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The truth about getting around due-on-sale clauses

Copyright 1999 by John T. Reed 1
Last update 5/26/03
There is great demand for ways to get around due-on-sale clauses in mortgages for four reasons:
to preserve a below-market interest rate
to avoid a credit check when the prospective buyer has poor credit or inadequate cash or income to afford the property
to use the Stonecrest line of Tax Court cases to avoid paying income tax on excess mortgage relief over basis.
to lease-option a one- to four-family house (which generally relates back to the second reason).
Reason for the due-on-sale clause
Real-estate investors who are not too bright tend to believe lenders want due-on-sale clauses because they are greedy. They then use that notion to rationalize illegal or immoral behavior toward the lender.
In fact, the main reasons for due-on-sale clauses is lenders want and need to know to whom they are loaning money and they need to be able to predict roughly when a mortgage will be paid off. If you loaned your car to a friend, who agreed in writing not to let anyone else use it, then you saw it going down the street with some stranger at the wheel, you'd be upset, and rightly so. By the same token, lenders do not like to loan one guy $100,000 to buy a house then find that someone else now has the house, especially when the new guy has lousy credit and/or inadequate equity or income. Neither can lenders tolerate making mortgage loans which will likely last seven years on average because of the due-on-sale clause, only to find that those mortgages are being passed onto subsequent buyers, thereby extending their terms which gives lenders negative spreads between their cost of funds and interest income during periods of high interest rates.
If you think making assumable mortgages is a smart idea, I dare you to go into that business. The fact that no one is in the assumable-mortgage business any more proves it is intelligence and experience, not greed, that motivates lenders to include due-on-sale clauses in their mortgages. Actually, the vast majority of lenders have no choice. The due-on-sale clause is required by the various federal agencies.
History of the due-on-sale clause
History lessons sometimes help real-estate investors understand what they need to know. Due-on-sale clauses are prime examples.
Due-on-sale clauses were common and believed to be enforceable twenty-five years ago. Then a nutty group of California Supreme Court justices decided the Tucker v. Lassen Savings & Loan Association (12 Cal. 3d 629, 1974) and Wellenkamp (Wellenkamp v. Bank of America, 21 Cal 3d 943, 8/25/7 Cool

cases. Those decisions said that due-on-sale clauses were not enforceable unless the lender could show impairment of security. Other state courts subsequently made similar decisions.
de la Cuesta U.S. Supreme Court decision
That unleashed a torrent of subject-to purchases, especially during the high-interest-rate early '80s. The savings-and-loan industry was hurting big time and subject-to purchases had the effect of extending the duration of below-market interest rates, which, in turn, bankrupted federally-insured S&Ls. The federal government pursued a lawsuit to get the Wellenkamp line of cases "overturned." They were soon successful in the U.S. Supreme Court de la Cuesta decision. (Fidelity Federal Savings and Loan Association v. de la Cuesta et al., 458 U.S. 156) On June 28, 1982, the U.S. Supreme Court said federal savings and loans could enforce their due-on-sale clauses even in states where state courts said otherwise.
Garn-St. Germain Act
The de la Cuesta decision gave Congress the courage to pass the Garn-St. Germain Depository Institutions Act of 1982 on October 15, 1982. The Garn bill pretty much said due-on-sale clauses were enforceable, period.
At his Web site, guru William Bronchick said that by passing the Garn Act, the Congress "usurped" the authority of the state judges who previously said due-on-sale clauses were not enforceable. Excuse me. According to Black's Law Dictionary, "usurp" means, "To seize and hold any office by force, and without right." At what law school did Bronchick learn that Congress has no right to pass laws related to federal mortgages? And what about de la Cuesta? Was the U.S. Supreme Court also "usurping" the power of state judges when they overturned lower-court decisions in that case? Referring to United States Code provisions pertaining to federally-related mortgages as usurpation of state court decisions is real-estate demagoguery.
FHA and VA assumable mortgages
The de la Cuesta decisions and the Garn-St. Germain Act made due-on-sale clauses enforceable. But what about mortgages which had no due-on-sale clauses? The most common examples were FHA and VA mortgages. On December 1, 1986, FHA began requiring credit checks before they would approve assumptions.
Starting 2/29/88, new VA mortgages were not assumable unless the VA approved the new borrower. Same reason as the FHA change. On 12/15/89, FHA put a number of strict assumption-and-subject-to-related rules into place.
The actual wording of the clause
It's paragraph 17 of the standard "Single Family FNMA/FHLMC UNIFORM INSTRUMENT Form 3005 9/90 Amended 8/91" which is used almost universally on one- to four-family mortgages in the U.S. Paragraph 17 reads as follows:
17. Transfer of the Property or a Beneficial Interest in Borrower. If all or any part of the Property or any interest in it is sold or transferred (or if a beneficial interest in Borrower is sold or transferred and Borrower is not a natural person) without Lender's prior written consent, Lender may, at its option, require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if exercise is prohibited by federal law as of the date of this Security Instrument.
If Lender exercises this option, Lender shall give Borrower notice of acceleration. The notice shall provide a period of not less than 30 days from the date the notice is delivered or mailed within which Borrower must pay all sums secured by this Security Instrument. If Borrower fails to pay these sums prior to the expiration of this period, Lender may invoke any remedies permitted by this Security Instrument without further notice or demand on Borrower.

