Contingency Clauses in Real Estate Purchase Contracts

Contingency clauses are some of the most important components of a real estate purchase contract, and can provide significant protections to buyers of real estate. A contingency clause typically states that a buyer’s offer to buy property is contingent upon certain things. For example, the contingency clause may state, “The buyer’s obligation to purchase the real property is contingent upon the property appraising for a price at or above the contract purchase price.” Under this contingency, the buyer is relieved from the obligation to buy the property if the buyer obtains an appraisal that falls below the purchase price. Because contingency cPhoto of a signpost with different directions with the text "Contingency Clauses in Real Estate Purchase Contracts."lauses provide the buyer a way to back-out of a contract they can be excellent tools for real estate investors who make numerous offers on properties.

Contingency Clause Examples

Here are some contingency clauses to consider in your real estate purchase contract.

1. Financing Contingency. A financing contingency clause states something like, “Buyer’s obligation to purchase the property is contingent upon Buyer obtaining financing to purchase the property on terms acceptable to Buyer in Buyer’s sole opinion.” Some financing contingency clauses are not well drafted and will provide clauses that say simply, “Buyer’s obligation to purchase the property is contingent upon the Buyer obtaining financing.” A clause such as this can cause problems as the Buyer may obtain financing under a high rate and thus may decide not purchase the  property. However, because the contingency only specified whether financing is obtained or not (and not whether the terms are acceptable to buyer), the clause can be unhelpful to a buyer deciding not to purchase the property. Some financing clauses are more specific and, for example, will say that the financing to be obtained must be at a rate of at most 7% on a 30 year term and that if the buyer does not obtain financing at a rate of 7% or lower then the buyer may exercise the contingency and back out of the contract.

2. Inspection Contingency. An inspection contingency clause states something like, “Buyer’s obligation to purchase is contingent upon Buyer’s inspection and approval of the condition of the property.” Another variation states that the Buyer may hire a home inspector to inspect the property and that the Seller must fix any issues found by the inspector and if the Seller does not fix the items specified by the inspector then the Buyer may cancel the contract. Inspection clauses are very important as they ensure that the Buyer is obtaining a valuable asset and not a money pit full of defects and repair issues.

Other important contingency clauses are clear and marketable title clauses, approval of seller disclosure documents, and rental history due diligence information (e.g., rent rolls, lease copies, financials, etc.).

Contingency Clause Issues

When using contingency clauses buyers should pay attention to a few key terms. I’ve personally seen many disputes arise as a result of one of the following issues.

1. What Happens to the Earnest Money. One important consideration that is often vague in real estate purchase contracts is what happens to the buyer’s earnest money when the buyer exercises a contingency. Does the buyer receive a full return of the earnest money? Does the seller keep the earnest money? If the contract is silent and if you as the buyer exercise a contingency, don’t count on the seller agreeing to a release of the earnest money as they are often upset that you are not going to purchase the property. Make sure the contract clearly states something like the following, “If Buyer exercises any contingency, Buyer shall receive a full return of any earnest money deposit or payment to Seller.”

2. Contingency Deadlines. Another important contingency clause issue is the date of the contingency clause deadline.  Most contingency clauses have expiration dates that occur well before closing. Those dates should typically be somewhere from 2 weeks to 2 months from the date of the contract, depending on the purchase and seller disclosure items and the type of property being purchased. For example, single family homes will typically have a shorter window as financing and inspection can occur more quickly than would occur under a contract to purchase an apartment building. Whatever the deadline is, make sure that the deadline is set far enough out so that you can complete your contingency tasks. You need to make sure you have enough time to obtain adequate financing commitments, to properly inspect the property, and that you have enough time to review the seller’s disclosure documents. Setting a two week deadline is sometimes done but two weeks is usually not enough time to complete financing commitments, inspection, and due diligence activities that are necessary to determine whether you are going to commit to purchasing the property. If contingency deadlines are approaching and you need more time, then ask the seller for an extension before the deadline arrives. If the Seller refuses an extension, then exercise the contingency you need more time to satisfy.

3. Exercise You Contingency in Writing. If you do exercise a contingency and decide to back-out of the purchase of the property, make sure you do it in writing. Don’t rely on telephone calls or even e-mails (unless the contract permits e-mails as notice). Additionally, make sure that the reason for the contingency and that the date of the contingency are put in writing and are sent to the seller in a method where the date can be tracked in accordance to the notice provisions of the contract. For example, if the contract requires a contingency to be noticed by fax or hand delivery, don’t rely on an e-mail to the seller or the seller’s agent as such communication will not invoke the contingency.

