CHAPTER 1 - CONTRACTS

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1 CHAPTER 1 - CONTRACTS Notes: Real estate transactions are ruled by specific documents such as leases, listings and offers to purchase. Such documents spell out the contractual rights and obligations agreed to by parties to certain transactions. Therefore, much of this chapter addresses the general area of law known as contract law. An understanding of contracts is essential in dealing with real estate. In simple terms, a contract is an agreement enforceable by law. Essential Elements for Valid Contracts Contracts that meet all legal requirements are valid and enforceable, which means that either party can hold the other party responsible for his or her agreement. Three requirements must be met before a contract is valid: 1. Offer and Acceptance To have a valid contract, there must be a meeting of the minds (mutual assent), nominally evidenced by an offer and acceptance. An offer is made by an offeror and expresses that person's willingness to enter into a particular agreement. The offeree is the person to whom the offer is made. When the offer is accepted by the offeree, a contract is formed. Unless the offer specifies a particular period of time for acceptance, it is considered to be held open for acceptance for a reasonable time. A newspaper or online advertisement usually is not regarded as an offer but merely an invitation to negotiate. If an offer states a time for acceptance but fails to indicate "time is of the essence," the courts could allow acceptance after the period for acceptance expires. If time is of the essence is stated in the offer, acceptance must generally occur within the period specified or the offer is canceled automatically. If the offer fails to specify the form for acceptance (letter, telephone call, telegram or even performance), the offer may be accepted in any reasonable manner. Under the Statute of Frauds (below), offers and acceptances for real estate transactions must be in writing. Acceptance does not take place until the offeror is notified, which usually is by delivery of a signed accepted copy of the offer to If you need further explanation or perspective, the offeror. remember the valuable online Q&A resource. a) Revocation of Offer For this Uniform course, in your browser type If the offeror did not receive any consideration for making the offer, the or click the link in the Uniform e-book while online. offeror can withdraw or revoke the offer any time prior to its acceptance. This applies even when the offeror promised 1

2 to keep the offer open for a specified period of time. The act of placing an acceptance in the mail is acceptance; however, a mailed revocation of an offer does not take effect until it is received. b) Death of Offeror The death of the offeror or offeree prior to acceptance voids the offer immediately. The death of the offeror or offeree after acceptance generally has no effect on the agreement, which becomes binding on the estate of the deceased party. However, if a contract called for the personal services of one of the parties to the contract, such as the services of a well-known architect, that party s death would terminate the agreement. The death of a corporate officer of the offeror or offeree corporation does not terminate the offer because a corporation is regarded in law as a separate being. c) Counteroffer An acceptance that varies in any way from the original offer due to a new or changed requirement customarily is regarded as a counteroffer. Because a counteroffer is really a rejection of the original offer, the original offeree now becomes an offeror with a new offer. The original offeror (now the offeree) can either accept the new offer and form a binding contract or reject that offer. Once an offer is rejected, it is considered dead, and any later acceptance constitutes a new offer. d) Options An option is a right to buy or lease property at a specified price during a designated period of time. The option right is given to the optionee by the optionor (owner). To create a valid option, the optionee must have given the optionor something of value as consideration (see below) to keep the offer open. Once given, an option cannot be revoked by the optionor, which makes the option an irrevocable offer. Right of First Refusal A right of first refusal gives the holder the right to buy (or lease) a property only if the owner decides to sell (or lease) it to another person. It is the right to match an offer - within a designated period of time - that an owner is otherwise prepared to accept. The owner, however, is under no obligation to sell (or lease) the property. This differs from an option, where the owner must sell (or lease) if the optionee wishes to exercise the option. Rights of first refusal are often found in leases giving the tenant first chance at any purchase or later lease agreement the owner wishes to accept. 2. Consideration For an agreement between two parties to be binding, the parties must give or promise something of value, called consideration. A promise unsupported by consideration really is a promise to make a gift and, therefore, is unenforceable in a court of law. Consideration does not have to be fair, although grossly 2

