THE PITFALLS OF CONTRACTS FOR DEED IN KENTUCKY – JAY MATHENY
JUST (DON’T) DO IT: THE PITFALLS OF CONTRACTS FOR DEED IN KENTUCKY
About once every two weeks, I receive a call from a frustrated (and sometimes angry) person, and the conversation goes something like this:
CALLER: “Yeah, I tried to sell this guy a house on a contract for deed, and now he isn’t paying me, so I want to evict him.”
ME: “Sorry to be the bearer of bad news, but your remedy isn’t to evict him. You’ve got to foreclose on him.”
CALLER: “What?! You mean I have to foreclose upon my own property.”
ME: “Sorry to be the bearer of bad news again, but it really isn’t your property anymore.”
Unfortunately, this scenario is all too common. And, it’s all because of a Kentucky Supreme Court case from 1979 called Sebastian v. Floyd, 585 S.W.2d 381 (Ky. 1979).
In most real estate transactions in Kentucky, the typical scenario is that someone finds a home they want to purchase, he/she enters into some type of purchase agreement for that home, and there is a closing. At the closing, the buyer/borrower signs a promissory note to some type of lender (usually a bank or some other financial institution), the lender finances the property for the buyer/borrower, the buyer/borrower gets a deed to the property, but, in turn, the buyer/borrower gives the bank a mortgage on the property as security for the loan. If the borrower defaults, the lender has a remedy: to foreclose on the property.
However, for some would-be home buyers, obtaining financing for the purchase of real property is not an option. Some prospective purchasers may have bad credit (or no credit) and/or no one to co-sign on a loan for them. In those instances, there may be a seller who is willing to finance the property for the buyer. This can be done in many ways, but a common way that this occurs is through a contract for deed (otherwise known as a land sale contract).
A contract for deed is, as the name implies, a contract that is entered into between a seller of real property and a buyer of real property under which the buyer usually agrees to make a down payment on the property and make monthly payments on the property thereafter for some specified period of time until all of the required payments on the contract are made. In the interim, the buyer is usually required to maintain the property, pay the taxes, pay the utilities, maintain insurance, and so on. Once the buyer has made all of the required payments on the property, the seller usually executes a deed to the buyer.
But, what happens if the buyer defaults on his/her payment obligations under a contract for deed. That is where Sebastian v. Floyd comes into play.
In Sebastian v. Floyd, the Kentucky Supreme Court opined that a contract for deed is really no different than a situation where a borrower signs a promissory note, obtains a deed for a piece of property, and, in turn, provides the lender with a mortgage on the property. The only difference under a contract for deed is that, instead of having actual/record title to a piece of real property, the borrower has an equitable interest in the property. The result of this holding is that, rather than being able to evict a borrower on a contract for deed, the remedy is judicial foreclosure. This can present a number of problems (both legal and practical) for someone who has served as the seller/lender under a contract for deed.
First, there is a significant amount of expense involved in any foreclosure action. Prior to foreclosing upon the property, the borrower/seller under a contract for deed needs to conduct a title examination on the property to make sure that no other liens or encumbrances have attached to the buyer’s interest in the property (which can be a fairly expensive proposition in and of itself). But, perhaps an even bigger issue may be the actual results of that title examination. If, following the execution of a contract for deed, the buyer/borrower has failed to pay the ad valorem taxes on the property (and, even worse, if those delinquent tax bills have been sold to a third party), the lien(s) for taxes have statutory priority as to any proceeds netted from the judicial sale of the real property.
An even more significant problem comes into play if the seller’s contract for deed is not recorded and there is a subsequently recorded lien or encumbrance. In that instance, the subsequently recorded lien or encumbrance may be accorded priority as to the proceeds from the judicial sale of the property over the seller/lender under a contract for deed. In short, this means that if there are subsequently recorded liens for income taxes or judgment liens after execution of the unrecorded contract for deed, those liens may be accorded priority, and the seller/borrower may lose out on a significant portion (or all) of the proceeds from the sale of the property because of those subsequently recorded liens/encumbrances. And, none of this even takes into consideration a diminution in the value of the property caused by a lack of maintenance to the property (which can further reduce the overall sale price of the property and, in turn, the total net proceeds to be distributed following a judicial sale of the property).
With all of that said, how can a seller protect himself or herself in a situation where he or she is going to finance the property for the buyer? There are several ways of accomplishing this objective. The first would be through a lease with an option to purchase. In this type of transaction, the “seller” is really a landlord, and the “buyer” is really a tenant. Lease payments are then made until such time as the tenant exercises an option to purchase the property, and all lease payments made up until that point are then treated as payments toward the purchase of the property. But, until that option is exercised, the tenant is still tenant, and, if the tenant does not make the required payments, then he or she can be evicted.
Another option would be to simply sell the property to the buyer/borrower through a conventional closing process, i.e. a promissory note, deed, and mortgage (the latter two (2) of which are immediately recorded). While this doesn’t change the remedy (foreclosure), it certainly accords a seller/lender priority over any subsequently recorded liens or encumbrances (with the exception of a lien for ad valorem property taxes, which is always accorded statutory priority). And, that gives the seller/lender a better chance of recovery when it comes time for a judicial sale and distribution of those sale proceeds.
SO, WHEN IT COMES TO CONTRACTS FOR DEED IN KENTUCKY, THE BEST ADVICE WOULD BE TO AVOID NIKE’S DIRECTIVE, AND JUST DON’T DO IT!
Jackie M. Matheny, Jr., Esq.
Denton Law Firm, PLLC
555 Jefferson Street, Suite 301
Paducah, KY 42001