Contracts for Deed and Lease Option Agreements on Residential Property in Texas

In traditional owner-finance, the seller deeds the property to the buyer and retains a vendor’s lien in the property to secure the repayment of the loan to the buyer. The buyer becomes the legal, deeded owner of the property. If the buyer fails to pay the loan, then the seller may foreclose on the loan. A contract for deed is a different form of seller-finance. In a contract for deed, the seller keeps the title to the property and the buyer does not receive a deed to the property. Instead, the seller signs a long-term purchase contract. The long-term purchase contract requires the buyer to make monthly or other periodic payments over a long period of time. The contract provides that the seller will deed the property to the buyer after the buyer completes all payments.

History of Contract-for-Deed Law in Texas. In Texas, contracts for deed on residential property are considered potentially predatory and subject to strict consumer-protection laws. Specifically, the Texas Legislature found that “contracts for deed have long been disfavored because they encumber title without transferring title, cannot be sold in the real estate market, cannot be used to borrower money to make improvements, and are potentially abusive transactions under which legal title to homestead property may be withheld until many years after the buyer has built a home and made other expensive improvements.” Bill Analysis, Senate Research Center, HB 311, By: Canales (Lucio), Business and Commerce, 5/8/2015, Engrossed.

In a contract for deed, buyers could purchase a house, complete most or all of the payments under the contract, and then get evicted by the seller, with the seller claiming some technical default causing forfeiture of all of the buyer’s rights. Many buyers lacked the money to litigate disputes over technicalities in the contract. Moreover, even if the buyer did default, the Texas legislature found the results draconian because the buyer often lost years, maybe decades, worth of built-up equity in the property. In a foreclosure sale, the buyer would receive some protection for the buyer’s equity position in the property built up over time. In a contract for deed, however, the buyer received no protection for the buyer’s equity position because, technically, the buyer never had an equity position, merely an executory contract right.

The Texas legislature, in 1995, began regulating contracts for deed, but only in counties along the Mexico border. In 2001, the Texas Legislature expanded that contract-for-deed protection statewide. As of January 1^st, 2006, the Texas legislature updated Subchapter D to provide that residential leases combined with an option to purchase the property are treated like contracts for deed and subject to all of the many Subchapter D rules.

In 2015, the Legislature enacted House Bill 311, 84^th Regular Session (hereinafter “HB 311”). HB 311 made the following changes, among other changes:

Sellers can only enforce the remedy of rescission or forfeiture and acceleration when the contract has not been recorded in the real property records. Tex. Prop. Code § 5.064(4).
Sellers must record the contract within thirty days of the date that the contract is executed. Tex. Prop. Code § 5.076(a).
If a seller fails to record the contract, then the seller can be liable for up to $500.00 for each calendar year of noncompliance. Tex. Prop. Code § 5.076(e).
Under the 40/48 rule, the seller “is granted the power to sell, through a trustee designated by the seller, the purchaser’s interest in the property,” and the seller’s ability to enforce the remedies of rescission or of forfeiture and acceleration are limited. HB 311 modified this rule to provide that, after the contract is recorded, the seller can no longer enforce the remedy of rescission or of forfeiture and acceleration, regardless of whether the buyer has met the 40/48 rule.
Amends Tex. Prop. Code § 5.079 to provide that “A recorded executory contract shall be the same as a deed with a vendor’s lien.”

Download the 2015 bill, HB 311 of the 84^th Regular Legislative Session, and legislative commentary on the bill here.

