform. Another risk is that the seller could stop paying his own mortgage which still attaches to the property, with little or no leverage to require him to do so. Also, neither an ILC nor a lease/option gives a buyer obvious cure or redemption rights (to protect what might be a substantial amount paid up front), which rights she would have had with third party financing. In reality, she does have those rights, and others discussed below, but she may need to expend substantial sums in attorneys fees to convince a court that the seller cannot simply evict her.
The seller is also at risk with either of these financing methods. One of those risks is the consequences of failing to comply with a little-known Colorado statute which requires him to designate the public trustee as the escrow agent for taxes (which compliance might result in taxes being escrowed twice, if the seller's lender is already doing so). This statute also calls for notification to the county assessor of the "transfer." This may also be applicable to lease/options if the lease portion lasts longer than 180 days. Non-compliance with this statute may allow the buyer to "void" the contract and receive a return of all payments made, plus interest, attorneys fees and costs! Another risk to the seller (as if the first risk isn't enough) is that the buyer may claim an "equitable interest" in the property under either document. This would force the seller to bring a judicial foreclosure or a quiet title action (rather than a quick eviction action, which the seller probably expected to do), which could take years and cost thousands of dollars. In the meantime, the buyer may get to stay in the property, sometimes without payment to the seller at all until the action is completed. Even a deed back to the seller held in escrow by a third party, prepared at the outset to protect him, doesn't avoid this result.
There is, however, another way to accomplish a form of owner-carry financing, without immediately paying off the seller's existing mortgage, which is less risky for both parties. It's called an all-inclusive or wrap-around mortgage, or "wrap" for short. [NOTE - if the seller owes on an FHA-insured (post March 1, 1988) or a VA-insured (post December 15, 1989) note and deed of trust, wrapping either of those types of loans in considered improper - possibly even fraudulent - by HUD, and is not recommended.]
Here's how a wrap works: take a property worth $200,000, secured by an existing $150,000 note and deed of trust. The seller's payments to his lender are about $900 per month, based on 6% interest and a 30-year amortization. The buyer has $15,000 to put down, but she can't currently finance the balance of $185,000 with a third-party lender, although she expects to be able to do so within a year or two. The seller cannot otherwise sell the property and is willing to take a risk with this particular buyer, but only for a limited time.
The seller can take the $15,000 down, a decent amount which should discourage the buyer from casually defaulting. (Whatever the seller gets as a down-payment should always be enough to at least cover his sales expenses, so that he's not out-of-pocket at the closing.) Title to the property transfers to the buyer at a normal closing, with Seller then financing the $185,000 balance on a Colorado form note and a custom "wrap" deed of trust, but with a one or two-year balloon. Obviously the seller's proceeds from closing aren't enough to release the first deed of trust, so that lien moves from the "requirements" section of the title commitment (Schedule B-1) to the "exceptions" section (Schedule B-2).
The $185,000 owner-carry financing, if also at 6% and on a 30-year amortization, would require a monthly payment from the buyer of about $1,100 per month. When the buyer pays those monthly payments to the seller, the seller in turn pays his underlying note payment of $900 and pockets the remainder. (If he doesn't pay his lender, the wrap document allows the buyer to pay that lender directly.) If all goes well, then on the balloon date the buyer re-finances the property and pays the seller the balance due on the $185,000 note, who in turn pays the balance due on the underlying note. Nice.
But what if all does not go well? What if the buyer's credit rating is no better on the balloon date than it was at the original closing, and she is not successful in refinancing the property? Worse yet, what if the buyer stops paying even before the balloon date? Then the seller quickly files a public trustee foreclosure action, which costs substantially less in attorneys fees than other litigation. Barring a bankruptcy by the buyer, which can delay the process, the seller is usually returned to title within four to six months. Or the seller might get paid in full from the foreclosure sale, if there are third-party bidders. Although the seller may need to scramble in the meantime to continue paying the underlying note, he would have to do that anyway if the buyer defaulted on the ILC or the lease/option. At least this way the seller can see the light at the end of a four to six month tunnel, rather than being stuck in litigation for years.
The main risk with a wrap, for both buyer and seller, is that the seller's original lender will discover the transfer and call that note "due on sale." This provision, in most Colorado deeds of trust, requires full payment of the note at the time of most "transfers" of the property. But entering into an ILC or a lease/option is probably a violation of that due-on-sale clause as well. If the seller is going to violate it, he may as well do so in a way which allows him to get the buyer out quickly and inexpensively.
It is not illegal to breach a deed of trust by selling the property without paying off the underlying mortgage (although it's not recommended for FHA- or VA-insured loans referenced above) - it's simply a breach of that "contract" which then allows that lender to foreclose. Either the buyer or the seller (by earlier agreement between them) would then have the obligation to re-finance, to avoid the foreclosure.
So when the underlying mortgage isn't FHA- or VA-insured, consider a wrap instead of either an ILC or a lease/option. For the price of either the buyer or the seller hiring an attorney to prepare the wrap documents, there's a lot of peace of mind provided to both sides of the closing table.
Karen J. Radakovich is of counsel with Frascona, Joiner, Goodman and Greenstein, P.C., a Colorado law firm.   Her practice areas include Real Estate, Bankruptcy, Finance, and General Law. She can be reached at contact Karen Radakovich.
Disclaimer -- Content is general information only. Information is not provided as advice for a specific matter, nor does its publication create an attorney-client relationship. Laws vary from one state to another. For legal advice on a specific matter, consult an attorney.