How To Insure a ‘Wrap’ Without Notifying The Lender

Insurance Problem Solved by Thinking Outside the Box

If you are involved with seller-financing a property with an existing mortgage, the obvious goal is to transfer ownership without tipping off the underlying lender. As stated in my article “Don’t Fear the Due-On-Sale Clause“, the lender, at their discretion if they find out about the sale or transfer, has a civil right under the mortgage contract to call a loan due upon a transfer of the property, but there is absolutely nothing illegal about violating this clause. It’s a contractual (civil) issue, not a criminal offense.

Unfortunately, issuing an insurance policy in the name of the new owner for a property that has been purchased with a wraparound mortgage is normally the biggest obstacle which presents the highest possibly of making the underlying mortgagee aware of the sale.  The reason for this deals with insurance law and the fact that both parties are trying to ‘skirt’ the system to keep the underlying lender in the dark about the transaction and insurance is simply not designed for this purpose. Since this article is concerned only with the insurance aspect of these transactions, we will forgo discussing how to record (or not record) deeds and other similar topics and focus solely on the property’s hazard insurance.

There are really only two ways to insure property taken ‘Subject To’ or with a wraparound purchase.  The first involves more of a traditional approach as outlined in my article “How to Insure Subject-To Properties” and the second is outlined on this page.

With regards to the due-on-sale clause which causes so much worry in these types of seller-financed transactions, it is important to be aware of an Act of Congress known as the Garn–St. Germain Depository Institutions Act of 1982.

This Act outlines some exceptions to a property transfer in which the underlying lender may not legally enforce the ‘due on sale’ clause in a mortgage.  Without listing the entire Act itself, the specific portion of this Act that applies to Wraparound Mortgage and Due on Sale clauses is (U.S.C.) 1701j-3 (Preemption of Due-on-Sale Prohibitions) and more specifically, section (d)(8), “Exemption of Specified Transfers or Dispositions”

Exemption of Specified Transfers or Dispositions

“With respect to a real property loan secured by a lien on residential real property containing less than five dwelling units, including a lien on the stock allocated to a dwelling unit in a cooperative housing corporation, or on a residential manufactured home, a lender may not exercise its option pursuant to a due-on-sale clause upon –

1.      The creation of a lien or other encumbrance subordinate to the lender’s security instrument which does not relate to a transfer of rights of occupancy in the property;

2.      The creation of a purchase money security interest for household appliances;

3.      A transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety;

4.      The granting of a leasehold interest of three years or less not containing an option to purchase;

5.      A transfer to a relative resulting from the death of a borrower;

6.      A transfer where the spouse or children of the borrower become an owner of the property;

7.      A transfer resulting from a decree of a dissolution of marriage, legal separation agreement, or from an incidental property settlement agreement, by which the spouse of the borrower becomes an owner of the property;

8. A transfer into an inter-vivos trust (see note below) in which the borrower is and remains a beneficiary and that does not relate to a transfer of rights of occupancy in the property; or

9.      Any other transfer or disposition described in regulations prescribed by the Federal Home Loan Bank Board.”

NOTE: For the purpose of clarity, “inter-vivos trust” is the legal term for a revocable trust (aka ‘Living Trust’) that is created while the donor is still alive in order to hold property for the benefit of another.

Fortunately, while written in ‘legalese’, the Garn Act is clear (at least in legal terms) when it specifically states that it applies to residential one-to-four family homes.  In other words, while it states the type of real property that is affected, it makes absolutely no mention that it must also be “owner-occupied.”

So, having now mentioned the Garn–St. Germain Act, the question is what does this have to do with property insurance?

Keep Reading…

Since we have determined that section (U.S.C.) 1701j-3 (d)(8) specifically allows for a transfer into an ‘inter-vivos trust’ (Living Trust), the two parties can take advantage of a specific type of trust known as a ‘land trust’ – which is exempted under this Act.  A land trust, which is very common, is a form of revocable living trust which is created by the use of two legal documents. This type of trust consists of a:

1.      A trust agreement between the creator (aka “grantor”) of the trust and the trustee that legally defines the trust arrangement; and,

2.      A deed from the creator (grantor) to the “trustee”.

In this arrangement, the trustee holds title for the benefit of the grantor and, in this situation; the grantor is also identified as the “beneficiary.” So far all requirements are met.