Contracts for deed and leases combined with an option to purchase residential property are strictly regulated in Texas by Subchapter D of Chapter 5 of the Texas Property Code (hereinafter “Subchapter D”). For the most part, the only thing that real estate investors in Texas need to know about contracts for deed and lease options on residential property is “don’t do them.” In theory, someone could originate real estate transactions in compliance with Subchapter D. In practice, no one tends to comply and even if someone did comply, the transaction still would not make sense. A contract for deed or residential lease option never makes sense for the seller/landlord in Texas because even if the seller/landlord complies with every regulation, a tenant’s/buyer’s dispute, whether in good faith or not, regarding compliance potentially deprives the justice of the peace court of jurisdiction over an eviction case and prevents nonjudicial foreclosure. Accordingly, the seller/landlord, in reality, can rarely evict a tenant/buyer who refuses to leave without filing a lawsuit in a District Court for the county that the property is located in. The lawsuit will likely take over a year before the suit is called to trial. The lawsuit will entail substantial legal fees and a significant investment of time and effort on paperwork and trial preparations. No real estate investor should even risk getting stuck in that situation. Hence, the foregoing advice to simply avoid these transactions. Instead, do a normal lease without an option, or do traditional owner-finance with a promissory note and deed of trust. Either of these options allows the seller to evict or foreclose then evict without the necessity of a District Court lawsuit. Eviction suits, in Texas, go through small claims court where a timely and binding decision by the Court can generally be obtained. District Courts, on the other hand, do not give timely decisions. Completing a District Court lawsuit, where one party wants to delay the case, in less than a year is nearly impossible. In theory, if both parties and the Court agreed to a quick trial setting, then a District Court case could potentially go to trial within one year, but, in reality, one party or the Court always wants to delay.

Does Subchapter D Apply to My Transaction?

Subchapter D “applies only to a transaction involving an executory contract for conveyance of real property used or to be used as the purchaser’s residence . . . .” Tex. Prop. Code § 5.062(a). Additionally, “an option to purchase real property that includes or is combined or executed concurrently with a residential lease agreement, together with the lease, is considered an executory contract for conveyance of real property.” Id. at (a)(2). However, Subchapter D does not apply to “an executory contract that provides for the delivery of a deed from the seller to the purchaser within 180 days of the date of the final execution of the executory contract.” Id. at (c). If a contract for deed is done between family members, then most of the particularly onerous requirements of Subchapter D do not apply. See Tex. Prop. Code § 5.062(d). The important takeaways here are that (1) Subchapter D does not apply to contracts for less than a six month term, and (2) Subchapter D only applies if the buyer/tenant intends to use the property as their residence or their family member’s residence.

Limits on Subchapter D Applicability to Lease-Option Agreements. Buyers under a lease-option agreement cannot convert the property to traditional owner-finance under Tex. Prop. Code § 5.081. See Tex. Prop. Code § 5.062(e). Also, the 40/48 rule (§ 5.066) does not apply to lease-options. Id. Additionally, if a lease-option has a term of less than three years and the parties have not had a contract to purchase the property for longer than three years, then only the notice and default provisions (§ 5.063-5.065), the terms and waivers provisions (§ 5.073), the right to cancel for improper platting (§ 5.083), and the requirement that the seller owns the property free and clear of liens or other encumbrances (§ 5.085) apply. Tex. Prop. Code § 5.062(f).

What Does Subchapter D Require of the Seller/Landlord?

So, you want to originate a Subchapter D-compliant contract for deed? First of all, stop right here. Re-evaluate your situation. Is there any possible way that you can handle the transaction differently? If so, then do it differently. But, for those that find themselves in a situation where they need to enter into a contract for deed and intend to comply with the Texas Property Code, then here is a non-exhaustive list of the various things that you need to do to comply with Texas law:

