Contracts for deed are back in style as a method of financing a real estate transaction. A contract for deed is seller financing. Instead of a third party lender financing the buyer’s purchase of a piece of property from the seller, the seller accepts installment payments which include principal and interest, with the final payment typically being a balloon payment. Contracts for deed are useful where a buyer has funds to make the monthly payments but lacks the creditworthiness (hence, the contract for deed provides a dual benefit: the buyer gets to purchase the property and re-establish creditworthiness sufficient to obtain financing for the balloon payment).
To have a successful contract for deed transaction, though, requires close attention to several seemingly small details. These details, if ignored, can lead to big headaches for one or both of the parties to the contract.
Here are the top five most overlooked issues when dealing with contracts for deed in Minnesota, based upon my experience working with clients in these transactions:
1. Beware the “Due on Sale” Clause in the Seller’s Mortgage. Many mortgages have a clause that permits a lender to accelerate the note and call the entire loan due in the event that the borrower transfers title to a third party without consent. In Minnesota, where a contract for deed creates a split between legal title (which stays with the seller) and equitable title (which passes to the buyer at the time the contract is signed), selling a property on a contract for deed where the property is subject to a mortgage will trigger the lender’s right to accelerate the loan. The first step if you are one of those owners with a due on sale clause is to contact the lender and seek written consent. More and more lenders are, believe it or not, giving such consent (which would seem to beat the alternative of having to foreclose on the property when the owner cannot make the monthly mortgage payment(s)). For those owners whose lender(s) will not consent, a lease with option is the alternative.
2. Use the Uniform Form Contract for Deed. There exists in Minnesota a uniform form contract for deed document; I recommend using it. One common mistake I have seen in this area time and again is the parties’ reliance on the contract for deed financing addendum which can be attached to a purchase agreement. This document is not intended to be the final and complete contract and it should not be used in such manner. The uniform form addresses almost all of the salient points of the contract for deed transaction and its use will minimize the possibility of a later dispute over contract terms.
3. Use the Contract for Deed Addendum. In addition to the uniform contract for deed form, Minnesota has created a uniform “contract for deed addendum” that contains some important clarifying terms to the transaction and, for that reason, should also be utilized in any contract for deed transaction. This form, which contains a series of yes/no check-the-box provisions on such issues as whether 1/12 of taxes and insurance amounts will be paid in addition to any monthly payment, what amount of improvements the buyer can perform on the property without the seller’s written consent and whether, on a default by the buyer, whether the seller can accelerate the entire contract balance and require that it be paid in order to stave off a cancellation of the contract. This short document carries significant implications as to its terms and should be executed along with the uniform contract for deed form.
4. Record the Contract for Deed. One way in which parties to a proposed contract for deed (particularly sellers) attempt to get around the due-on-sale clause issue is to simply not record the contract for deed. This is not a solution and, in fact, Minnesota law provides for civil penalties to the buyer of up to 2% of the original contract balance if the contract is not recorded. Always record your contracts for deed.
5. Close the Transaction With a Title Company. Finally, given that a contract for deed is between two parties and does not involve an outside third party lender, the temptation exists to simply sit down as buyer and seller, sign the contract and record it. In other words, since no third party lender is involved who will force the parties to close at a title company as a condition of financing a purchase, the parties simply choose to save a few hundred dollars by skipping out on using a title company. This is a terrible idea. First and foremost, in order to have an insured closing (where both the contract seller – known as the “vendor” and the contract buyer – known as the “vendee”, obtain policies of title insurance), the parties must engage a title company to close the deal. Second, and equally important, title companies are expert in closing all sorts of real estate transactions and if an “i” is not dotted or a “t” is not crossed, a good closer catches the issue and takes steps immediately to correct it. Without that type of oversight, a mistake could arise with the contract this is only discovered years later when the cost to fix it increases substantially.