So, if you as a property owner simply decide to place your property into a land trust for estate planning or anonymity reasons, you have not violated the acceleration (due on sale) clause so long as there isn’t a change in occupancy. Everything is fine.

However, let’s say you are a property owner who needs to sell his or her property and the only realistic option is through the use of seller-financing. The obvious concern you may have is the “due on sale” clause in your mortgage.  While there is no ‘perfect’ solution, here’s the best and safest way for completing this property transfer while keeping the underlying lender blissfully unaware that a sale or transfer has ever taken place.

  • You (the seller) create and sign a trust agreement with the buyer. You (the seller) are both the “Grantor” (sometimes also known as the “Settlor” or Trustor”) and the “Beneficiary” and the buyer is the “Trustee”;
  • You (the seller) then transfer title to the property to the “Trustee” (the buyer). No violation of the due-on-sale clause has taken place because you (the seller) still remain as the “Beneficiary” of the trust.
  • You (the seller) then assign your interest under the trust as “Beneficiary” to the new buyer. The buyer is now both the “Beneficiary” and the “Trustee” and this assignment of interest is not recorded in any public record and the lender has no way of learning about the transfer or sale. The buyer moves into his or her new home and begins making payments.

Technically, your assignment of your interest in the trust as the “Beneficiary” to the buyer does constitute a violation of the due-on-sale clause, however, who’s going to notify the original lender? Neither you nor the buyer are going to send a letter or make a phone call informing the lender of the property transfer and there is no public record of the assignment – so it’s a perfectly legal – and invisible – transaction.

To be blunt, there are really only three ways I which the lender might learn about the transfer of the property, the first two being virtually non-existent with the most likely scenario being the third.

  • The lender notices a name change of the deed. This is extremely unlikely since lenders never have any reason whatsoever to even look at a deed after their initial closing has taken place (unless they are foreclosing) and they certainly don’t have employees at every County clerk’s office scanning every single deed of trust that gets filed. This is a non-issue and you probably have a better chance of getting struck by lightning on the moon than of a lender finding a name change on a deed after-the-fact.
  • Someone at the lender’s loan servicing location notices that the name on the payment check is different than the borrower’s name. Extremely unlikely. Payment processing centers are usually staffed with uber-apathetic clerks who couldn’t care less about anything else except whether or not a check is in the envelope that they just opened and how much longer they have left before the end of the day.  They have virtually nothing to do with mortgage officers or other bank employees and are often actually third-party companies or subsidiaries of the lender that are responsible for servicing loans. The check arrives, they post the payment, open the next envelope… Again, another non-issue.
  • Different named insured on the insurance policy.  This is the most likely cause of the lender getting wind of the transfer. However, since title to the property was transferred into a land trust, the named insured on the policy should actually be the trustee of the land trust itself. The lender won’t have any problem with this since it is a common estate planning strategy that occurs often; especially with high-net-worth individuals. The only caveat to this is that not all insurance companies will allow policies to be issued for a trust in the name of the trustee. Many will but some won’t. There are some carriers whose underwriting and eligibility guidelines specifically prohibit insuring properties titled in the name of a trust. There is no compelling reason for this refusal to insure a trust-held property since there is absolutely no increased liability exposure or risk of physical loss, but it exists with some companies nonetheless and even the underwriters and management staff themselves cannot explain why this is the case – but it is.  This may limit your options when selecting a new insurance policy.

While more complicated than the traditional wrap-around insurance scenario where the new buyer must purchase an insurance policy in his or her name with the seller listed as an additional insured or additional interest, if offers more anonymity and liability protection for the buyer and greatly reduces both the visibility of the transfer to the underlying mortgagee and lessens even the possibility of the loan being called due.