1. If the contract for deed negotiations are primarily not in English, then the seller “shall provide a copy” in the primary language used for negotiations “of all written documents relating to the transaction, including the contract, disclosure notices, annual accounting statements, and a notice of default required by this subchapter.” Tex. Prop. Code § 5.068.
2. The seller can only “enforce the remedy of rescission or of forfeiture and acceleration” (Tex. Prop. Code § 5.064) if a notice of default and explanation of how to cure default is given that complies with all of the many, many rules in Sections 5.063 and 5.065 of the Texas Property Code.
3. The 40/48 Rule. “If a purchaser defaults after the purchaser has paid 40 percent or more of the amount due or the equivalent of 48 monthly payments under the executory contract or, regardless of the amount the purchaser has paid, the executory contract has been recorded, the seller is granted the power to sell, through a trustee designated by the seller, the purchaser’s interest in the property as provided by this section. The seller may not enforce the remedy of rescission or of forfeiture and acceleration after the contract has been recorded.” Tex. Prop. Code § 5.066. So, most of the time, a contract for deed can only be unwound with a foreclosure auction, despite the buyer having no legal title to the property. There is a lot to unpack there, including:
(a) A sixty-day notice to cure default is required and the notice of trustee’s sale under Section 51.002 of the Property Code is not valid unless it is given after the 60-day notice to cure expired. Tex. Prop. Code § 5.066(c).
(b) At the foreclosure sale, the trustee must (1) “convey . . . fee simple title,” and (2) “warrant that the property is free from any encumbrance.” Tex. Prop. Code § 5.066(d). STOP AND THINK FOR A MINUTE ABOUT THIS. In a typical wrapped lien foreclosure sale, the foreclosure on the seller-financed second lien leaves the seller’s un derlying wrapped first lien unaffected. THIS IS NOT THE CASE IN CONTRACTS FOR DEED. Instead the underlying lien must be paid off. Otherwise, no fee simple title free of encumbrance can be conveyed. The seller probably wants to open the bidding with a credit bid sufficiently high to pay the first, wrapped lien off, but can the seller do that? Also, how does the seller find a trustee that is willing to “warrant that the property is free from any encumbrance?” Can the trustee be liable on that warranty? There are no good answers to these questions because the statutes and caselaw do not adequately address these issues.
4. The seller must provide the buyer with a recent survey, a legible copy of any document that describes an encumbrance or other claim (including restrictive covenants), and a written notice in the format prescribed by Section 5.069(a)(3) of the Texas Property Code. Tex. Prop. Code § 5.069(a). Moreover, the seller may have to provide a utilities availability notice if the property is not located in a recorded subdivision, advertisements must disclose information about availability of utilities, and the seller’s failure to provide the foregoing information is a violation of the Texas Deceptive Trade Practices Act (DTPA) and “entitles the purchaser to cancel and rescind the executory contract and receive a full refund of all payments made to the seller.” Tex. Prop. Code § 5.069(b)-(d).
5. Before doing a contract for deed, the seller must provide the purchaser with a tax certificate and a legible copy of any insurance policy, binder, or other evidence related to insurance. The seller’s failure to comply is a violation of the Texas Deceptive Trade Practices Act and “entitles the purchaser to cancel and rescind the executory contract and receive a full refund of all payments made to the seller.” Tex. Prop. Code § 5.070.
6. Before doing a contract for deed, the seller must provide the buyer with a written statement containing the purchase prices, interest rate, dollar amount of interest charged for the term of the contract, total amount of principal and interest to be paid, late charges, and a statement that “the seller may not charge a prepayment penalty or any similar fee if the purchaser elects to pay the entire amount due under the contract before the scheduled payment date under the contract.” Tex. Prop. Code § 5.071.
7. Contracts for deed must be in writing and cannot be varied by oral agreements. Moreover, the seller must give the borrower a written notice in 14-point boldfaced type or 14-point uppercase typewritten letters, in the exact statutory form, advising the borrower regarding the prohibition against oral agreements. The seller’s failure to provide this statutory notice violates the DTPA and “entitles the purchaser to cancel and rescind the executory contract and receive a full refund of all payments made to the seller.” Tex. Prop. Code § 5.072.
8. Late payment fees are strictly regulated, the buyer cannot be prohibited from pledging the buyer’s interest as security for a loan for improvements, no prepayment penalty or similar fee can be charged, no option fee can be forfeited due to late payments, and the borrower cannot be penalized in any way for requesting repairs or exercising rights under Chapter 92 of the Texas Property Code. Tex. Prop. Code § 5.073. Finally, any waivers or exemptions of the foregoing provisions are void. Id.
9. The buyer can cancel for any reason within fourteen (14) days of the date of the contract. The seller must give the buyer a statutory notice to this effect. Tex. Prop. Code § 5.074.
10. The seller must record the executory contract within thirty (30) days. The seller also must record the instrument terminating the contract. The seller that violates this section is liable for up to $500.00 for each year of noncompliance. Tex. Prop. Code § 5.076.
11. The seller must provide the buyer an annual accounting statement in the statutory format even after the contract for deed is converted to actual title. The seller that fails to send the proper annual accounting is liable for either (1) $100 per year plus attorney’s fees, or (2) $250 per day not to exceed the fair market value of the property plus attorney’s fees, depending on whether the seller has conducted “less than two transactions in a 12-month period under this section” or whether the seller has conducted “two or more transactions in a 12-month period under this section.” Tex. Prop. Code § 5.077.
