Intro to Land Contracts
A land contract has been defined as "an agreement for the purchase of land under which the purchase price is payable in installments and the conveyance of title is to be deferred until the last installment is paid." Black’s Law Dictionary; Section 1. An installment agreement may also be referred to as a "contract for deed, an executory contract for the sale of land, an installment contract or an executory sales contract" Id. at Section 2. A Land Contract can also best be described as an alternative to a traditional mortgage or finance agreement used to purchase real estate. In Michigan , a Land Contract is a valid and recognized method of transferring an interest in real estate. MCL 566.1 et al.
A Land Contract can be a most preferred method to transfer an interest in real estate between family members as an alternative tool or instrument to a traditional mortgage or a finance agreement. In many cases, this will allow the seller (the family member transferring the property) to retain a stream of monthly income which may be preferential to transferring the property to a family member and making them responsible for the monthly taxes and assessments.
Advantages of a Family Land Contract
Land contracts are a useful way to purchase real estate, and entering into a land contract with family members has its own set of benefits. One of the significant advantages is that the terms are more flexible than in a typical deal. If one family member wants to keep some stipulations out and another prefers to keep certain vestiges of the prior owner, concessions can be negotiated in a way that’s beneficial to both parties. Flexibility in the payment structure is also available, with payments perhaps going directly to a single family member instead of a third party. There can be flexibility in the length of time before the buyer must purchase the property as well, and how any other parties might be involved in the purchase.
There may be tax advantages that come with a land contract as opposed to a traditional sale. A gifted property requires payment of capital gains taxes if it’s sold, which is why you’ll notice that many parents create such agreements with their children. However, there’s no rule that says a sale has to occur. Parents can forgive the debts involved with the land contract, so in effect, it’s a gift that’s not subject to taxation.
It’s also possible to include personal arrangements with a family land contract that make things easier for both the seller and the buyer. A seller who has moved out can still retain the right to be buried on the property with a land contract, for example. There might be room for any prior owner’s burial rights to be included as well, along with other stipulations that are more personal in nature.
Legal Issues
In addition to reaching a meeting of minds as to the key terms of the transaction, a land contract should be carefully drafted so as to cover the terms which need to be covered. Although family members may not feel that certain provisions are necessary, in nearly all contracts we recommend that the following provisions be included:
· The date for possession.
· The sale price to be paid either upon the closing or over time. "Closing" means the deal is done; you get title and take possession of the property. If title work needs to be completed or work on the property completed before the transaction can close, a closing date should be stated in the contract.
· The date for payment of real estate taxes.
· Provisions for how taxes are handled if the contract extends over a calendar year.
· A provision as to who pays the closing costs.
· A provision as to whether the buyer will be purchasing title insurance.
· If the buyer wants a right to inspect the property prior to closing, it is important to provide when this right will occur.
· A contingency provision allowing for either party (or both) to obtain financing, especially where the buyer is seeking a land contract to pay for the purchase of the land. This contingency could specify the amount of time the buyer has to find financing (or the owner financing the property has to find a replacement property, as the case may be).
· A provision as to how contingencies are satisfied. For example, do they need to be satisfied by a particular date and what happens if they are not? Who pays for inspections if the contingencies are satisfied?
· A provision dictating what happens in the event of a default. The contract should provide a process (e.g., contacting an attorney, sending a letter, providing the buyer with time to cure the default) which should be followed if there is a default.
It is easy to forget the basics when dealing with family members. However, a clearly-drafted land contract is the best way to avoid conflict later on. Where complicated issues such as financing and lien priorities are concerned, it is strongly recommended that you consult with professionals.
Liabilities and Limitations
Despite their benefits, there are countless ways that land contracts among family members can go awry. A layperson may not appreciate these risks, which is where an estate planning attorney can be invaluable.
One risk of entering a land contract, whether with a family member or third party, is the potential for misunderstanding. The seller and buyer may mistakenly believe that they have a shared understanding about one or more issues relating to the sale, and as a result, the land contract may be incomplete or not reflect their intentions. In a worst-case scenario, the seller may have sought to impose conditions or qualifiers that the buyer did not agree to. Although land contracts may be easier to enforce than an oral agreement, there is still no substitute for putting every aspect of the transaction in writing and having both parties review it carefully.
