A once popular option for selling property, seller financing (land contracts) has been largely overshadowed in the last 50 years by the conventional mortgage market. The sheer size of the conventional mortgage market has made the necessary documents standardized and easy to obtain. However, in this current tight real estate market, land contracts are becoming more common as a means of selling property.
For clients who own property, the benefits of a land contract are fairly obvious: cash down payments, profit from the interest rate, potentially steady payments, and retention of legal title to the property during its pendency. In addition, there is the ability to sell the land contract outright in the secondary real estate market. On the flip side, a land contract can be an excellent path to homeownership for a client who does not qualify for a conventional mortgage.
However, in spite of their growing appeal, most land contracts are written by individuals or drafted without the help of a knowledgeable attorney. This article is intended to provide a basic introduction to land contracts, guidance for basic drafting, and tips to pass along to clients looking to sell in this manner.
THE BASICS
Land contracts and traditional mortgages both accomplish the same task but by different means — that is, by securing a debt with different collateral property. While the outcome is basically the same, the legal ownership, documentation, assignment, and recovery options do vary.
As to legal ownership, land contracts transfer use of the property to the vendee (buyer), while the vendor (seller) retains legal title until the vendee fully performs. Rather than having a separate mortgage and promissory note, a land contract is both the security and the obligation all in one and can be transferred by assignment or deed.
Another unique characteristic of a land contract is recovery of the property via forfeiture rather than foreclosure. While forfeiture is gen erally quicker, and less expensive, there are some drawbacks, the largest being limitations in monetary recoveries. When considering a land contract, make sure to review the legal requirements for forfeiture, starting with the statutes governing summary proceedings.1
DRAFTING BASICS
Though land contracts differ from traditional mortgages, many of the provisions will be substantially similar. At a minimum, make sure to include provisions detailing the parties, the property’s legal description, repayment, responsibility for taxes and insurance, title being conveyed, default remedies, assignments, other encumbrances, and costs to close. It is also typical for land contracts to contain provisions that are more suited to leases than mortgages. Example provisions include rights to enter and inspect the property after notice, duties to repair, and prohibitions on waste. Many of these may seem obvious, or basic contract-drafting skills, but you might be surprised how often the information is missing or incorrect. This article is not intended to provide guidance on all the provisions which could be included, but let’s quickly cover a few of the most important.
REPAYMENT
To start, the repayment provisions need to provide specifics on the terms of repayment. Details to provide include the total contract price, amount of any down payment, total amount financed, interest rate, term, payment amount, first and continuing payment date, balloon payment (if any), and any grace periods and late fees. The payment amount should indicate whether it is principal and interest only or includes other expenses, such as homeowners association fees, taxes, and/or insurance. Also, if you are going to escrow for taxes and insurance, remember to include that the payment amount may increase.
TAXES & INSURANCE
Ensure it is clear which party is responsible for taxes and when that responsibility begins. Some contracts make the vendor responsible along with the buyer for reimbursement. However, a better solution is to place the responsibility solely on the vendee with, or without, the funds escrowed by the vendor. Remember when drafting that some accrued tax will already be owed at the time the land contract is executed. Is the vendor responsible for that amount, or will the entirety of the next payment be due from the vendee? This may seem like a trifle, but courts have looked at the payment of taxes as evidence that a vendee had not defaulted on the contract in the eyes of the vendor.2 Clear responsibility and execution can help in reclaiming the property or establishing the lack of default.
Regarding hazard insurance, land contracts are unlike any traditional mortgage, which always requires the owner to provide hazard insurance. Land contracts should clearly define who will be paying for hazard insurance, the acceptable amount of coverage, and how the proceeds will be applied in the event the worst occurs. Should the parties agree to have the vendee insure the property, it is a good idea to require the vendee to provide proof of the insurance upon request. In such cases, make sure the insurance is payable to the vendor and vendee jointly or to the vendor as mortgagee.
A final tip here is to include a provision allowing the vendor to pay the past due taxes and insurance on the vendee’s behalf to protect the asset and add the amount paid back into the principal of the debt if not paid timely.
TITLE
Transferring title is another key provision to ensure you get right. Properly drafted, this should specify that title is only delivered to the buyer after full performance of the contract. Further, it needs to detail what kind of title is being delivered (quit claim, warranty, etc.). Quit claim is most common, as warranty deeds can get a bit tricky if the seller later decides to allow the buyer to assume an underlying mortgage and take title early. A title policy, or search at a minimum, is prudent to ensure the property isn’t already encumbered or affected by other ownership interests.
Be careful with title transfers, as another aspect of a land contract is that a vendor’s interest in the contract transfers with the land by deed. A vendor may accidentally convey their interest in the contract without knowing it. Estate planning is most often the reason a vendor may do this, transferring the property to a family member without considering the underlying land contract. It has been my experience that some vendors will also title the property without the contract being completed for almost no reason at all. Either way, make sure your client is informed up front, and hopefully it will save you some headaches on the back end.
