Standard Operating Procedure. Traditional real estate financing involves a purchase evidenced by a deed, coupled with a promissory note secured by a mortgage. The seller typically (but not always) is out of the picture because title transfers at closing. The seller receives the full purchase price in exchange for delivering a deed to the buyer. (The exception is when the seller takes back a note and mortgage and thus become the lender/mortgagee, but most transactions are financed by a third party.) In a conventional sale, what remains post-closing is a lien on the real estate that serves as collateral for the loan. If the new owner (borrower/mortgagor) defaults under the loan, the lender/mortgagee has the right to sue for the debt and foreclose its mortgage.
Purchase Without A Loan. A land contract is another, albeit less conventional, form of real estate financing. The deal normally requires the buyer to make payments over time to the seller (the owner). In many instances, the contract will require a down payment and/or a large balloon payment. Only after the buyer fully pays the contract price does the buyer get a deed and become the owner. In the interim, although the buyer gets to possess and occupy the real estate, legal title remains with the seller, although something called equitable title vests with the buyer. See Skendzel v. Marshall, 261 Ind. 226, 234, 301 N.E.2d 641, 646 (1973) (“Legal title does not vest in the vendee [buyer] until the contract terms are satisfied, but equitable title vests in the vendee [buyer] at the time the contract is consummated.”) One might say that the seller is a hybrid between a landlord and a bank. Usually, but not always, these transactions apply to situations where the buyer is unable or unwilling to get a traditional loan, or to informal deals between family and friends.
Rights Upon Breach? Indiana substantive law and the procedural rules related to mortgage foreclosures are fairly settled, which is to say that the parties’ rights and remedies are well established. This is not the case with land contracts, which may seem simple to close yet can be complicated to enforce. When there is a breach of the agreement, the dispute may look and feel like an eviction proceeding, a mortgage foreclosure action, or both. Frankly, lawyers and judges struggle with how best to handle land contract disputes, and the parties themselves rarely understand what can or should happen if the deal goes bad.
I attribute this potential complexity to the overlapping ownership and possessory rights of the parties. Should the contract be treated like a lease (possession only) or like a mortgage (lien/ownership)? Upon a default, should the seller/owner be permitted to simply evict the buyer, or should the seller be forced to obtain a foreclosure decree and have a sheriff’s sale?
Sale Or Lease? When faced with a purported land contract enforcement action, one should examine whether the contract fits the mold of a sale versus a lease. The answer to this question will control the remedies upon the default. (By the way, these issues are not unique to real estate law.) In a standard land contract dispute, the owner/seller will want the buyer out of the property asap with as little legal and practical hassle as possible. In other words, the owner will want to evict the buyer, a remedy known as forfeiture in this context. On the other hand, the buyer may want to protect its alleged equity in the real estate or, in other words, will want credit toward ownership for the payments made. This is to say that the buyer may want the rights attendant to mortgage foreclosure actions (time, right of redemption, sheriff’s sale process, etc.).
The Rainbow Realty Case.
The Issue. This brings me to today’s topic, last year’s Indiana Supreme Court opinion in Rainbow Realty Group v. Carter, 131 N.E.3d 168 (Ind. 2019). The decision is interesting and impactful on many levels for non-traditional lenders, real estate developers, and landlords. For purposes of my blog and particularly today’s post, however, I’ll zero in on the Court’s discussion of whether the written agreement was a land contact or a lease. Were the parties to the dispute sellers/buyers or landlords/tenants? Unlike most land contract disputes, the buyers in Rainbow wanted the agreement to be a lease so they could countersue for damages.
The Facts. The contract in Rainbow was labeled a “Purchase Agreement (Rent to Buy Agreement).” The language in the agreement clearly expressed an intent to be a thirty-year land contract as opposed to a lease, although the first two years of payments were in fact for “rent.” If the buyer performed for the first two years, the parties would execute a separate “Conditional Sales Contract (Land Sale)” for the remaining 28 years. The seller contended the agreement was a land contract, and the buyer asserted the agreement was a lease. The heart of the dispute was whether the seller could be liable to the buyer for damages for failing to comply with Indiana’s residential landlord-tenant statutes, Ind. Code 32-31. The seller contended it was exempt from those laws.
