Most real estate purchases require some form of financing. Banks that issue loans for the purchase of real estate protect their investments in several important ways. The most well-known is the deed of trust, by which the borrower conveys a security interest in the property to the lender. If the borrower defaults on loan payments, the deed of trust gives the lender the right to foreclose on the property. Most deeds of trust contain a “due on sale” clause, which is another way banks protect their interests. This clause limits a property owner’s ability to transfer title to their property. It is worth noting that enforcement of due-on-sale clauses is fairly rare, but it is still an important issue for California real estate investors to understand.
The standard due-on-sale clause states that, if the property owner transfers title without first obtaining written consent from the lender, the entire outstanding balance of the loan comes due. Most sales of real property involve a buyer who puts the full purchase amount into escrow prior to or at closing. The escrow agent can then disburse the outstanding mortgage loan balance to the lender, pay other expenses, and give whatever is left to the seller. Triggering the due-on-sale clause in this sort of situation is typically not a problem, since paying off the loan is part of the plan. The language of the standard due-on-sale clause, however, does not limit enforcement to formal sales to third-party buyers.
Real estate investors often use business entities, such as corporations or limited liability companies (LLCs), to hold investment properties and conduct investment-related activities. If an investor took out a loan to purchase property in their own name, transferring title to a corporation or LLC could trigger the due-on-sale clause. This could also occur to an individual who wants to transfer real property into a living trust as part of their estate plan.
Laws Affecting Due-on-Sale Clauses
The history of due-on-sale clauses is controversial. Mortgage lenders began including them as a standard feature in the 1970s. Borrowers argued that banks did this to take advantage of rising interest rates. Up to that point, home buyers often assumed sellers’ existing mortgages, which had much lower rates. Lenders argued that due-on-sale clauses were necessary to keep track of their collateral.
Regardless of the reasons, early due-on-sale clauses ran afoul of California law, which disfavors “conditions restraining alienation” of property. The California Supreme Court ruled in Wellenkamp v. Bank of America in 1978 that lenders could not enforce due-on-sale clauses unless they could show that it was “reasonably necessary to protect against impairment to its security or the risk of default.” Both the U.S. Supreme Court and Congress, however, affirmed the enforceability of due-on-sale clauses in 1982 in Fidelity Fed. Sav. & Loan Assn. v. De La Cuesta and the Garn–St. Germain Depository Institutions Act.
Transferring a Property Subject to a Due-on-Sale Clause
As mentioned earlier, enforcement of due-on-sale clauses is fairly rare. The risk is still very real. Perhaps the best way to avoid triggering a due-on-sale clause in a real estate deal is to obtain the lender’s consent for a transfer.
State and federal laws identify numerous transactions that do not trigger a due-on-sale clause. California’s Homeowner Survivor Bill of Rights, which took effect in 2017, addresses transfers of property to surviving spouses or heirs after the death of a property owner. Federal regulations implementing Garn-St. Germain also identify transactions that are exempt from enforcement by a lender. Prior to seeking a lender’s consent, investors should confirm that it is needed.
More Blog Posts:
Sale of Real Property by a Trustee in California, Part 1: Fiduciary Duties and Best Practices, Titles and Deeds, March 15, 2019
Sale of Real Property by a Trustee in California, Part 2: Legal Pitfalls, Titles and Deeds, April 26, 2019
Anatomy of a Commercial Real Estate Transaction for Commercial Real Estate Investors, Titles and Deeds, January 19, 2019
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