Understanding Land Sale Contracts

A land sale contract is a version of the purchase and sale agreement commonly used in real estate transactions, with some important differences. It has been around a long time, probably more than 100 years, but its use increased in the 1970s when institutional lenders began including “due-on-sale” clauses in their notes and security instruments (i.e., deed-of-trust, or mortgage).

As a result, the Garn-St. Germain Act of 1982 (12 U.S. Code 1701j-3-Preemption of Due-on-Sale Prohibitions) was passed. Under the definitions it says: “(1) the ‘due-on-sale’ clause means a contract provision which authorizes a lender, at its option, to declare due and payable sums secured by the lender’s security instrument if all or any part of the property, or an interest therein, securing the real property loan is sold or transferred without the lender’s prior written consent.”

The land sale contract has important uses and benefits, which are discussed below.

Characteristics

Essentially, a land sale contract is a way to buy and sell real estate without involving a bank or third-party lender. Under the land sale contract, the seller, called “vendor,” retains title to the property; the buyer, called “vendee,” receives possession and makes payments to the vendor until the vendor is fully paid. The contract is usually not processed through an escrow, recorded at the county, or the receipt of title insurance. It is purposely “off the record.” Nobody—competitors, investigators, family and “exes,” creditors, lenders, etc.—are supposed to know of the new ownership. In this case, there are no closing costs either.

The Internal Revenue Service considers it a sale when the vendor receives money from the vendee and delivers possession to the vendee. For the vendor, the sale could be set up as an “installment sale” under IRC 453(b)(1) to defer taxes on capital gains over the term of the contract. (Always seek professional tax advice for matters of this type).

Property taxes, on the other hand, are not reassessed upon the sale because the tax assessor is not made aware of the sale by recording of a deed. Down the road, however, when a deed is finally recorded, all the “escaped taxes” plus penalties and costs become due. Ostensibly, a buyer down the ownership chain could get stuck with all the back taxes.

The land sale contract is actually a mortgage, because in effect fee ownership via a deed is not given to the vendee until all sums are paid. Moreover, it is a non-recourse purchase money transaction. The vendee cannot be held responsible for any loss the vendor incurs in the event the vendee defaults.

Land sale contracts come both with and without “power of sale” provisions. Those without these provisions do not give the vendee a path to reinstate in the event of a default. With a “power of sale” provision, however, the vendee can reinstate. Both versions can be foreclosed by a judicial foreclosure, but then the vendee has the “right of redemption” to recover the property by paying the principal balance, back interest, and all costs. The duration of this right varies by state, but since the vendee has an “equitable interest” in the property, the vendee has the right to recover if they can.

Disclosure Responsibilities

In California, licensed real estate agents or brokers involved in land sale contract transactions are required to provide vendees with disclosures regarding the use of the land sale contract and the condition of the property. Private parties do not have these disclosure requirements, although making such disclosures is a good idea to avoid disputes. Users of the land sale contract should learn the rules applicable in their state.

Applications/Benefits

The land sale contract is mostly applied in three instances:

• When a lender’s “due-on-sale” clause is being avoided
• When a buyer is not lender-qualified, but is trusted enough to enter the transaction
• When public notice of the transaction is not desired

Disadvantages

Disadvantages arise due to the fact that ownership is retained by the vendor and not transferred by a deed at the time the contract is fully executed. The vendor could over encumber the property, or even sell it without the vendee knowing. These situations would, of course, create a big mess. It is permissible for the vendor to borrow against the property up to the purchase price with the vendee; in so doing, the vendor is just extracting equity and can still fulfill the contract with the vendee. Besides, a vendor who sells the property will have defrauded the vendee.

Buyer’s Default and Foreclosure

Under a land sale contract, the vendee is required to make payments to the vendor, pay the property taxes, and keep the property insured (with the vendor included on the policy). Failure to do any of these is a default on the contract, making the property eligible for foreclosure by the vendor. Given the nature of a land sale contract (i.e., a “contract”), foreclosure would be judicial (i.e., through the courts), which is time-consuming and expensive. Including a “power of sale” in the contract can speed up the foreclosure. Even so, the vendee still has the “right of redemption” provided by state law.

Contract Termination

The alternative contract termination is a quitclaim deed from the vendee to the vendor. Some vendors obtain a quitclaim deed up front and keep it ready to record if the vendee defaults. In other situations, if the vendee is not in default, it can be recorded with the vendee’s permission.

There are two problems with this alternative. First, the land sale contract is unrecorded, so a title insurer will be confused by finding a recorded quitclaim. Second, the vendee has an “equitable interest,” so what do you do with that?

The best solution is for the vendor and vendees to go to a title company and discuss the best way to obtain an insurable title for the vendor. With the unrecorded contract, “equitable interest,” and “right of redemption” all hanging out there, this is no time to do it yourself “on the cheap.” The vendor might have to compensate the vendee for some of their equity and pay some transfer expenses to restore a clean title.

Alternatives

No financing method is ideal—not even cash. The land sale contract is complicated, because the vendor retains fee simple title, yet the vendee enjoys an “equitable interest.” There are two alternatives:

1. Lease-Option. In a lease option arrangement, the buyer leases and gets possession but does not get an “equitable interest.” The buyer can exercise their option to purchase at any time before its expiration.
2. All Inclusive Deed-of-Trust. In this situation, the buyer gets the deed and possession and just owes the seller note payments. No muss, no fuss.

If you are interested in reviewing a land sale contract, you can readily find a PDF template on the internet.

Bruce Kellogg has been a real estate agent and investor in California for 44 years. He has purchased approximately 350 investment properties for himself, mostly with high-leverage and tax-deferred exchanges. In the process, he made three fortunes and has experienced three real estate downturns since 1980. Kellogg has transacted roughly 550 properties for clients, creating fortunes for several. His book “Real Estate Investing Wisdom” is currently in publication. He can be reached at Brucekellogg10@gmail.com or (408) 489-0131.