InstallmentLand Contracts: Pitfalls and Cautions
Dale A. Whitman[*]
Visiting Professor of Law
PepperdineUniversity, Malibu, California
Introduction. Because of the increasing difficulty of obtaining institutional financing for real estate purchases, it is likely that the provision of purchase-money financing by sellers will increase. In many areas of the nation, the installment land contract is a common vehicle for implementing seller financing. While the installment contract seems superficially attractive, its use carries many risks for both vendors and purchasers that are not raised by the use of an ordinary purchase-money mortgage or deed of trust. This outline discusses many of those risks.
I. The installment contract: what is it?
A. The purchaser takes immediate possession.
B. No deed is delivered until the final payment is made (and until then, the purchaser has only “equitable title.”)
C. The purchaser typically pays property taxes, insurance, maintenance and repairs, and other operating expenses.
D. A “forfeiture clause” permits the vendor to cancel the contract, retake possession of the property, and retain all payments received if the purchaser defaults.
II. Enforceability of the forfeiture clause. From the vendor’s viewpoint, the forfeiture clause is the principal advantage of the installment land contract over use of a purchase-money mortgage. The forfeiture clause appears to offer the vendor an extremely easy and inexpensive method of realizing on the real estate security. But whether the clause will be enforced varies greatly around the nation, and may be highly fact-specific within a given jurisdiction.
A.Statutory regulation. Some jurisdictions regulate installment contracts by statutes, which usually impose specific notice requirements and grace or cure periods to benefit purchasers. These statutes usually uphold forfeiture if the necessary notices are given and no cure is made. See, e.g., Ariz. Rev. Stat. §§ 33-741 to -749; Iowa Code Ann. §§ 656.1-.7; Mich. Cons.L.Ann. §565.356 et seq; Minn. Stat. Ann. § 559.21; N.D. Cent. Code §§ 32-18-01 to -06; Ohio Rev. Code Ann. §§ 5313.01-.10; Tex. Prop. Code Ann §§ 5.061-.063; Wash. Rev. Code Ann. §§ 61.30.010-.911. Note that even though the statutes legitimize forfeiture, they are not necessarily advantageous to vendors; the Arizona statute, for example, allows a 9 month cure period if more than 50% of the purchase price has been paid. A deed of trust foreclosure could be accomplished in a shorter time.
Note that most of the statutes permit a cure during a specified period simply by payment of the arrearages – typically, the missed payments plus any interest accrued on them and any costs incurred by the vendor. Hence, any purported acceleration of the debt by the vendor is suspended until the end of the cure period.
B. Recognition of a right of redemption. Even in the absence of statutory regulation, courts often recognize the existence of a right of redemption in the purchaser. Since this right cannot last forever, its recognition necessarily requires the court to set a date after which no redemption will be permitted. Thus, it is similar to strict foreclosure of a mortgage. See, e.g., Petersen v. Hartell, 707 P.2d 232 (Cal. 1985); White v. Brousseau, 566 So. 2d 832 (Fla. Dist. Ct. App. 1990); Jenkins v. Wise, 574 P.2d 1337 (Haw. 1978); Nigh v. Hickman, 538 S.W.2d 936 (Mo. Ct. App. 1976); Moore v. Prindle, 394 P.2d 352 (Nev. 1964); Lamberth v. McDaniel, 506 S.E.2d 295 (N.C.App. 1998); Lewis v. Premium Invest. Corp., 568 S.E.2d 361 (S.C. 2002).
The courts recognizing a right of redemption typically do not suspend any purported acceleration by the vendor. Hence, if an acceleration has occurred, the purchaser must pay the entire outstanding balance of the purchase price, often a difficult prospect for a purchaser. In this respect, judicially-recognized redemption differs from the statutory procedures in paragraph II A above.
