Installment Sales Contracts for the Purchase of Real Estate and Equitable Foreclosure: Buyer and Owner Beware

Installment sale contracts are a popular method to transfer real estate, especially when obtaining traditional financing from a bank is simply not possibly for the buyer. Bad credit, excessive credit card debt, a previous bankruptcy — there are a myriad number of reasons why a buyer may not be able to obtain traditional financing. Bad things happen to good people. It’s the American dream to own your own home and sometimes an installment sale contract is the only way to make that dream a reality for a buyer.

In an installment sale contract — sometimes called a contract for deed — generally the owner agrees to sell the real estate to the buyer for periodic payments to be applied to the purchase price in some fashion. These types of contracts give the buyer and seller great flexibility to negotiate terms such as the interest rate and the length of the contract. The buyer usually receives possession of the real estate during the term of the contract.

But what happens when payments are missed or there is some other default on an installment sale contract? The answer is not always simple and requires a little background on how a traditional foreclosure works in Kansas.

Kansas is what is called a “lien jurisdiction” as opposed to a “title jurisdiction,” like Missouri or Colorado. In a lien state like Kansas, the lender that provides financing for a buyer to purchase real estate will receive a lien on the property through a mortgage that is typically filed in the county’s Register of Deeds office. The property’s title is transferred to the buyer at closing. Since the buyer is the registered owner of the real estate, the filed mortgage provides notice to the world that while the owner may possess title to the property, it is subject to a lien. In title jurisdictions title to the property is usually held by the lender. Title jurisdictions typically allow “non-judicial foreclosures,” or in other words, lenders can foreclose on property in the event of default without a court’s involvement. In a lien jurisdiction like Kansas, the lender must seek judicial foreclosure in the event of default.

The way to understand how a traditional foreclosure works in Kansas is to focus on the two documents typically involved in a sale of real estate: a promissory note and a mortgage. The promissory note is simply the agreement between the buyer and the lender outlining the terms of how the buyer will pay back the lender for providing the money to purchase the real estate. The mortgage provides the lender with what is called a secured interest, or a lien, on the property. If there is a default on the promissory note, the lender will usually have the ability to declare the note in default and “accelerate” the remaining amount due. In isolation, all this means is that the lender has the right to seek a judgment against the buyer for the remaining amount due. The mortgage is the tool that allows the lender to satisfy this judgment through a sale of the property.

In a typical residential foreclosure action in Kansas, the lender will seek a judgment against the buyer for the accelerated amount due on the promissory note due to the buyer’s default. Typically, the promissory note allows penalties in the event of default and costs of enforcing the terms of the promissory note such as the lender’s attorney fees. The lender will request that the amount due is satisfied through a sale of the property. If the judgment is granted by the court, the court will order the property be sold at a sheriff’s auction. At the auction, the lender usually will bid all or part of the judgment it obtained against the buyer. If the sale is confirmed by the court, the lender receives title to the property. If the lender only bids part of the judgment at the sale, it may receive a personal judgment against the buyer for the remaining amount due, typically called a “deficiency judgment.”

However, Kansas law allows the buyer what is called a “redemption period” before the sale is confirmed. This redemption time is the amount of time the buyer has to satisfy the judgment before the sale is confirmed and the lender receives title to the property. The time for redemption is ordered by the court and by law the buyer is entitled to possession of the property during the redemption period. K.S.A. 60-2414 governs the redemption time a court can allow. The rule of thumb is that if less than one-third of the amount due has been paid by the buyer, the redemption period will be set at three months. If more than one-third has been paid, the redemption period may be set at as much as 12 months. This determination is highly fact specific and there are a number of factors a court will consider when setting the redemption period.

But this idea of a redemption period is where a traditional foreclosure and a default on a contract for deed intersect. The idea behind allowing the buyer this redemption period is fairness — the buyer should have a chance to save any equity in the home. Say the home is worth $200,000 and the judgment is for $50,000. If the foreclosure goes through that $150,000 in equity the buyer had built up over the years is gone. Also, property generally increases in value over time so any appreciation gained in the property is lost. In theory, the redemption period allows the buyer to find a way to satisfy the judgment and save any equity. In reality, the buyer may not be able to obtain financing to satisfy the judgment. A lender will be very hesitant to lend money to someone in the middle of a foreclosure.

So how is equity dealt with when it’s an installment sales contract situation? That’s the tricky area that both sellers and buyers need to think through before entering into an installment sale contract.