3 inadequate consideration could be evidence of fraud or undue influence. Love and affection are deemed to be good consideration. However, they are not deemed to be the valuable consideration required to support a contract. Valuable consideration is a right, an interest, a profit, or even an agreement to refrain from any (lawful) act, any one of which the promissor considers valuable. Consideration, then, need not be money, but it must have worth. 3. Absence of Defenses Even though a contract may have Offer, Acceptance, and Consideration, making it (at least preliminarily) a valid contract, some defense may arise from one or more of the parties or the terms of the contract itself, rendering the contract either unenforceable, voidable, or void. Unenforceable means that in the event of a legal dispute between the parties regarding the terms or execution of the contract, there is a Rule that prevents the court from even hearing (enforcing) the contract. The contract may have been perfectly valid and one of the parties is truly in "breach" - but they didn't follow the Rule, so the court throws it out. Rules that could cause a contract to be unenforceable: a) Statute of Limitations: the injured party waits too long (longer than the law says) to file suit. It spite of the merits of the case, the court can't even hear the case. A state statute of limitations defines the period of time during which various types of legal action must be brought. The statute of limitations starts on the date an obligation is due. If no payment is made or no legal action taken during the prescribed period, the right to enforce the agreement is lost. Example: assume that your state has a four-year statute of limitations on written contracts. If a person was obligated under a written contract to pay the sum of $10,000 to another person by a specified date, the person entitled to the $10,000 would be barred from forcing a collection if more than four years had elapsed from the date the money was due. b) Statute of Frauds: (is constantly tested on the Uniform license exam.) This was created over 500 years ago to prevent people from later returning to say they had a verbal agreement they wanted the court to enforce. So the English Courts made up a list of items that they courts weren't even allowed to hear (meaning that a lawsuit couldn't even be brought to court if a party were trying to enforce a contract based on one of the topics on the list.) Examples: All agreements for the sale of real estate. In most states, listing agreements must be in writing because real estate is involved; however, a few states allow oral listing agreements that are one year or less in term. Any lease for more than one year. 3

4 Contracts that by their terms cannot be fully performed within one year of the parties entering into the agreements Promises to pay the debt of another Promises made in contemplation of marriage. (This means promises for some thing or some action, made in return for a promise to marry. It does not simply mean a promise to marry must be in writing.) Contracts for the sale of personal property for more than $500 All of these examples would have to be in writing, or the court would (and will to this day) throw out the case. This is what is meant by unenforceable the court will not enforce it. Otherwise, verbal contracts can be valid and enforceable, unless they are required by the statute of frauds to be in writing. Remember: The Statute of Frauds does not say that all contracts must be in writing. It also does not say that all real estate contracts must be in writing. It simply says that if it is a real estate contract, and the parties try to bring suit, the court will not enforce that real estate contract. It won t even hear the case! c) Doctrine of Estoppel: The courts may allow enforcement of a verbal real estate purchase contract even though the statute of frauds requires a written agreement, in cases where there has been partial performance based on the verbal agreement. This is the doctrine of estoppel whereby a person is prohibited ( estopped ) from denying his or her verbal promise after the other party has acted to his or her detriment after relying on that promise. Void - means the problem with the contract or the parties is so fundamental, that the court will treat it as if the contract never existed. It could be an agreement that is void because it offends our basic sense of morality or is clearly illegal. Example: murder or a drug deal. It doesn't matter whether one or both parties want to go through with the agreement - the court will in no circumstance recognize it. Also a contract presumably would be void if both parties lacked the required consent (See, mutual mistake, below) or capacity (See, Incompetent Parties, below). Voidable - means that the problem is with one of the parties - such as a minor. The party with the incapacity would be able to claim the contract invalid. Example: Janet and Fred are only 17 when they contract to buy a house. They may back out of that contract at any time, even if the seller wants to enforce it. However, if the minor validates the contract (also known as "ratifying") by actually paying for the property, then the contract will be held by the court to be valid. So, the only way a potentially-voidable contract will end up getting "voided" is if the party with the option to void (stop) it chooses to void it. (That s why it s called voidable. On the other hand, if that party chooses to go through with the contract, then the issue of being "voided" will disappear. 4

