Owner Financing
Mortgage vs. Contract for Deed, Part II
Quite often, property sold in foreclosure is not sold for enough money to satisfy the costs of the sale and the debt owed on the mortgage. In such cases, the creditor can pursue a deficiency judgment, which is a personal judgment against the debtor for the remaining amount due, which can be satisfied by seizing other property owned by the debtor.
Contract for Deed. In cases when an owner provides financing to a buyer of real property, a “contract for deed” ( “land contract” or “installment sale agreement”) is an alternative to a mortgage. A contract for deed is a contract whereby the seller retains legal title, and the buyer agrees to make payments over a specified time while being in possession of the property. At the end of the term of the contract for deed, the seller delivers legal title by way of a deed.
The payments are generally the same as mortgage payments, part interest and part principal. The portion attributable to principal reduces the amount owed to the seller. However, equity does not build in the sense that it builds when there is a mortgage on the property, because if the buyer defaults, the contract is forfeited, and the buyer loses all the money that the buyer has paid up to that point. Also, there is no legal equity that can serve as collateral for a second mortgage.
On the other hand, if the buyer is permitted under the terms of the contract to prepay, the amount that the buyer will need to prepay will have been reduced by the principal reductions made by the periodic payments.
The buyer is permitted by the IRS to deduct the interest portion of payments as mortgage interest. The IRS considers a contract for deed to be an installment sale, so the seller can spread his or her capital gains over the term of the contract for deed. However, though the seller still owns legal title, the seller cannot claim depreciation or any other tax benefits on the property.
The forfeiture resulting from a buyer’s default is done without a foreclosure sale or any judicial action. Generally, only one or two certified mailings and a passage of time is involved, after which the seller owns the property free and clear of the contract for deed. This is contrasted to a default under a mortgage, where a foreclosure sale is required. Therefore, the many protections, and time, afforded to a borrower under a foreclosure are not afforded to a borrower by a forfeiture of a contract for deed.
One caveat to a seller should be made at this point. Forfeiture should not be made under a relatively minor failure of performance. “[A] court may refuse to enforce a forfeiture provision in a contract for deed when there are substantial equitable circumstances… The right of forfeiture can be a harsh remedy producing great hardships, and therefore, before a forfeiture is enforceable, equity requires strict compliance with the important terms of the contract even where there is an express provision for forfeiture.” Harness v. Curtis, 87 Ark. App. 337, 192 S.W.3d 267, 270 (Ark. App. 2004). Sellers should also make sure that the default provisions of the contract are substantially complied with. It is recommended that an Arkansas attorney be retained to ensure the contract for deed is properly forfeited.
After the buyer has satisfactorily performed under the contract for deed, the seller conveys the property to the buyer by warranty deed and generally provides evidence of good title at that time.
Often the seller has a mortgage on the property that contains a due on sale clause. A contract for deed will violate the due on sale clause. Therefore, it is important to get the lender’s consent to the contract for deed.
If the lender consents to the contract for deed, the buyer will want to make sure that the seller’s lender is being paid on a monthly basis. Generally, the parties hire an escrow company to hold a warranty deed from the seller to the buyer and a quitclaim deed from the buyer to the seller. The escrow company receives the buyer’s monthly payments and pays the seller’s lender out of those payments. At the end of the contract for deed, the escrow agent delivers the warranty deed to the buyer. If the buyer defaults before the end of the contract, the escrow agent delivers the quitclaim deed to the seller.
Presumably, the seller’s lender would be paid off by the end of the contract for deed. However, when there is a balloon, the balloon pays off the seller’s lender. The buyer generally pays the balloon through a refinancing.
At the end of the contract, the seller and the buyer will incur some closing costs, such as deed stamps, recording costs and title insurance premium. The seller’s costs can be deducted from the last of the buyer’s payments.
Farm real estate is often purchased through a contract for deed. Though, upon the buyer’s default, a contract for deed is easily forfeited, that is not the case with farm real estate. In the case of an indebtedness of $20,000 or more, the Arkansas Farm Mediation Act applies to a contract for deed (and to a mortgage) on agricultural property. That Act provides that a farmer may demand mediation with his or her creditor and the Arkansas Farm Mediation Office and that a release must be obtained from the Farm Mediation Office before a creditor may pursue its remedies, such as forfeiture of a contract for deed or foreclosure.
Many people think that a contract for deed is the same as the old “bond for title,” which has actually fallen into disuse. A contract for deed is an “executory contract of sale with a forfeiture clause where time is of the essence” (a contract for deed must have the appropriate language and should be drafted by an Arkansas attorney). A bond for title recites that the seller has sold the real estate to the buyer.
Therefore, a bond for title is not executory, or “designed or of such a nature as to take effect on a future contingency,” i.e., punctual payment. Nor does a bond for title have a forfeiture clause. A bond for title is accompanied by bonds or notes. For those reasons, the courts treat a bond for title like a mortgage and require foreclosure.
Kristi Kendrick, a semi-retired Eureka Springs lawyer, has compiled some of the more common questions she has been asked in her 40+ years of practice. She has been AV-rated by Martindale-Hubbell, the highest peer rating in ability and ethics, for more than 20 years.