Once the deadline to exercise a contingency has passed, the buyer is obligated to purchase the real property and may be sued for specific performance (meaning they can be forced to buy) or at the least the buyer will lose their entire earnest money deposit. Contingency clauses are the best defense mechanism to a bad deal and should always be used by real estate buyers. Keep in mind that until you close on the property, the only investment you have is a contract and if you have a bad contract, then you have a bad deal.

IRAs and the UBIT/UDFI Tax Exception for REITs

Photo of shiny high-rise buildings with the text "IRAs and the UBIT/UDFI Tax Exception for REITs."An IRA may invest into a real estate investment trust. Real estate investment trusts (“REIT”) are trusts whereby the company undertakes certain real estate activities (e.g. own or lend on real estate) and returns profits to its owners. An IRA may invest and be an owner in a REIT. As many self directed IRA investors know,  a form of unrelated business income tax (“UBIT” tax) known as unrelated debt financed income tax (“UDFI” tax) can arise from real estate leveraged by debt.

Many REITs engage in real estate development activities and/or use debt to leverage their cash purchasing power and as a result may cause a form of UBIT tax known as UDFI tax to IRA owners. Most REITS will not pay corporate taxes and as a result will not be considered exempt from UBIT tax as a result of having paid corporate tax. However, income from REITs is still typically exempt from UBIT and UDFI tax because the definition of a “qualified dividend” in a REIT has been defined to include dividends paid by a REIT to its owners. IRS Revenue Ruling 66-106. Qualified dividends from a REIT are exempt from UBIT and UDFI tax. REITs can be publically traded or private trusts but are not easy to establish. They require at least 100 owners and must distribute at least 90% of their taxable earnings to their owners each year. Despite the general application of exception to UBIT/UDFI tax for REITs, a REIT may be operated in a manner that will not allow for qualified dividends to be paid and therefore income from the REIT would not be exempt from UBIT/UDFI tax. If you’re investing into a REIT with an IRA, make sure you know whether the REIT intends to be exempt from UBIT/UDFI tax or not. As discussed, most will be exempt from UBIT/UDFI tax but some REITs may choose to operate in ways that will not qualify for the exception. Because UBIT/UDFI tax is about 39% at $10,000 of annual income this is something every IRA should understand before investing into a REIT.

 

What to Use?: A Warranty, Grant or Quit Claim Deed

When it comes to transferring property, such as our rental properties into LLCs and our personal residence into a Trust, it can be confusing understanding the differences between a Quit Claim Deed, Warranty Deed and other terms that may be thrown out.

Some states use the term “Grant Deed”, California being one of the most preeminent. The reality is that a Grant Deed can be used as a Quitclaim Deed OR a Warranty Deed. It essentially depends on the verbiage used inside the terms of the Deed itself. Bottom line- Make sure that you look at the language used in the deed itself. Don’t think that because you have a Grant Deed you have all of the benefits of a Warranty Deed. Here is a brief description of each type of Deed:

Quitclaim Deed

A quitclaim deed transfers whatever ownership interest a person has in a property. It makes no guarantees about the extent of the person’s interest. Quitclaim deeds are also frequently used when there is a “cloud” on title — that is, when a search reveals that a previous owner or some other individual, like the heir of a previous owner, may have some claim to the property. The transferor can sign a quitclaim deed to transfer any remaining interest.

Warranty Deed

A warranty deed transfers ownership and explicitly promises the buyer that the transferor has good title to the property, meaning it is free of liens or claims of ownership. Also, whatever the ‘title’ of the deed is you may use, check the verbiage in the deed itself to understand what warranties you may be making, if any. The transferor guarantees that he or she will compensate the buyer if that turns out to be wrong. The warranty deed may make other promises as well, to address particular problems with the transaction.

Our Recommendation

Always double check the ‘local’ state and county laws regarding the type of deed to use when transferring property and what the different types of deeds actually provide. HOWEVER, we generally recommend the Warranty Deed when transferring property to yourself, your trust, or your own company; because we want to make sure that the Title Policy and all of its benefits transfer to the Grantee of your deed.