5 Examples of Defenses: Problems with the parties or formation of the contract, which would void a contract, or make it voidable: a) Illegal Purpose - void To be enforceable, a contract must be for a legal purpose. A contract made for an unlawful purpose is illegal and generally would be void and could not be enforced by either party. Example: murder or a drug deal. b) Incompetent Parties void or voidable (depending on state) Competency is a legal "term of art" meaning that contracting parties must have mental and legal capacity to enter into a valid contract. Persons found to be mentally incompetent cannot contract. Legal capacity is determined by legal age, which is set by law. Example: A legal minor. Most states have set the legal age for contracting at 18. In some states, deeds by minors are considered void, while in other states, (Colorado, for example) deeds by minors are considered voidable, which means that the minor has the option to choose to be bound by the agreement or to void it. A minor may disaffirm ( deny ) a contract within a reasonable period of time after reaching contractual age; however, a minor cannot disaffirm a contract for a necessity, such as food or clothing. A minor can buy real estate from an adult; however, the minor has the option of voiding the transaction. Therefore, great care must be exercised when dealing with a minor. A minor could, of course, receive real estate as a gift. In some states, emancipated minors, such as married minors, are allowed to contract as adults. The right of convicted prisoners to contract is governed by individual state laws. These rights generally are restricted. c) Parol Evidence Rule The Parol Evidence Rule must be linked to the Statute of Frauds. It provides that where an agreement has been put in writing and the parties intend it as the final and complete expression of their agreement, evidence of any earlier statements (oral or written) is not admissible to vary, add to or contradict the terms of the writing. The Parol Evidence Rule will generally keep parties from trying to introduce evidence in court that they really meant something other than what they stated in the contract. d) Mistake of the terms or facts of a contract. 1) Unilateral mistake on the part of one party only will not allow that person to get out of the contract. Example: Buyer mistakenly believed that the zoning would allow a particular use, and the seller chose not to tell buyer that her plans were impossible: The contract is still valid and binding. 2) Mutual mistake of fact by both parties, however, or makes the contract unenforceable. (Also may be called bilateral mistake.) 5

6 Example: Assume the buyer and seller both believed an irregularly shaped parcel contained the necessary square footage to construct a duplex. They later discovered that the actual square footage was less than believed so that a duplex could not be built: The buyer could likely void the agreement based on the mutual mistake. e) Duress or Menace Contracts entered into under mental or physical force (duress) or threat of force (menace) may be voided by the injured party. Example: A contract signed at gunpoint. f) Fraud Fraud is an intentional statement or omission that persuades or influences another to act to his or her harm. It can also be a false statement made by a person who did not know whether it was true or false. Concealing a material (key, important) defect or fact could also be fraud (negative fraud). Fraud can be a criminal as well as a civil wrong. A contract entered into because of fraud may be voided by the injured party. Fraud as to the nature of the contract could make the contract void rather than voidable. Examples: An owner representing a purchase contract as an option to buy; a seller representing a house as brand-new, when in fact it is 40 years old. g) Misrepresentation Misrepresentation is a misstatement or concealment of an important fact so that another party is led to act to his or her detriment. Whereas fraud requires the element of intent to deceive, misrepresentation could be a false statement made by someone who believed it to be true. Misrepresentation also allows a contract to be voided and, like fraud, could subject the wrongdoer to civil damages. If a person knew that a statement made to them was false or that a material fact was being concealed, the contract would not be voidable by that person because he or she was not deceived into acting to his or her detriment. Puffing - is merely a statement of opinion. It is not generally considered sufficient basis to void a contract even though the statement influences another party to act to that party's detriment. Example: A salesperson says: this is a good value. h) Undue Influence Undue influence is where a person does not act voluntarily because of an overpowering relationship. If Abe enters into an unfair contract with Bob against Abe's own free will because of their confidential relationship (client/attorney, broker/owner, doctor/patient, parent/child), Abe can void the agreement. Example: A senior citizen is coerced by her lawyer to sell her property by a high-pressure sales technique that preys on her fears of being abandoned by her loved ones. 6

7 i) Unconscionable Contracts If a contract is so harsh that a court considers it unconscionable (shockingly unfair), the court will refuse to enforce it. j) Impossibility of performance: a change in the law or circumstances surrounding the contract makes it impossible to fulfill the contract. In these rare cases, the parties are legally relieved of their duty to perform. Example: The parties have a contract for the purchase of a industrial warehouse, but the zoning changes to residential. Since it is impossible to comply with the law (zoning) and still uphold the contract, the parties would not and could no longer perform. Remedies for Breach of Contract A breach of contract is the failure of a party to comply with a material (key) contractual provision. Following are some legal remedies for broken contractual promises. 1. Compensatory Damages Money awarded by the court to the injured party to make up for the loss suffered is called compensatory damages. Assume a seller agreed to sell a lot for $100,000 and later refused to honor the agreement. If the buyer had to pay $110,000 for a similarly desirable lot, the buyer could seek compensatory damages in the amount of $10,000. The injured party has a duty to try to keep the damages as low as reasonably possible when a contract is breached. This effort is referred to as mitigation of damages. For example, if a tenant breaks a lease, the landlord has a duty to use reasonable effort to obtain a new tenant. If the contract is partially executed, and the injured party will save on expenses, or can resell materials (salvage), this amount will be reduced from the court's award. Example: "Contractor contracts to build a deck on Owner's house for a fee of $10,000. Contractor plans on expenses of $8,000 and $2,000 profit. After Contractor expends $4,000 in expenses during construction, Owner backs out of the contract. Contractor can sell the lumber he has already purchased for $1,000 salvage value." Contractor's compensatory damages would be $5,000, ($4,000 (expenses) - $ 1,000 (salvage recovered) + $2,000 (profit not realized) = $5,000). 2. Punitive or Exemplary Damages Courts may award damages beyond compensatory damages to punish (punitive) or make an example (exemplary) of a party who committed a willful and/or an outrageous act or breach of an agreement. 7