C. Recognition of a right of restitution. A number of courts have recognized that if a forfeiture occurs the result may be to unjustly enrich the vendor, who essentially receives the value of the land in addition to all of the payments previously made on the contract. To avoid this unjust enrichment, a court may order the vendor to refund to the purchaser the payments received, insofar as they exceed the vendor’s damages resulting from the breach. See, e.g., Moran v. Holman, 501 P.2d 769 (Alaska 1972); Petersen v. Hartell, 707 P.2d 232 (Cal. 1985); K.M. Young & Assocs. v. Cieslik, 675 P.2d 793 (Haw. Ct. App. 1983); Howard v. Bar Bell Land & Cattle Co., 340 P.2d 103 (Idaho 1959); Randall v. Riel, 465 A.2d 505 (N.H. 1983); Bellon v. Malnar, 808 P.2d 1089 (Utah 1991); Weyher v. Peterson, 399 P.2d 438 (Utah 1965). See Conway, "Equitable Adjustment"' in Real Estate Contract Foreclosures: Victory for the Contract Vendee or Death of InstallmentLand Contract Financing?, 35 So. Dak. L. Rev. 402 (1990).
It is easy to state this principle in broad terms, but the courts have had little success in implementing it in any consistent manner. Under one approach, the court may measure the vendor’s damages as the difference between the contract price and the market value of the property at the date of the breach. See, e.g., Park Valley Corp. v. Bagley, 635 P.2d 65 (Utah 1981). While this approach is widely used in measuring damages for the breach of an earnest money contract, it makes little sense with installment contracts because it fails to take into account the time value of money.
An alternative approach to measurement of the vendor’s damages is, in effect, to regard the payments made on the contract as analogous to rent, and to require the vendor to refund any amount received in excess of the property’s fair rental value. Of course, in many cases the payments will be roughly equal to fair rent, leaving little or no amount to be refunded.
In Honey v. Henry's Franchise Leasing Corp., 415 P.2d 833 (Cal. 1966), the California Supreme Court held that the two methods of computing restitution were alternatives open to the vendor, who could exercise an election to use one or the other of them. Of course, if real estate prices have generally risen during the term of the contract, the difference-in-value approach above will almost never produce any damages, and will therefore require the vendor to give restitution of much or all of the money received in contract payments. In such an environment, vendors will nearly always choose the second, “rental value,” approach.
1. Limitations on restitution. Some of the courts that recognize the restitution remedy for purchaser are willing to apply it only if the result of a complete forfeiture would be “unjust,” would “shock the conscience” of the court, or would meet some other similar concept of unfairness. See, e.g., Clampitt v. A.M.R. Corp., 706 P.2d 34, 40 (Idaho 1985); Warner v. Rasmussen, 704 P.2d 559 (Utah 1985). Success in meeting this sort of standard is difficult to predict; long and costly litigation may be necessary to determine whether it has been satisfied, making the supposedly quick and cheap remedy of forfeiture just the opposite! Moreover, courts are sometimes very reluctant to find that a forfeiture “shocks the conscience.” For example, in Russell v. Richards, 702 P.2d 993 (N.M. 1985), the court refused to order restitution despite the fact that the purchaser would otherwise lose about $50,000 in equity in the property.
D. Finding a waiver of the duty of strict performance. Vendors under installment contracts often establish a pattern of accepting late payment from purchasers over a protracted period. When this has occurred, a court may treat it as a waiver of the purchaser’s duty of strict timely performance. If so, the court will refuse to recognize the vendor’s declaration of forfeiture unless the vendor has first notified the purchaser that timely payment will be required in the future, and has given the purchaser a reasonable time to catch up the payments and come into compliance. See, e.g., Jahnke v. Palomar Financial Corp., 527 P.2d 771 (Ariz.App. 1974); Shirley v. Tolbert, 945 P.2d 567 (Or.App.1997); Bogad v. Wachter, 283 S.W.2d 609 (Mo. 1955).
E. Treating the installment contract as a mortgage and requiring foreclosure. A growing number of states have held that installment contracts must be foreclosed in the same manner as mortgages, by judicial sale. In a few cases, this change has been made by statute; see Okla. Stat. Ann. tit. 16, §11A; Fla.Stat. §697.01; Ohio Rev. Code §5313 (requiring judicial foreclosure of residential property if the purchaser has paid more than 20% of the purchase price or has paid on the contract for more than 5 years); Tex. Prop. Code Ann. §§5.091-.092 (requiring power of sale foreclosure of contracts for deed where 40% or more of the price has been paid, the contract is on land that is the purchaser's residence, the land is in a low-income county, and the land is within 200 miles of an international border).