The Holding. The Court concluded that the agreement was not a land contract, even though wording in the document said things like “My intent is to purchase … [and] I am not renting the property….” Indeed the Court conceded “that most of the transaction’s terms and formal structure suggest this was a sale … necessitated by the Couple’s inability to afford a down payment for the House.” Sometimes, the label or title to a contract, or written stipulations in the contract, are immaterial. Rarely does form prevail over substance. The Court in Rainbow said: “the transaction’s purported form and assigned label do not control its legal status.”
The Rationale. The key appeared to be that the agreement operated as a lease for two years with a contingent commitment to sell, which sale would require a separate contract. Importantly, “if the Couple defaulted before executing the subsequent ‘Land Contract’, or they failed to make payments or to close this latter transaction, they were subject to eviction and forfeiture of all payments made.” The opinion reads:
During the Agreement's twenty-four-month term, [the seller] reserved for themselves a landlord's prerogative to enter the premises, restricted the Couple's use of the land, and, upon the Couple's default, evicted them as if they were tenants and kept their “rental payments”. These features, taken together, are particular to a residential lease. Thus, the parties' Agreement—a purported rent-to-buy contract—is not a “contract of sale of a rental unit” and thus is not exempt from the Statutes' coverage under Section 32-31-2.9-4(2).
The Policy. The seller’s structure in Rainbow backfired. There is a lot more to story, so please read the opinion if you are interested in more detail. There are consumer rights themes built into the Court’s findings. In a nutshell, following a payment default by the buyer, the seller sued for damages and repossession, not unlike a land contract dispute. To the chagrin of the seller, which appeared to be offering financing and housing to low income individuals, the seller ended up facing a judgment for money damages and attorney fees as a de facto landlord. The Court held that the structure of the deal in Rainbow, namely an initial two-year rental term followed by a subsequent sale term, was not a land contract, at least for the first two years, making the seller a landlord. Here is the Court’s policy statement:
If this case were simply about the parties' freedom of contract, the [buyers] would have no legal recourse. Plaintiffs disclaimed the warranty of habitability, informed the [buyers] that the House required significant renovation, and forbade them from taking up residence there before it was habitable. The [buyers] agreed to these terms but soon thereafter violated them. Were it not for the governing Statutes, Plaintiffs would be entitled to relief against the Couple for having breached their Agreement. But the Statutes are not about vindicating parties' freely bargained agreements. They are, rather, about protecting people from their own choices when the subject is residential property and their contract bears enough markers of a residential lease. Unless a statute is unconstitutional, the legislature is entitled to enact its policy choices. The disputed statutes at issue here reflect those choices.
Some Takeaways.
Can’t have it both ways. The format of a “rent-to-buy” aka a land contract is often ambiguous and places the owner in a hybrid role as both a landlord and seller. Seemingly, in Rainbow the development company drafted an agreement that was a combination of a lease and a land contract. It wanted the document classified as a land contract so it did not have the responsibilities of a landlord. At the same time, the developer wanted the benefit of a lease for the first couple of years so it could easily evict the buyer if he or she did not pay. Parties entering into these types of agreements should be wary of how their contract will be characterized. Both the format and substance of the agreement should be consistent to avoid any confusion regarding the parties’ rights and obligations. Not often will the law allow one to have its cake and to eat it, too.
Be clear. If as a seller you want to be able to retain ownership and simply evict an occupant after he/she fails to make payment, then you should expect the court to treat the agreement as a landlord-tenant arrangement. If on the other hand you want to sell the property through payments over time, the form and substance of the agreement should make it clear that the deal is to convey ownership, and you should recognize that equitable title and its associated rights vest with the buyer.
My two cents. Finally, in case you’re wondering, I personally would never recommend entering into a land contract, as either a seller or a buyer. There are too many risks and uncertainties. With leases or loans, everyone – including the courts – knows where the parties stand. If traditional financing isn’t an option, seller financing in the form of a standard note and mortgage is, in my view, better than a land contract.
(Thanks to my colleague David Patton for his help with this article.)
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I represent parties in real estate and loan-related disputes. If you need assistance with a similar matter, please call me at 317-639-6151 or email me at john.waller@woodenlawyers.com. Also, don’t forget that you can follow me on Twitter @JohnDWaller or on LinkedIn, or you can subscribe to posts via RSS or email as noted on my home page.