Many investors have asked me a variety of questions concerning a clause that is common in mortgages and promissory notes called a “due-on-sale clause”. A due-on-sale clause is a clause in a mortgage and/or promissory note that provides that a default may be declared and the loan may be called due (repaid in full) upon sale or transfer of ownership of the property secured by the mortgage without the bank’s consent. In other words, the bank has the right to demand full payment of the note if the property is transferred without the bank’s permission (this does not include a traditional closing where the bank is paid off and the lien released at closing).
…you may need to transfer your investments… into a limited liability company (or companies).Edward Schenkel
Why should a real estate investor understand be aware of the due-on-sale clause in a mortgage? For several reasons. First, as an investor, you will want to make sure you are protected by keeping the property in a limited liability company so you are shielded individually if there is a lawsuit. This means that you may need to transfer your investments, which are currently held in your name, into a limited liability company (or companies). If there is a due-on-sale clause, such transfer may technically violate the clause. Accordingly, you should be aware that if you transfer the properties in a company without the bank’s consent, there is a risk the bank could declare that this is an act of default and call the loan. However, this is low risk since the bank’s primary concern is receiving the monthly mortgage payment and that the property is not wasting away. Also, if the bank did complain, you could transfer it back. Still, to be safe, it is recommended you either purchase the property in a corporate entity or that you obtain the bank’s consent before transferring the property to your company, even if it is a sole member limited liability company where you are the sole member.
This means that you will have more bargaining power to discuss the terms you want in and out of the loan documents.Edward Schenkel
Second, a good reason to understand the due-on-sale clause is so you can negotiate it out of future deals, or at least negotiate room to transfer to companies where you own an interest. As an investor progresses in his or her career, he or she may find a good deal that involves seller or alternative financing. This means that you will have more bargaining power to discuss the terms you want in and out of the loan documents. Being aware of this clause means that you can either take it out, allowing you to freely transfer the Property to your companies or partners, or draft a due-on-sale provision that is more flexible and suitable to your needs.