8 3. Nominal Damages If a breach does not result in an actual dollar loss, token amounts - called nominal damages - are awarded. For example, a court might award nominal damages for a wrongful trespass where no money damages occurred. 4. Liquidated Damages Liquidated damages are breach-of-contract compensation agreed on by the parties at the time of their agreement. If liquidated damages are set too high, the courts might determine that they are actually penalties, which are unenforceable. Example: Construction contracts often include a daily liquidated damages amount if a job is not completed on time; Purchase contracts customarily provide for the buyer to give up the earnest money deposit in the event of the buyer's breach. 5. Specific Performance If an owner entered into a contract to sell his or her real property and later refused to convey the property, rather than money damages the buyer could request the court force seller to sell the parcel (specific performance). Because every parcel of real estate is unique, money damages are not always an adequate remedy. Courts will, therefore, grant the remedy of specific performance for real estate contracts. Courts generally will not grant specific performance if the consideration is not considered adequate. 6. Injunction An injunction is a court order to stop doing a certain activity (cease and desist). Injunctions may be permanent or temporary. 7. Declaratory Relief This remedy consists of a court determination of rights and duties of the parties before actual damages occur. 8. Reformation An action to correct a mistake in an agreement or a deed is called reformation. The action amends an agreement to conform to the original intention. 9. Rescission Rescission cancels the contract and restores the parties to the positions they held prior to entering into the contract. One party can use a breach by the other party as the basis for rescinding the contract. Restitution is the return of consideration when a contract is rescinded. 10. Waiver A party to a contract can waive a contractual breach by the other party and choose to remain bound by the contract. For example, a buyer might waive the seller's failure to correct a defect and, in doing so, insist on closing. A party also can waive any provision that is for his or her sole benefit. For example, if an 8

9 agreement was contingent on the buyer obtaining an 80 percent (of sale price) loan at no more than 7% interest, buyer could waive the contingency if such a loan could not be obtained and choose to go ahead with the transaction. Waiver leaves the parties as they are; rescission puts them back the way they were. 11. Accord and Satisfaction Accord and satisfaction is the agreement to accept a lesser consideration than that specified in a contract. Such agreement is common in construction contracts when there is disagreement as to proper performance of the work. 12. Assignment Assignment of a contract is the transfer of all the interests of one of the contractual parties to a third person. Contracts that do not specifically prohibit assignment can be transferred. However, contracts that are personal in nature (for particular personal services) cannot be assigned. For example, if a party contracted with a particular distinguished architect to design a building, that architect could not assign the contract to another architect because the contract would be considered personal in nature. In an assignment, the assignee stands in the shoes of the assignor and is primarily liable for the contractual duties of the assignor. The assignor, however, retains secondary liability, which means that the assignor could be held to the contract should the assignee fail to perform. (This situation differs from a novation, in which a new party is substituted for the old party.) 13. Novation Substitution of a new contract for an old one is called novation. Parties to a novation agree to cancel the old contract in favor of the new agreement, as when a buyer and a builder make a contract for a model home that is different from the one originally chosen and named in a contract. Novation also is considered to occur when all parties agree to the substitution of a new party for one of the original contract parties and to the full release of the original party from all obligations under the agreement. (Novations may be used in loan assumptions in which the seller is released from all loan obligations by the substitution of the buyer.) Types of Contracts 1. Bilateral Contract A promise made in exchange for a promise is a bilateral contract. Sales agreements generally are bilateral - a promise to buy is given for a promise to sell. Similarly, an exclusive right-to-sell listing may be a bilateral contract where the owner agrees to pay a commission if the agent is successful and the agent in return agrees to use his or her best efforts to locate a buyer. 9