In a number of other states, the courts have held, without statutory prompting, that installment contracts must be foreclosed as mortgages. See Luneke v. Becker, 621 So. 2d 744, 746 (Fla. Dist. Ct. App. 1993); Skendzel v. Marshall, 301 N.E.2d 641 (Ind. 1973); Sebastian v. Floyd, 585 S.W.2d 381 (Ky. 1979); Bean v. Walker, 464 N.Y.S.2d 895 (App. Div. 1983). California reached a similar conclusion, with the provision that the purchaser must have made substantial payments on the contract, in Petersen v. Hartell, 707 P.2d 232 (Cal. 1985). In Colorado the trial court in its discretion may order foreclosure as a mortgage; see Grombone v. Krekel, 754 P.2d 777 (Colo.App. 1988); Paraguay Place-View Trust v. Gray, 981 P.2d 681 (Colo. App. 1999). The Nebraska courts, while not announcing an absolute rule, have indicated a strong preference for foreclosing the contract as a mortgage; see Mackiewicz v. J.J & Assoc., 514 N.W.2d 616 (Neb. 1994).
The Restatement (Third) of Property (Mortgages) §3.4(b) states simply that “[a] contract for deed creates a mortgage.” This language is likely to encourage additional courts to require foreclosure as a mortgage. See Grant S. Nelson, The Contract for Deed as a Mortgage: The Case for the Restatement Approach, 1998 B.Y.U. L. Rev. 1111 (1998).
III. Other vendor remedies. While vendors usually attempt to employ the forfeiture remedy when faced with an uncured default by the purchaser, that is not the only choice.
A. Specific performance action for the price. If the purchaser has the funds with which to pay the judgment, the vendor may sue for specific performance. This is analogous to a suit on the debt in a mortgage context. See Steinhoff v. Fisch, 847 P.2d 191 (Colo. Ct. App. 1992); Puziss v. Geddes, 771 P.2d 1028 (Or. Ct. App. 1989); Simon Home Builders, Inc. v. Pailoor, 357 N.W.2d 383 (Minn. Ct. App. 1984); SAS Partnership v. Schafer, 653 P.2d 834 (Mont. 1982). Note that states that have “one-action” rules may also prohibit an action for specific performance of installment contracts.
B. Action for damages after a forfeiture. If a vendor declares a forfeiture and retakes possession of the property, it is possible that the property will have insufficient value to satisfy the purchaser’s obligation to pay remainder of the purchase price. In such a case, a vendor might sue for damages for the unpaid portion of the price. Such a suit is analogous to an action for a deficiency after a mortgage foreclosure. See Nemec v. Rollo, 114 Ariz. 589, 562 P.2d 1087 (App.1977); Paulson v. Lisowy, 152 Wis.2d 41, 447 N.W.2d 374 (App.1989); Hillabrand v.McDougal Botanical Trust, 2004 WL 764456 (Mont.2004).
In states that bar deficiency judgments in mortgage transactions, a suit for damages or a deficiency after forfeiture in an installment contract case may also be barred; see Venable v. Harmon, 43 Cal.Rptr. 490 (Cal.App.1965), so holding. In many other states, an action for a deficiency after a forfeiture may be barred by the so-called “election of remedies” doctrine, which holds in effect that vendor who exercises the forfeiture remedy must be content to take back the property, and cannot recover additional damages even if the property lacks sufficient value to fully compensate the vendor. See Nemec v. Rollo, 562 P.2d 1087 (Ariz. Ct. App. 1977); Hepperly v. Bosch, 527 N.E.2d 533 (Ill. 1988); Michigan Nat'l Bank v. Cote, 546 N.W.2d 247 (Mich. 1996); Gruskin v. Fisher, 273 N.W.2d 893 (Mich. 1979); Covington v. Pritchett, 428 N.W.2d 121 (Minn. Ct. App. 1988); Porter v. Smith, 486 N.W.2d 846 (Neb. 1992); Buckingham v. Ryan, 953 P.2d 33 (N.M. Ct. App. 1997); Trans W. Co. v. Teuscher, 618 P.2d 1023 (Wash. Ct. App. 1980). See also Summit House Co. v. Gershman, 502 N.W.2d 422 (Minn. Ct. App. 1993), in which a clever vendor’s lawyer circumvented the election of remedies doctrine by obtaining a personal judgment against the purchaser for the price, levying on the purchaser’s interest in the property to satisfy a portion of the judgment, and then collecting the remainder of the judgment out of the purchaser’s other assets.