The original post-Garn FNMA/FHLMC due-on-sale clause said:

"If all or any part of the Property or an interest therein is sold or transferred by Borrower
without Lender's prior written consent, excluding (a) the creation of a lien or encumbrance
subordinate to this Mortgage, (b) the creation of a purchase money security interest for
household appliances, (c) a transfer by devise, descent or by operation of law upon the death
of a joint tenant or (d) the grant of any leasehold interest of three years or less not containing
an option to purchase, Lender may at Lender's option declare all the sums secured by this
Mortgage to be immediately due and payable."

The current clause lets the underlying federal statute and regulation deal with the details which previously were spelled out in the mortgage clause. I suspect the lenders decided it was better to claim the broadest possible right to accelerate the loan and to force people who wanted to learn of the limitations on enforcement to look up the law.

Not just ‘sales’
To understand the clause, you have to break it down into small parts. When you do, you immediately find that "due-on-sale" is a misnomer. A better name would be “due-on-transfer-of-any-interest clause.” The list of actions covered by the actual clause is far broader than just “sales.” The federal regulation (12 C.F.R. 591.2) says the due-on-sale clause is triggered by:
“...transfers of real property subject to a real property loan by assumptions, installment land sales contracts, wraparound loans, contracts for deed, transfers subject to the mortgage or similar lien, and other like transfers.”

A great many exceedingly ignorant investors think that all you have to do to get around a due-on-"sale" clause is a transaction that is not a "sale" per se. As the regulation shows, that is not true.

Land contracts
Note that the first sentence covers transfers of "an interest." That, and the regulation, make the clause cover not only sales, but land contracts. Many investors erroneously think that because the deed does not change hands in a land-contract sale, it is not a "sale" that triggers Paragraph 17 of the FNMA/FHLMC mortgage.
Lease options
Many gurus say you can get around the due-on-sale clause by doing a lease option instead of a sale. Wrong. Subparagraph (d) of the longer clause covered that. Now you have to look at the law itself [§1701j-3(d)(4)] to learn that the due-on-sale clause is triggered by any lease longer than three years. And it's triggered by any lease that contains an option to purchase the property, regardless of the length of the lease.
In the mortgage (Paragraph 6), you promise to "...occupy, establish, and use the Property as Borrower's principal residence within sixty days after execution of this Security Instrument and shall continue to occupy the Property as Borrower's principal residence for at least one year after the date of occupancy..." The lender is prohibited from "unreasonably withholding" permission to not occupy during that period and "extenuating circumstances beyond Borrower's control" are an exception to the occupancy promise. In the absence of lender unreasonableness or extenuating circumstances, you may not do any kind of lease until you have lived in the property for a full year. If you habitually buy properties and immediately lease-option them, you will not be very credible arguing extenuating circumstances.
Land trusts
Another guru gimmick is for the current owner to transfer the property to a trust, then sell the beneficiary interest in the trust to the guy who wants to take over the mortgage.
The statute [12 USC 1701j-3(d)( Cool