DEFAULT REMEDIES
Land contracts have three options for recovery in the event of buyer default: breach of contract, forfeiture, and foreclosure. Breach of contract and foreclosure claims are both available even if not written in the contract. However, forfeiture is only an option if it is included, in the contract. While all three remedies do not have to be included, it is best to do so to provide the seller with options in the event of default.
is to place the responsibility solely on the vendee with, or without, the funds escrowed by the vendor. Remember when drafting that some accrued tax will already be owed at the time the land contract is executed. Is the vendor responsible for that amount, or will the entirety of the next payment be due from the vendee? This may seem like a trifle, but courts have looked at the payment of taxes as evidence that a vendee had not defaulted on the contract in the eyes of the vendor.2 Clear responsibility and execution can help in reclaiming the property or establishing the lack of default.
Regarding hazard insurance, land contracts are unlike any traditional mortgage, which always requires the owner to provide hazard insurance. Land contracts should clearly define who will be paying for hazard insurance, the acceptable amount of coverage, and how the proceeds will be applied in the event the worst occurs. Should the parties agree to have the vendee insure the property, it is a good idea to require the vendee to provide proof of the insurance upon request. In such cases, make sure the insurance is payable to the vendor and vendee jointly or to the vendor as mortgagee.
A final tip here is to include a provision allowing the vendor to pay the past due taxes and insurance on the vendee’s behalf to protect the asset and add the amount paid back into the principal of the debt if not paid timely.
TITLE
Transferring title is another key provision to ensure you get right. Properly drafted, this should specify that title is only delivered to the buyer after full performance of the contract. Further, it needs to detail what kind of title is being delivered (quit claim, warranty, etc.). Quit claim is most common, as warranty deeds can get a bit tricky if the seller later decides to allow the buyer to assume an underlying mortgage and take title early. A title policy, or search at a minimum, is prudent to ensure the property isn’t already encumbered or affected by other ownership interests.
Be careful with title transfers, as another aspect of a land contract is that a vendor’s interest in the contract transfers with the land by deed. A vendor may accidentally convey their interest in the contract without knowing it. Estate planning is most often the reason a vendor may do this, transferring the property to a family member without considering the underlying land contract. It has been my experience that some vendors will also title the property without the contract being completed for almost no reason at all. Either way, make sure your client is informed up front, and hopefully it will save you some headaches on the back end.
DEFAULT REMEDIES
Land contracts have three options for recovery in the event of buyer default: breach of contract, forfeiture, and foreclosure. Breach of contract and foreclosure claims are both available even if not written in the contract. However, forfeiture is only an option if it is included, in the contract. While all three remedies do not have to be included, it is best to do so to provide the seller with options in the event of default.
ASSIGNMENTS
Unless otherwise prohibited, land contracts are assignable by either party. In the secondary market, sellers of land contracts do not want the vendee to be free to assign their interest to another. This ensures their due diligence on the current vendee is not wasted and helps determine the risk in purchasing the contract. So, from a vendor’s perspective, it is best to prohibit the vendee from assigning the contract while allowing the vendor to assign their interest in the event they wish to sell the contract. From the vendee’s perspective, they may want the flexibility to allow the contract to be assumed if they run into payment problems or need to move. However, most vendors don’t allow this for the reasons mentioned above.
OTHER ENCUMBRANCES
Often, vendors have underlying mortgages which take priority over the land contract. What happens if the vendor defaults on the underlying mortgage? In this situation, it is best to allow the vendee to take over the payments and pay the underlying mortgage directly on the vendor’s behalf. Even if the property is currently free and clear, it makes sense to include a provision which limits the vendor from taking a mortgage on the property, or which limits the amount of the indebtedness to less than the balance now due on the land contract.
COST TO CLOSE
Most people might associate costs to close with traditional mortgages but forget that land contracts also have expenses. Deed preparation, recording, title searches, and transfer taxes are all applicable. Transfer taxes especially often get missed because the tax isn’t applicable until the legal ownership officially changes hands.3 Transfer tax in Michigan is by statute the obligation of the seller,4 and since the official transfer happens well after execution of the contract, the seller may be caught off guard.
OTHER TIPS
Most attorneys, and vendors, are unaware that a market exists for the sale of executed land contracts. As stated at the beginning, this article is written keeping that idea in mind. The existence of the market opens up opportunities for vendors down the road that might not be considered when drafting the contract. Following the tips presented, you should have a decent handle on the basics of drafting a land contract. And don’t forget, once the land contract is properly drafted and executed, make sure it gets recorded with the county!