The same result as with the election of remedies doctrine is sometimes reached by holding that a forfeiture results in a complete termination of the contract, so that no further suit on it is permissible; see Gray v. Bowers, 332 N.W.2d 323, 325 (Iowa 1983).
C. Judicial foreclosure. Virtually all jurisdictions permit the vendor to elect a judicial foreclosure rather than a forfeiture. See, e.g., Mackiewicz v. J.J. & Assoc., 245 Neb. 568, 514 N.W.2d 613 (Neb.1994) (dictum); Ulander v. Allen, 37 Colo.App. 279, 544 P.2d 1001 (1976); Rickel v. Energy Systems Holdings, Ltd., 114 Idaho 585, 759 P.2d 876 (1988); Mustard v. SugarValleyLakes, 7 Kan.App.2d 340, 642 P.2d 111 (1981). Ryan v. Kolterman, 215 Neb. 355, 338 N.W.2d 747 (1983); Lamont v. Evjen, 29 Utah 2d 266, 508 P.2d 532 (1973). See generally, Annot., Vendor's Remedy by Foreclosure of Contract for Sale of Real Property, 77 A.L.R. 270 (1932).
D. Strict foreclosure. If a court is willing to conclude that the purchaser’s interest contains no equity value, it may be willing to order a strict foreclosure. This is, in effect, a judicial declaration of forfeiture. However, unlike a forfeiture, in a strict foreclosure the court will almost certainly fix a foreclosure date and permit redemption by the purchaser prior to that date. See, e.g., Westfair Corp. v. Kuelz, 280 N.W.2d 364 (Wis.App.1979); Canterbury Court, Inc. v. Rosenberg, 224 Kan. 493, 582 P.2d 261 (1978); Ryan v. Kolterman, 215 Neb. 355, 338 N.W.2d 747 (1983); Swaggart v. McLean, 38 Or.App. 207, 589 P.2d 1170 (1979); Kallenbach v. Lake Publications, Inc., 30 Wis.2d 647, 142 N.W.2d 212 (1966). See generally Randolph, Updating the Oregon Installment Land Contract, 15 Wil.L.Rev. 181, 211–12 (1979); Vanneman, Strict Foreclosure of Land Contracts, 14 Minn.L.Rev. 342 (1930); Annot.,Vendor's Remedy by Foreclosure of Contract for Sale of Real Property, 77 A.L.R. 270 (1932). Some courts routinely give strict foreclosure without calling it such; they simply award a "grace period" for the purchaser to pay the contract, and declare a forfeiture if he or she does not do so. See Jesz v. Geigle, 319 N.W.2d 481 (N.D.1982); Moeller v. Good Hope Farms, 35 Wash.2d 777, 215 P.2d 425 (1950) (grace period discretionary).
IV. Steps to protect the vendor. The following precautions will help protect the vendor’s interest in a real estate installment contract.
A. Include an acceleration clause. Failure to do so, or failure to exercise the clause, may result in the vendor’s remedies of specific performance, damages, and judicial foreclosure being essentially useless. See, e.g., Carpenter v. Smith, 147 Mich.App. 560, 383 N.W.2d 248 (1985); Rickel v. Energy Systems Holdings, Ltd., 114 Idaho 585, 759 P.2d 876 (1988) (vendor may not foreclose judicially for the entire contact amount where there is no acceleration clause in the contract). But see Carpenter v. Smith, 147 Mich.App. 560, 383 N.W.2d 248 (1985), finding that the purchaser’s anticipatory repudiation of the contract acted to accelerate the debt.