12. The insured must notify the insurer of the executory contract and the insurer must disburse proceeds jointly to the purchaser and the seller designated in the contract. Both the purchaser and seller must ensure that insurance proceeds are used to “repair, remedy, or improve the condition on the property.” Tex. Prop. Code § 5.078. The failure to comply is a DTPA violation. Id.
13. Interestingly, “A recorded executory contract shall be the same as a deed with a vendor’s lien.” Tex. Prop. Code § 5.079. What exactly the Texas Legislature meant by that sentence is anyone’s guess. The buyer on a recorded executory contract gets the warranties that would come with a general warranty deed unless otherwise limited by the contract. Id. The seller that fails to transfer recorded, legal title after receipt of final payment can be subject to large liquidated damages statutory penalties. Id.
14. Under Section 5.081 of the Texas Property Code, the buyer “at any time and without paying penalties or charges of any kind” is entitled to convert the contract-for-deed into recorded, legal title by tendering a promissory note for the balance owed with the same terms as the contract. The seller that fails to tender a deed and give the required written explanations can face draconian penalties in the form of $500.00 per day in liquidated statutory damages. The savvy buyer will tender a promissory note pursuant to the Texas Property Code to the seller and then try to stick the seller with penalties that are in no way proportionate to the seller’s wrongdoing. Most sellers that do contracts for deed are unsophisticated and have no ability to comprehend why or how they could get stuck with such liability or why Texas law would impose such heavy-handed measures on them.
15. The buyer on a contract for deed can demand to know the amount owed under the contract and the name and address of the seller’s desired foreclosure trustee. Tex. Prop. Code § 5.082. If the seller fails to provide the information, then the buyer can determine the amount and notify the seller of the amount determined. Id. The seller then has to contest the amount determined based on “written records kept by the seller or the seller’s agent that were maintained and regularly updated for the entire term of the executory contract.” Id.
16. The buyer on a contract for deed can rescind the agreement at any time if the seller has not properly subdivided or platted the property and fails to timely cure the issue. Tex. Prop. Code § 5.083. The buyer seeking to rescind should follow the statutory procedures. If the rescission occurs, then the seller may have to “return to the purchaser all payments of any kind made to the seller under the contract and reimburse the purchaser for (a) any payments the purchaser made to a taxing authority for the property; and (b) the value of any improvements made to the property by the purchaser.” Id. at (b)(2).
17. The buyer on a contract for deed can deduct any amounts owed to the buyer by the seller under Subchapter D of Chapter 5 of the Texas Property Code from amounts owed to the seller without taking any judicial action. Tex. Prop. Code § 5.084.
18. One of the most problematic issues with Subchapter D regulations is Section 5.085 of the Texas Property Code (the “Fee Simple Title Required Rule”). This section prohibits a seller from entering into a contract “if the seller does not own the property in fee simple free from any liens or other encumbrances.” This may be the single most violated Subchapter D rule. Many sellers doing contracts for deeds have a mortgage on the property and use a contract for deed to resell the property without paying the mortgage off. The seller obviously should take the buyer’s monthly payments and apply the payments towards the seller’s mortgage. But, unscrupulous sellers sometimes take the buyer’s money, fail to pay the mortgage, and then file for bankruptcy protection when the mortgage is getting foreclosed. This results in a disaster to the buyer who will incur a lot of legal fees and may or may not be able to save the property. Those sellers deserve whatever liquidated damages penalties Subchapter D imposes on them.
(a) There are a few exceptions to the Fee Simple Title Required Rule, with the most important one probably being the one applicable to purchase-money loans that the seller used to acquire the property prior to execution of the contract for deed. Sellers with a prior purchase-money loan must comply with an extensive list of requirements, including but not limited to (1) providing written disclosure of the wrapped lien information in the statutorily-required format, (2) the lien does not encumber other properties, (3) the lien secures indebtedness that will never be greater than the balance owed by the contract for deed buyer, (4) the contract for deed contains various statutorily-required covenants, (5) the lienholder does not prohibit the property from being encumbered by an executory contract, and (6) the lienholder consents to work with the contract for deed buyer. Tex. Prop. Code § 5.085. Virtually every underlying lienholder will have a due-on-sale clause. It could probably be argued that nearly any contract for deed violates nearly any due on sale clause, so, this exception is likely not particularly helpful for most sellers, at least until there is some caselaw on file interpreting contracts for deed as generally not violating due on sale clauses.
(b) The penalties for violating the Fee Simple Title Required Rule are stiff. A violation of Section 5.085 of the Texas Property Code is a DTPA violation. In addition to DTPA damages, the buyer can rescind the executory contract and receive from the seller a refund of all payments of any kind made to the seller under the contract, reimbursement for taxes paid, and reimbursement for improvements made to the property. Tex. Prop. Code § 5.085(c).
(c) The seller who has a lien placed on the property by a person other than the seller has thirty days to take all steps necessary to remove the lien. Tex. Prop. Code § 5.085(d).