] and the federal regulation [12 C.F.R. 591.5 (b)(vi)] say transfer of a home into an inter vivos trust does not trigger the due-on-sale clause.
Statute
"...a transfer into an inter vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property;"
Regulation
"A transfer into an inter vivos trust in which the borrower is and remains the beneficiary and occupant of the property, unless, as a condition precedent to such transfer, the borrower refuses to provide the lender with reasonable means acceptable to the lender by which the lender will be assured of timely notice of any subsequent transfer of the beneficial interest or change in occupancy"

Their purpose was to enable people who wanted to make use of the probate-avoiding aspects of those trusts. Note that the regulation exception does not cover subsequent sales of the inter vivos trust to someone else, only transfer of the home to an inter vivos trust owned by the same people as the original mortgage borrowers. The regulation's purpose most definitely was not to open up a loophole for avoiding due-on-sale clauses.

Remember also the title of paragraph 17 in the mortgage document: "Transfer of the Property or a Beneficial Interest in Borrower."
The exception to the due-on-sale enforcement only applies to owner-occupied homes. If you put the property into a trust then sell the beneficial interest in the trust and move out, you have triggered the due-on-sale clause.
Finally, the regulation says with regard to the inter vivos trust exception that the borrower must not refuse "to provide the lender with any reasonable means acceptable to the lender by which the lender will be assured of timely notice of any subsequent transfer of the beneficiary interest or change in occupancy..."
Triggering is dangerous, but not illegal or immoral
Taking an action that triggers the due-on-sale clause is neither illegal nor immoral. It simply gives the lender the right to call the loan, that is, to make you pay it off completely right now. If you cannot afford to do that, and most people cannot, that is a financially dangerous situation. Entering into a deal where the due-on-sale clause has been triggered puts a Sword of Damocles over your head.
Concealment is illegal or immoral
Triggering a due-on-sale clause may not be illegal or immoral, but concealing the fact that such a clause has been triggered could possibly be both. Various gurus urge different methods of concealing the transfer of ownership and/or occupant. Each of those methods probably requires one or more parties to the deal to breach ethics or to commit crimes or violate common laws like fraud or breach of contract.
People who are prosecuted in mortgage matters are typically charged with one or more of the following federal felonies:

Crime
Section of the U.S. Code
Definition
Punishment
False statement (HUD loan)
18 USC 1012
false statement... influences such Department to...enter into any contract
1 year, fine, or both
False statement (conventional loan)
18 USC § 1014
knowingly...false statement...influencing in any way...federal...loan...or any change or extension...deferment of action
2 years, $5,000, or both
Mail fraud
18 USC § 1341
...obtaining money or property by means of false or fraudulent pretenses...[sends]...or... receives...any...thing
5 years, $1,000, or both
Concealment
18 USC § 1001
...in any matter within the jurisdiction of any department or agency of the United States...knowingly conceals or covers up by any trick, scheme, or device a material fact
5 years, $10,000, or both
Conspiracy
18 USC § 371
...two or more persons conspire...defraud the United States or any agency thereof...and one or more of such persons do any act to effect the object of the conspiracy
5 years, $10,000, or both
Racketeering
18 USC § 1961
...at least two acts of [mail fraud...within a ten-year period]
20 years, $25,000, or both
Under 18 USC 1964, a lender could sue you for racketeering and would be entitled to triple damages if they won

Note that virtually all institutional (e.g., bank, credit union, savings and loan) mortgages are federally related because of federal deposit insurance, federal mortgage insurance, government backed bonds, federal charters of the lender, etc.