B. Avoid recording of the contract if possible. Because recordation of the contract clouds the vendor’s title, it gives the purchaser additional leverage in the event of a default by the purchaser and an assertion of forfeiture by the vendor.
C. Provide expressly for alternate remedies. The wise vendor will provide expressly that, at the vendor’s option, the vendor may obtain a forfeiture, a foreclosure by sale, a strict foreclosure, specific performance (a suit for the price), and damages (a suit for a deficiency after a forfeiture or foreclosure). If the jurisdiction permits nonjudicial foreclosure by power of sale for mortgages, this remedy should be provided as an option for the vendor in an installment contract as well. (Unfortunately, in many jurisdictions that permit nonjudicial foreclosure, the only instrument that can be foreclosed in that manner in a deed of trust.)
D. Provide for adequate insurance to protect the vendor. The vendor needs to be certain that both casualty and liability insurance coverage in an adequate amount will be maintained, with the vendor named as an insured on the policies. The purchaser should be required to provide initial certificates of insurance, and to provide evidence of premium payment on an ongoing basis. The vendor may wish to consider monthly escrowing of the insurance premium and property tax payments.
E. Obtain a promissory note from the purchaser for the purchase price. In some jurisdictions, this may be helpful in avoiding the “election of remedies” doctrine.
V. Steps to protect the purchaser. Just as the steps above are advantageous to the vendor, they are disadvantageous to the purchaser. Thus the purchaser should:
A. Avoid inclusion of an acceleration clause if possible.
B.Limit the vendor’s available remedies insofar as possible. In particular, the forfeiture remedy is potentially most detrimental to the purchaser’s interest, and its inclusion should be avoided if possible.
C. Record the contract or a memorandum of it. Recording will protect the purchaser against the vendor’s subsequent attempts to convey or encumber the property to a bona fide purchaser, and also against any judgment liens entered against the vendor.
If the vendor’s signature on the contract is not acknowledged, it may be impossible to record the contract itself. In that case, the purchaser might attempt to get the vendor to execute and acknowledge a one-page memorandum of the contract. Failing that, the purchaser might execute and record a “notice of interests,” or a straw assignment and reassignment of the contract. In a recording jurisdiction that employs only name-based (grantor and grantee) indexes, such a document will be “wild” and will probably not give constructive notice, but it can still be practically effective because title insurance companies will also most certain pick it up and will index it by tract in their private title plants.
D. Include a provision for notice of default to the purchaser and a generous cure period prior to the exercise of any remedies by the vendor.
E. Obtain a title report and title insurance. Most title companies are entirely willing to insure a purchaser’s interest in an installment contract, despite the fact that the purchaser does not yet have legal title. (Of course, the title company will ordinarily require recordation of the contract or a memorandum of the contract as a condition of issuing title insurance.) It is critical that the purchaser examine title prior to entering into the contract, and that title insurance be effective when the contract is entered into. Sometimes purchasers obtain title insurance when they make the final payment and accept delivery of a deed, but that is far too late to be useful.
- If the contract wraps a preexisting mortgage, take steps to protect the purchaser’s payments. Where a preexisting mortgage loan continues to encumber the property begin sold on an installment contract, the purchaser has a legitimate interest in ensuring that the payments on that loan will continue to be made. One way to accomplish this is to set up a payment escrow, with the purchaser making the contract payment each month into escrow. The escrow holder will be instructed to divide the funds, making the required payment on the mortgage and turning the remainder of the cash flow over to the vendor.
Sometimes a purchaser will be invited to accept an installment contract that wraps a preexisting blanket mortgage on numerous lots or condominium units. This situation presents an unacceptable risk to the purchaser and should be avoided at all costs. The payments on the blanket mortgage are typically much larger than the payments on the installment contract, and hence cannot be covered by a payment escrow. In addition, the balance owing on the blanket mortgage is typically so large that it far exceeds the balance on the installment contract, making it impossible for the contract purchaser to redeem the mortgage if it goes into default.