A land contract is a form of seller financing. The owner of the property agrees to sell the property directly to the buyer, financing the sale herself according to the terms of the contract. Upon the satisfactory completion of the agreed-upon payment schedule, the owner transfers ownership of the property to the buyer by means of a deed.
What Is a Land Contract?
Land contracts are often used when the buyer can't obtain third-party financing. This doesn't necessarily mean the buyer's a bad credit risk, although it may. Sometimes, the buyer's inability to get a mortgage loan has more to do with general financial conditions, such as a recession. Often the sale occurs because the property's value isn't recognized by lenders.
Properly done, a land contract benefits both buyer and seller by enabling a sale that lenders wouldn't finance. In San Francisco, for instance, buyers of Mission District properties in the 1960s had trouble obtaining mortgages from banks, which at that time saw the area declining. One such self-financed sale for $25,000 of a small redwood warehouse near Mission Street was eventually resold in 2008 for $5 million. In 2018, the Mission District is considered one of hottest areas in San Francisco's exploding real estate market.
Land Contract Versus Rent-to-Own
Land contracts and rent-to-own agreements have common elements. In both cases, the underlying motivation for the property owner may be to sell a difficult property and in both cases buyers may not have resources or credit histories enabling them to obtain a mortgage through a commercial lender. In either situation, the title passes to the buyer at the end of the contract period.
The biggest difference between the two agreements is that in a land contract, the buyer can obtain title information before buying and can register the sale with the county at the time of sale. The prospective buyer in a rent-to-own agreement can't do either because the title remains with the seller until the buyer buys the property at the end of the agreement period.
Another difference between the two is that a land contract is fully binding when it's entered into; the usual terms of a rent-to-own agreement allow the renter to leave either at any time or after an initial period (one year, for example). There are no penalties, other than the termination of the agreement that might eventually have allowed the buyer to apply some or all of the rent payments against the purchase price.
How Does a Land Contract Work?
A land contract works by making the buyer the "equitable owner" when the contract is signed, meaning a party with an equity interest. Although legal ownership remains with the seller until the transfer by means of the deed, equitable ownership makes the buyer responsible for property taxes, maintenance and any of the other costs normally assumed by the owner. His equity interest means that the seller cannot enter into a sales agreement with a third party. Rent-to-own contracts may or may not require the prospective buyer to pay property taxes; more often they do require the renter to maintain the property, but the title remains with the owner until the buyer pays the owner whatever is owed at the end of the rent-to-own contract period. Sales to third parties in the midst of a rent-to-own contract period are not unknown. The prospective buyer needs to have specific language included in the agreement that prevents this.
If the buyer defaults in a land contract, usually the result of failing to make the agreed upon monthly payments, before the seller can regain full control of the property, they'll need to file a "land contract forfeiture" action in court. If the action succeeds, the buyer loses equitable ownership and forfeits all payments.
What Happens at the End of the Contract Period
It's possible to draw up the deed transferring ownership to the buyer at the end of the land contract period. However, in a NOLO article describing ways of closing on a land contract, attorney Kelsey Cooke recommends the deed being drawn and signed by both parties at the time of closing on the land contract, that is, at the beginning of the contract period rather than at the end. This deed can then be held in escrow until the successful completion of the payment terms of the land contract. Depending on which state you live in, the escrow holder can be a title company, a private attorney or a financial institution.
A land contract agreement usually begins with a discussion of the agreement terms by a buyer and seller, neither of whom may have knowledge or experience in real estate law. At some point in the process, each party will benefit from professional legal advice. The final agreement is more likely to work the way the parties intend if attorneys for both buyer and seller have shaped the agreement. This same caution pertains to rent-to-own agreements.