10 2. Unilateral Contract A promise made in exchange for an act is a unilateral contract. Acceptance of an offer is not in the form of another promise but in the form of an act. Examples: Broker promised to pay a salesperson a $50 bonus for each listing for a four-bedroom house. If the salesperson obtained such a listing, the salesperson would be entitled to the bonus. Even though the salesperson was not obligated to perform, his or her performance of an act made the acceptance. Henry gives Eliza $500 for a first right-of-refusal should Eliza decide to sell her house in the next 5 years. (If Eliza does decide to sell, she has to give Henry at least the option of matching any offers.) Even though Henry has given Eliza the $500 for the option, Henry still is not required to buy the house from her. However, if Eliza does decide to sell during the agreed-upon period of the option having accepted the ($500) option, she is required to give Henry that first right-of-refusal. Only one side is required to act (unilateral). 3. Executed Contract An executed contract is a contract that has been fully performed. 4. Executory Contract An executory contract is a contract that is not yet fully performed. (It is in the process of being performed.) 5. Express Contract An express contract is one specifically agreed to, either verbally or in writing. Because they are required by the Statute of Frauds to be in writing, real estate contracts are express contracts. 6. Implied Contract An implied contract is one that is understood to be a contract because of actions of the parties, although a specific agreement is not stated. For example, in requesting a carpenter to make repairs, you might fail to specify a fee. It is implied, however, that you will pay a fair price for the services received. Interpretation of Contracts Generally speaking, the courts will try to interpret contracts in accordance with the intent of the parties. Words will be given their common meaning within the trade or profession involved. If more than one meaning is possible in interpreting a contract, the contract is ambiguous. The courts attempt to resolve ambiguities based on the intent of the parties. If the ambiguities are such that intent cannot be identified, a contract is considered unenforceable in that it lacks mutual agreement. Typed material takes priority over the pre-printed form, and handwritten portions take priority over typed content because these additions to a printed or typed 10

11 contract clearly indicate the intent of the parties. Written words take priority over numerals. For example, if a contract states, "forty-six thousand dollars, $40,000," then $46,000 (not $40,000) would stand as the contractual amount. In the event of an ambiguity between two (or more) documents, a later agreement generally takes precedence over a prior agreement in that the later (or latest) one indicates the final intent of the parties. Obvious typographical errors can be disregarded. Ambiguities in a contract usually are decided against the party drafting the instrument. MATTERS TO BE CONSIDERED IN COLORADO REAL ESTATE CONTRACTS (This text has been adapted from the Colorado Real Estate Manual) The following information will be tested on the Colorado final- and prep-exams. Please carefully review the Instructions booklet for more details. The contract of sale is the most important document in a real estate transaction. To name a few reasons, the contract determines the kind of title to be conveyed, the type of deed, the liens and encumbrances that the land will be sold subject to, and the manner of payment of the purchase price. Numerous controversies involving real estate licensees arise out of contracts for the sale of property. Rarely is there any dishonesty or wrongdoing on the part of the licensee. Rather, the difficulty usually arises because of the licensee's lack of thoroughness or lack of knowledge. Real estate brokers should continually strive to increase their own proficiency and that of their employed licensees in writing good contracts. It is a real art to write a sound, workable contract which is inclusive of all important matters and which is also reasonably clear and understandable. Although Colorado licensees are fortunate in having contract forms available which have been approved by the Real Estate Commission, they nevertheless must pay close attention to completing these forms in a competent manner. The following are the main items to be considered in drawing up real estate contracts. This is not an complete list because no two real estate transactions are alike. Only through careful study, experience and guidance will the real estate licensee learn to recognize the essential items to be included in a given transaction. 1. Names and Signatures of the Parties. The seller and buyer must be named in the contract and be properly designated as to which is the seller (vendor) and buyer (vendee). If the property is owned by two or more persons, all should be named and all should sign - unless, of course, only one is selling their interest. (See Chapter 3, for how this could be done.) If the property is being bought by 11