Equitable Limitations on Statutory Damages Under Subchapter D. Even though Subchapter D often allows the buyer to rescind the contract “and receive a full refund of all payments made to the seller,” the Texas Supreme Court has imposed equitable limitations on the literal language of the statute. Morton v. Nguyen, 412 S.W.3d 506, 511 (Tex. 2013). The Supreme Court, citing the Restatement (Third) of Restitution and Unjust Enrichment, said

“‘[R]escission is not a one-way street.’ Id. at 825. Rather, as we explained in Cruz, ‘[recission] requires a mutual restoration and accounting, in which each party restores property received from the other.’ Id. at 825–26 (citing Restatement (Third) of Restitution and Unjust Enrichment § 37 cmt. d (2011)). A seller’s wrongdoing does not excuse the buyers from counter-restitution under the circumstances of this case. See id. at 826. But here, as in Cruz, we similarly hold that notice and restitution or a tender of restitution are not prerequisites to the cancellation-and-rescission remedy under Subchapter D, as long as the affirmative relief to the buyer can be reduced by (or made subject to) the buyer’s reciprocal obligation of restitution. See id. at 827 (citing Restatement (Third) of Restitution and Unjust Enrichment § 54(5) (2011)).” Id.

Specifically, the Texas Supreme Court said that when the buyer rescinds, the buyer must “restore to the seller the value of the buyer’s occupation of the property” and that the trial court should consider “the rental value of the property during” the buyer’s occupation of the property. Id. So, rescission under contract for deed law may not be as terrifying for sellers as it seems at first glance. But, do not forget that these equitable setoffs apply only to rescission claims and may have no applicability to statutory liquidated damages or DTPA claims. Also, keep in mind that the buyer will probably continue to occupy the property for the duration of the lawsuit regarding any dispute.

The Seller Involved in a Contract for Deed Dispute With a Buyer Generally Has No Good Options Because Both Foreclosure and Eviction May be Unavailable or Highly Problematic. In any contract for deed dispute, the buyer will probably occupy the property for the entire duration of the lawsuit. Regardless of how fair that is or how much financial pressure the holding costs put on the seller, the seller’s options in dealing with the buyer are limited. To foreclose on the buyer, the seller usually has to conduct a foreclosure sale where the foreclosure trustee must (1) “convey . . . fee simple title,” and (2) “warrant that the property is free from any encumbrance.” Tex. Prop. Code § 5.066(d). If the seller has a loan on the property, then this becomes problematic. Also, figuring out how to properly paper the foreclosure process on a contract for deed is a nearly Sisyphean task for any attorney. The seller on a contract for deed faces similar problems with evictions. If the contract for deed does not expressly provide “for a landlord-tenant relationship if the buyer breach[es] the contract,” then no justice of the peace court or county court at law on appeal from the justice of the peace court has jurisdiction over an eviction suit. Aguilar v. Weber, 72 S.W.3d 729, 734 (Tex. App.—Waco 2002, no pet.). Accordingly, there is usually no easy or timely way to get a defaulting contract for deed buyer evicted.

