Real Estate Purchase Agreement: Contract for Deed or Mortgage – It Makes a Difference

In re Edwards, 606 B.R. 356 (Bankr. E.D. Ark. 2019) –

A chapter 13 debtor proposed a plan that treated a contract for deed as a secured claim. The seller objected, contending that the contract was terminated prepetition so that the debtor had no interest in the property.

The parties entered into a real estate contract for purchase of property, and the debtor and her spouse executed a promissory note payable over 20 years, with terms including the following:

  • The seller was obligated to deliver a deed upon payment in full.
  • If principal and interest due under the note was not paid within 30 days, a $75 late fee was added to the amount due.
  • If amounts due were not paid within 120 days, the seller had an option to accelerate the note.

The debtor and her spouse occupied the property as their residence and made significant improvements.

A series of ongoing payment defaults culminated in a letter from the seller’s attorney accelerating the note and demanding payment by a certain date. The letter also included a “Notice to Quit for Nonpayment.” (The court later noted that there did not appear to be any legal basis for the Notice to Quit.) The day before the deadline, the debtor filed bankruptcy.

The debtor’s plan treated the seller’s claim as a secured claim for long-term continuing debt. It proposed to continue the contractual installment payments and to cure the prepetition arrearage by making additional monthly payments over the life of the plan. The seller objected, contending that the purchase agreement was an executory contract that was terminated prior to bankruptcy.

If the agreement was a terminated executory contract, the debtor would not have any interest in the property and it would not become part of the bankruptcy estate. On the other hand, if the agreement was treated as a security device, the debtor would have an interest in the property that would become part of the bankruptcy estate since the interest was not foreclosed prepetition.

In a bankruptcy, typically property interests are determined by state law. Under applicable state law there were various methods of financing real estate sales:

  • Note and mortgage. A typical debt instrument secured by a lien on property.
  • Escrow contract. Under this alternative the seller executes a deed upfront and places it into escrow with an escrow agent. The escrow agent delivers the deed to the buyer upon payment in full of the purchase price. Generally, an escrow contract will provide that if the buyer defaults, the escrow agent returns the deed to the seller.
  • Contract for deed. Under this alternative the seller is not obligated to execute a deed until the purchase price is paid in full.

Both an escrow contract and contract for deed usually provided that, if there is a default, amounts already paid are treated as liquidated damages, and the default constitutes a breach that excuses performance by the seller and renders the contract void.

However, in some cases a contract for deed is treated as an equitable mortgage (referred to as a “bond for title”). The key issue is whether the contract has a valid forfeiture clause where time is of the essence. If so, the forfeiture may be enforced and the contract will not be considered a mortgage.

In this case the contract did not include a forfeiture clause, nor did it provide that time was of the essence. Instead, the remedy was acceleration of the debt. Based on these findings, the court concluded that the real estate agreement was a contract for deed that should be treated as a security device.

Accordingly, the court overruled the seller’s objection to the plan because the debtor’s interest in the property was part of the bankruptcy estate and the contract could be treated similar to a mortgage.

In Michigan (where I practiced for a number of years), land contracts were an established category of financing. In times of high interest rates they were popular with non-institutional parties (such as sellers offering seller financing) because the usury statute authorized a relatively high interest rate. In addition, under Sixth Circuit precedent land contracts were treated as executory contracts, which meant that they could not be crammed down. However, it seems doubtful that land contracts would be nearly as useful if their treatment was subject to the kind of uncertainty seen in this case. Once again, the nuances of local real estate law are critical.

Vicki R Harding Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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