12 two or more buyers, all should be named and should sign, together with a designation as to whether they are buying as joint tenants or tenants in common. 2. Sale Price and Payment Provisions. The contract is incomplete and unenforceable unless it contains the sales price. If there is no provision as to the method of payment, the law presumes it is to be a cash sale. The contract should state, when applicable: the amount of the deposit; the amount to be paid at closing; the method of payment; the balance either by assumption of the existing mortgage or by a new mortgage; and any and all other pertinent financial provisions. 3. Description of the Property. The description of the real estate should be sufficiently definite to identify the land sold with reasonable certainly. Although the street address, with the city and state, is sometimes sufficient, it is better to use the legal description contained in the seller's deed. Even though the contract may not mention them, such additional rights to the land as easements, rights of way, and other appurtenances belonging to the land (Chapter 3) will automatically pass to the buyer in the transfer of ownership. For the sake of clarity and completeness, they should be mentioned in the contract. In addition, all items of personal property to be included in the sale should be listed. 4. Type of Deed. The contract should provide for the type of deed by which the property will be conveyed, whether by quitclaim, general warranty, or other kind of deed. (Chapter 7) In the event the type of deed is not stated, the courts will probably require that kind of deed that is customary to that particular type of transaction in that locality. 5. Condition of Title. Real estate sales contracts traditionally provide that title is to be merchantable; that is, free from defects and which a reasonably prudent buyer is willing to accept. Even without this provision, the law presumes that merchantable title is to be conveyed. Mortgages, tax liens, and other liens and encumbrances are considered to be defects. (Chapter 10) Therefore, if the property is to be conveyed subject to a mortgage or other encumbrance or restriction, the contract should clearly state so. Another customary provision states that the buyer will give written notice of defects of title, not excepted in the contract, and that the seller will be given a certain period of time in which to clear up said defects. The seller has the duty of proving that their title is good. The contract should provide that the owner will establish their title by furnishing evidence of their ownership, such as a title insurance commitment. In approved Colorado sales contract forms, the seller does not specifically agree to provide merchantable title. However, the seller does agree to provide the buyer with a title insurance commitment, and, if the buyer objects to the merchantability of title, the seller must correct unsatisfactory title conditions or the contract shall terminate. 12

13 6. Default Provisions. The rights of the parties should be stated in the event that one side fails to perform. The law, of course, gives the parties remedies for nonperformance, but a lawsuit can be avoided if the parties will mutually agree to a settlement beforehand. Therefore, provision should be made as to the disposition of the buyer's deposit if the buyer should default, and any other arrangements deemed appropriate. 7. Contingency Provisions. The buyer may be willing to buy, but in order to do so they might have to accomplish something beforehand, such as borrowing additional money or selling their present property. In such cases, the offer to purchase should clearly state such conditions. It is possible that the seller may also wish to provide for some contingency. Poorly written contingencies are one of the major causes of disputes between the parties and complaints against real estate licensees. (See the Legal Issues course.) Any contingency clause must state not only the conditional situation or event, but also provide a definite method and time period to accomplish the contingent requirement, remove the contingency or terminate the contract, including disposition of earnest money. 8. Possession. If the time of closing the transaction and the time that possession of the premises is to be given to the buyer are not the same, the date of possession should be stated. 9. Apportionment or Adjustment. The contract should provide for the apportionment of all charges or assets concerning the property - such as, taxes, assessments, water rents, interest on assumed encumbrances, mortgage insurance premiums or rents. (See the Closings course for more on prorations.) 10. Risk of Loss. If, after the contract is signed but before the deed is delivered, the property is damaged or destroyed by fire, flood or storm, who suffers the loss - the seller or the buyer? The answer is not as simple as it seems. Ordinarily in most jurisdictions, when a binding real estate contract exists, and where specific performance may be enforced by either party, the buyer is considered to be the owner of the property and the loss falls upon them. Although buyer does not yet have legal title (a recorded deed) the buyer is said to have the equitable title (some rights in the title). The buyer can legally force the seller to convey the legal title. Also, the seller can force the buyer to accept the legal title and perform their part. This right is called specific performance: the parties lose the right only if they waive it in the contract. (See above.) Many courts, though, following the theory of equitable title, say it is unjust to put the burden of loss on the buyer because, not being in possession, they are unable to protect their interest. But the majority of courts seem to hold that the loss falls on the buyer unless the contract provides to the contrary. To avoid misunderstanding and possible controversy, the importance of providing against this possibility is readily apparent. It is usual for the contract of sale to provide that the risk of loss remains with the seller. 13