In Texas, disputes regarding contracts to purchase real property are considered title disputes because the buyer under an executory contract to purchase real property is considered to hold “equitable title.” Johnson v. Wood, 138 Tex. 106, 110, 157 S.W.2d 146, 148 (Comm’n App. 1941) (by performing under a contract for purchase of real property, the buyer’s equitable right to specific performance “ripened into an equitable title” that, “as distinguished from a mere equitable right, will support an action for trespass to try title”); Leal v. ASAS, Ltd., 13-10-00629-CV, 2011 WL 3366363, at *3 (Tex. App.—Corpus Christi Aug. 4, 2011, no pet.) (justice court deprived of jurisdiction over eviction where “determining the right of possession necessarily involved a title inquiry into the contract to purchase land”); Cadle Co. v. Harvey, 46 S.W.3d 282, 287–88 (Tex. App.—Fort Worth 2001, pet. denied) (buyer under an executory contract for sale of real property acquired equitable title to the property when he took possession even though he had not yet paid the full purchase price). So, in theory, a contract for deed could be drafted with a landlord/tenant relationship clearly spelled out that would allow for the tenant to be evicted through an action for forcible detainer in the justice of the peace court, but in reality, a justice court or county court at law on appeal from justice court will rarely issue a writ of possession in a contract for deed dispute. Even if there is a landlord-tenant or tenancy-at-sufferance clause, you also have the 40/48 rule to deal with, along with the rules regarding recording of the contract and recording the contract making the contract equivalent to a promissory note and deed of trust. Reconciling those laws, some of which came out in 2015 after the Aguilar and Leal cases, with the ability to evict a contract for deed buyer in justice court is difficult.

Can I just have the buyer waive Subchapter D of Chapter 5 of the Texas Property Code? No, you cannot. See Tex. Prop. Code § 5.073(b). Also, many Subchapter D rules create DTPA violations and DTPA violations cannot be waived unless the waiver is in writing and signed by the consumer, the consumer is not in a significantly disparate bargaining position, and the consumer is represented by legal counsel that is not “directly or indirectly identified, suggested, or selected by a defendant or an agent of the defendant.” Tex. Bus. & Com. Code Ann. § 17.42 (West). Moreover, DTPA waivers must be bold and use the statutorily-required language. Id. at (c).

Are There Any Ways to Structure a Transaction That Does Not Trigger Subchapter D Without Doing a Deed, Promissory Note, and Deed of Trust, i.e., Traditional Seller-Finance? Maybe, but none of them are proven to work in court. If you use any of these methods, then you use them at your own peril. Here are the methods that could be tried:

Use of a Land Trust. You could transfer the subject real property into a trust. The buyer could contract to purchase the beneficial interest in the trust rather than the property itself. Upon completion of payments, the buyer would be entitled to receive the beneficial interest in the trust. The seller/beneficiary under the trust would be selling the rights as beneficiary of the trust (e. the beneficial interest in the trust) as opposed to the real property itself. In this scenario, the beneficial interest in the trust is personal property, not real property. Because Subchapter D applies only to “an executory contract for conveyance of real property,” not personal property, Subchapter D would arguably not apply to this transaction. Tex. Prop. Code § 5.062(a) (emphasis added). You could also combine the land trust with an option agreement. Use of this method is not recommended. There is no guarantee that a court would actually accept this theory. This method is overly technical and, in general, consumer-protection laws, like Subchapter D, are not amenable to clever workarounds.

Successive Six-Month Options. Subchapter D applies only to “an executory contract that provides for the delivery of a deed from the seller to the purchaser within 180 days of the date of the final execution of the executory contract.” Tex. Prop. Code Ann. § 5.062. Accordingly, Subchapter D would not apply to an option agreement that provided for the delivery of a deed from the seller to the purchaser within 180 days. Option agreements can, thus, be entered into without triggering Subchapter D for about six months or less. One could, in theory, include a provision in the contract allowing for the option to be renewed every six months as long as the buyer was not in default and provided that various other conditions are met. In theory, if option renewal was not guaranteed, then this would not trigger Subchapter D because the only option would be the initial six-month option. Each successive option would be a novation (e., a new contract). The buyer, however, would be at the seller’s mercy on whether the seller would enter into each six-month renewal. This arrangement may or may not trigger Subchapter D. Use of this method is not recommended. There is no guarantee that a court would actually accept this theory. This method is overly technical and, in general, consumer-protection laws, like Subchapter D, are not amenable to clever workarounds.

Disclaimer: This document is for informational purposes only. Do not rely on any part of this document as legal advice. Instead, seek out the advice of a licensed attorney with regard to the particular facts and circumstances of your legal matter. Also, this information may be out-of-date or wrong and is not intended to be comprehensive or to address any potential or specific factual or legal scenario.