Moreover, because land contracts are legally binding and cannot be changed unilaterally, the buyer may have lingering regrets about agreeing to the terms of the purchase price, the down payment , or the payment schedule. A remedy provided by Michigan law allows the buyer to void the contract if it is not in writing. If the contract is written, then the buyer’s remorse may not be so easily addressed.
Beyond potential misunderstandings, there are practical and financial risks to consider. If the buyer fails to make payments according to the terms of the contract or abandons the property, the seller will need to consider what to do next and how best to mitigate losses. In the extreme, the seller could end up going through a foreclosure process to obtain clear title to attempt to minimize further losses.
There is also the potential for emotional turmoil or conflict that often arises within families. If family members experience any degree of buyer’s remorse or perceive that an agreement was unfair in some way, this could lead to years of litigation with surprising outcomes. In a worst-case scenario, a lawsuit could destroy a family.
Maintaining good communication during the drafting process is the best way to avoid these pitfalls.
Writing a Family Land Contract
The drafting of a family land contract does not follow the same pattern used for residential or commercial transactions. In the context of a land contract, time is often less relevant and the parties are expected to be tolerant of the foibles of their relations. A greater emphasis is placed on retaining control over the property in this type of transaction.
Non-Standard Terms
There are certain non-standard terms that should be considered for inclusion in a land contract involving family members:
- Payments as gifts rather than purchase price – unless you are truly estranged from your family member, you may not want to charge interest or otherwise treat the land contract as an arm’s length transaction. Having the payments treated as a gift will remove them from the heir’s gross estate and reduce the income tax consequences to you when the land is sold.
- Right of first refusal – in addition to the right of first refusal customary in many commercial leases, this term gives the seller the first right to buy back the property if the buyer defaults under the land contract.
- Property Management – does the landowner want to retain control over the management of the property until payment is received in full? Probably so. Does the seller want the buyer to reimburse him or her for costs of management?
- Living arrangements – is the buyer going to live on the property? Should the seller be obligated to reimburse the buyer for any taxes or maintenance costs?
- Costs – will the seller assist with the cost of financing or the costs of closing? These may also be gifts.
- Expenditure reviews – is the buyer going to be required to provide the seller with copies of business plans and annual financial statements?
- Most importantly, you need to be able to find the property now and in the future. This means that the legal description of the property is critical and must be exact. You must also decide if the land contract will be recorded.
Other Options Instead of a Land Contract
A land contract is not the only way for an owner to pass on property to a family member. In fact, there are several other common alternatives that you should consider.
One option is to gift the property or interest in the property to the recipient. If the recipient will be acquiring only a partial interest in the gift, you should make sure that your gift does not violate the "Rule Against Perpetuities." Or, depending on what interests are granted, you may need to recharter the land for tax assessment purposes to reestablish the school district boundaries.
A more common option among immediate family members is to enter into a formal mortgage or other agreement. The land owner parties to the agreement set forth the terms of the agreement, including (and most importantly) the amount of the payments and interest rate. The junior lienholder would then have a security interest in the property.
The last option is outright joint ownership. A joint tenant with rights of survivorship (or "JTWRS") interest in real estate allows the property to pass to the surviving tenant upon the death of a co-owner without any probate administration. A joint tenant does not have to sign a deed. Instead, the deceased’s interest in the property passes to the surviving tenant/owner immediately upon death by operation of law. This is often the most common option for married partners or other unrelated owners to a prior ownership agreement.
The advantages to gifting property are often tax related. There are no taxes associated with the transfer. Tax responsibility is also limited because the new owner will be required to pay all future taxes on the property. The new owner does not have to pay for an appraisal of the property and can take possession immediately. However , once the property is deeded away to a new owner, the original owner loses the right to possess or use the property. Further, unless JTWRS is chosen, the new owner has no special rights upon the original owner’s death.
The advantages to a formal mortgage agreement are similar to those of a gift, but with fewer limitations. The agreement respects the original boundary lines, avoids any problems with future mortgage loans, and permits the original owner/landlord to retain some interest in the property as a lessor. The mortgage documents are recorded so that anyone searching land records can see that the title is encumbered. And the mortgage document can be recorded with a legal description consenting the property to a position for tax assessment purposes. The downsides are that the original owner is responsible for taxes on the property and the new owner must establish their own mortgage servicing arrangements.
While joint ownership creates no title problems, it also creates title problems to be resolved upon the death of one of the owners. Regardless of which alternative is chosen, the recipient may incur considerable fees, and may create an undesired affect in the estate of the giver.