14 COLORADO SALES CONTRACTS These sales contracts, used by licensees, are often referred to as "preliminary contracts", earnest money contracts" or "executory contracts". They contain, among other provisions, a promise by the buyer to pay for the land and a promise by the seller to deliver a deed to the land. These contracts are for the purpose of establishing good faith until the delivery of the deed. These sales contracts are not recorded (except for very good reason) because many such contracts fail and are never consummated. Recording would cloud the title to the land if delivery of a deed did not occur. (See Chapter 7.) There are several types of sales contracts approved by the Real Estate Commission and used by Colorado licensees. These include the Residential Contract to Buy and Sell Real Estate; Income-Residential; Commercial; Land; and the Contract to Buy and Sell for the Colorado Foreclosure Protection Act. Below is printed the default provisions for the most common the Residential Sales Contract. Note the difference in the remedies afforded. CONTRACT TO BUY AND SELL REAL ESTATE (Section 21 of the Residential Contract to Buy and Sell Real Estate ) 21. TIME OF ESSENCE, DEFAULT AND REMEDIES. Time is of the essence hereof. If any note or check received as earnest money hereunder or any other payment due hereunder is not paid, honored or tendered when due, or if any other obligation hereunder is not performed or waived as herein provided, there shall be the following remedies: 21.1 IF BUYER IS IN DEFAULT: (1) Specific Performance. Seller may elect to treat this contract as canceled, in which case all Earnest Money (whether or not paid by Buyer) shall be paid to Seller and retained by Seller; and Seller may recover such damages as may be proper, or Seller may elect to treat this contract as being in full force and effect and seller shall have the right to specific performance or damages, or both. (2) Liquidated Damages, Applicable. This shall apply unless the box in is checked. All Earnest Money (whether or not paid by Buyer) shall be paid to Seller and retained by Seller. Both parties shall thereafter be released from all obligations hereunder. It is agreed that all Earnest Money specified in 4.1 is LIQUIDATED DAMAGES and not a penalty, which amount the parties agree is fair and reasonable and (except as provided 10.4, 22, 23 and 24) said payment of Earnest Money shall be the SELLER'S SOLE AND ONLY REMEDY for Buyer's failure to perform the obligations of this contract. Seller expressly waives the remedies of specific performance or damages, or both. 14

15 (b) IF SELLER IS IN DEFAULT: Buyer may elect to treat this contract as canceled, in which case all Earnest Money received hereunder shall be returned and Buyer may recover such damages as may be proper, or Buyer may elect to treat this contract as being in full force and effect and Buyer shall have the right to specific performance or damages, or both. The broker is in a position to strongly influence the choice of remedy. This position of influence should be used guardedly because there are circumstances when the use of a particular remedy may be injurious to one of the parties. Note that the Liquidated Damages is the default option. Seller must choose the Specific Performance option if so desired by checking the box to the left. Liquidated Damages is the standard option for various reasons: In the event of default by the buyer, the usual seller does not want to become involved in a lawsuit against the buyer in order to enforce the specific performance of the contract. The seller is usually more concerned about getting the property back on the market and making a successful sale. The broker has the same desire. The average home buyer is not often engaged in a real estate transaction and is not aware of the possibility that they might be compelled to purchase the house. The knowledge of such a buyer usually extends no further than knowing that the earnest money is endangered. The specific performance and damages remedy has, however, grown increasingly popular in recent years. In particular, if the buyer and seller are experienced in real estate dealings, it may be the fairest because it offers both parties an equal right to seek extended damages. Earnest money deposits are another critical element of any contract. Earnest money should be adequate to demonstrate the buyer's serious intent to purchase and, in the event of the buyer's default, to compensate the seller for the act of taking the property off the market during the period prior to closing. The earnest money should not be identified to apply to any purpose other than earnest money and part payment. If a check or an earnest money note is taken, it must be identified as a check or note on the contract and the note must have a definite due date. The Commission strongly recommends that notes not be taken with due date "at closing." Such notes create confusion as to forfeiture rights of the seller if no closing ever takes place and the buyer is at fault. The Commission approved sales contracts include a mediation clause whereby the parties to the contract agree to submit matters in dispute to mediation when the dispute cannot be otherwise resolved. Mediation is non-binding on the parties to the dispute. If the dispute is not resolved within 30 days of the written notice requesting mediation, the mediation will terminate unless the parties mutually agree otherwise. 15