When I consult either a seller or a buyer when they are considering entering into a contact for deed, the first question is usually: “What happens to the money that was paid before the default?” Does the seller get to keep the payments? After all, the buyer was in possession of the property and there’s an argument that the payments should be retained by the seller as the rental value of the property. In other words, the payments made by the buyer are nothing more than rental payments. But from the buyer’s viewpoint, he or she entered into a contract to purchase the property and much like a traditional lending situation there’s an argument the buyer has obtained equity in the property, regardless of the seller’s lost ability to generate income from the property.

Typically, a seller will want a provision in the contract that addresses the issue by providing that the buyer forfeits any and all payments that were made to make up for the seller’s damages. This sometimes is referred to as a “liquidated damages” provision, a staple of contract law. The idea is that in the event of the buyer’s default, the seller has lost the ability to generate income from the property during the time the contract was in force. The seller has damages that are measurable, mainly what the property would have generated from being rented to a tenant. This is a particularly strong argument when the buyer’s payments are less than what would be received as rental payments for the property. The provision will usually provide that in the event of default the seller keeps all payments made, the seller can cancel the contract and is entitled to immediate possession of the property.

But these provisions are not always enforced by a court. Often, when a buyer defaults on a contract, a seller will sue for breach of the installment sale contact, seek retention of the payments that were made as liquidated damages and possession of the property. On the flip side, the buyer will argue for what’s called an “equitable foreclosure.” The buyer’s argument is that regardless of what the liquidated damages provision states, the buyer has obtained equity in the home and much like a traditional foreclosure the buyer should be entitled to a redemption period. There are two cases from the Kansas Court of Appeals that highlight this push and pull.

In Mustard v. Sugar Valley Lakes, 7 Kan. App. 2d 340, 642 P.2d 111 (1981), the court unequivocally and broadly states: “A purchaser of land under an installment contract for deed is entitled to equitable foreclosure.” In this case, the buyers under a contract for deed to purchase a vacant lot sued the seller after the seller sold the vacant lot to a third party when the buyer defaulted on the payments. The buyers argued they were entitled to an equitable foreclosure, and both the trial court and the Court of Appeals agreed. The Court of Appeals looked at several older cases and concluded that a court has the equitable power to order a traditional foreclosure-style resolution when there is a default on a contract for deed: “The common element of the relief granted was an allowance of additional time for the purchaser to tender full performance, thereby retaining the accumulated equity in the land and any appreciation in value.” In other words, courts have the equitable power to establish a redemption period for the buyer when there’s a default on a contract for deed.

But, like most things in the law, it’s not always that simple. In Dallam v. Hedrick, 16 Kan. App. 2d 258, 826 P.2d 511 (1990), the court backed off its statement that a buyer is always entitled to equitable foreclosure in a contract for deed situation. In this case, the court held that since the buyer had not made “substantial payment on the purchase price” the payments could be forfeited to the seller and the buyer was not entitled to equitable foreclosure. The court held that since only eight percent (8%) of the purchase price had been paid by the buyer, the contract should be enforced according to its terms and the seller should be allowed to retain the payments that were made.

In short, both sellers and buyers need to be aware that if the installment sale contract goes south there is no clear cut answer as to what will happen. The court may order an equitable foreclosure and give the buyer time to pay the remaining amount owed, essentially granting a redemption period. Or, the court could order the payments forfeited to the seller and grant the seller immediate possession. The answer most often uttered by a lawyer to any question from a client is “It depends.” And a default in a contract for deed situation is no different. Any time you are considering entering into an installment sale contract, you should consult an attorney. Certainty is always the goal in the formation of any contract. Unfortunately, certainty and equity sometimes can be at odds when dealing with an installment sale contract.

Aaron R. Bailey is an attorney licensed to practice in state and federal courts in Kansas. He has experience assisting clients including experience drafting contracts for deed for both buyers and sellers and litigating disputed contracts. If you have questions about contracts for deed in Kansas, call Aaron at 785-357-6311.

The information and materials on this blog are provided for general informational purposes only and are not intended to be legal advice. The law changes frequently and varies from jurisdiction to jurisdiction. Being general in nature, the information and materials provided may not apply to any specific factual and/or legal set of circumstances. No attorney-client relationship is formed nor should any such relationship be implied. Nothing on this blog is intended to substitute for the advice of an attorney, especially an attorney licensed in your jurisdiction. If you require legal advice, please consult with a competent attorney licensed to practice in your jurisdiction.