16 If mediation fails to resolve an earnest money dispute the approved contract forms provide that if a dispute arises between buyer and seller and the buyer demands the return of the earnest money and the seller claims the earnest money as a forfeiture, an interpleader action is appropriate (covered in Chapter 21.) Under this provision, if the broker does not receive mutual written instructions from the parties, the broker may place the money into court and let the court decide the matter. Although the broker may interplead without such a provision, the existence of the provision encourages the parties to make settlement. The provision also enables the court to relieve the broker from court costs and attorney's fees. Nothing, of course prohibits a broker from refunding an earnest money deposit to a buyer if, in the broker's judgment, that is what the contract calls for, but the broker may subsequently become liable to the seller if the disbursement is found to be wrongful. A broker may never unilaterally declare a forfeiture of the buyer's earnest money; only the seller may declare a forfeiture. COMPETENCY IN PREPARING CONTRACTS In any agreement to sell real estate, the terms must be carefully drafted. Contingencies and promises must be completely defined. Consideration of the circumstances affecting the parties involved in the transaction must be carefully weighed beforehand - spelling out the terms. 1. Loan Contingency. The ordinary buyer cannot buy if unable to borrow sufficient funds on reasonable terms. Ethical procedure would demand that the contract be made contingent upon the buyer's or seller's ability to secure such a loan for the buyer. In other circumstances the buyer may be unable to buy unless the sale of their current home is consummated and any offer on their part should contain the proper contingency. The existence of a pending contract to sell the buyer's home would not obviate the necessity for such a contingency; there is still no guarantee that the transaction will close and the buyer may be making their offer dependent on the sale proceeds. 2. Assumptions. When an existing mortgage is to remain on the property after sale, the responsibility of the parties must be carefully set forth. The buyer may assume and agree to pay the existing mortgage or they may buy the property subject to the existing mortgage. The usual seller will want the buyer to assume and agree to pay because such an agreement and assumption will make the buyer responsible on the original note as well as the seller. In either case, both parties to the transaction should be informed of the resultant effect of the sale. Unscrupulous buyers of equities have too often purchased subject to or even agreed to assume and pay an existing loan. Such unscrupulous persons then collect rents from the property for as long as they can, meanwhile deliberately defaulting on the loan payments and letting the property go into foreclosure sale. A deficiency judgment against the original owner (seller) may result but the 16

17 deficiency judgment would not be against the buyer. Such conduct, known as equity skimming, is a class 4 felony in Colorado. It is equally important that the broker assure that, if necessary, a buyer is properly qualified to assume a loan and that the assumption is properly processed through the lender. Licensees are subject to disciplinary action for failing to ensure that loan assumptions are finalized through the lending institution. 3. Buyer's Creditworthiness. The licensee's service (for which they are paid) to the seller is to procure a buyer, ready, willing, and able to buy. What is meant by able to buy? Certainly it means more than the buyer's ability to execute the contract and make the initial payment. The licensee has a duty to the seller to make a reasonable effort to determine if the buyer is truly able to buy. If the buyer is assuming an existing loan made by the seller, or if the seller is carrying back a purchase money mortgage, or if the seller is conveying by means of an Installment Land Contract (see discussion below and in Chapters 5 and 10) the seller is in a high risk position. There is no third party lending institution to investigate and determine the buyer's qualifications. The usual seller of an existing home is not a speculator, they do not wish to be forced to spend money on a foreclosure action, nor do they wish for the return of property they have sold. The seller will turn to the licensee for guidance. Although the licensee may have no legal obligations to investigate the buyer, the licensee will at least have the duty to inform the seller of the inherent dangers in the transaction and to advise the seller to make some type of an investigation concerning the buyer's ability or willingness to pay. In a similar situation, a buyer may wish to use the seller's credit. This is done by having the seller secure a loan or refinance the existing loan so that the buyer can purchase with less cash or no cash and without responsibility. The seller might also be induced to carry a second purchase money mortgage (seller carry-back or owner-will-carry), which sometimes even results in cash being given to the buyer at the time of closing. Thus, the buyer purchases without a down payment. This type of transaction may be perfectly proper if the seller knows the buyer and has faith in the buyer's creditworthiness. However, the seller is in an extremely vulnerable position and the broker should alert the seller to this fact. 4. Balloon Payments. If a buyer agrees to sign a second note and trust deed as part payment, the terms should be specifically set forth. If this second note requires regular equal installments and the note will not be completely paid at the time the note matures, a larger (balloon) payment will be required at the maturity date. If the buyer cannot raise the money for such a balloon payment they may be in danger of a foreclosure action. In such a case, the licensee should make the buyer and seller aware of this eventuality. At the time the balloon payment 17

18 becomes due the buyer may be dependent on the ability to refinance. The borrower is now protected by law in this regard. 5. Surveys. Many properties have not been properly surveyed. This is true particularly in areas that have not been formally subdivided into platted parcels. Some subdivided areas also contain irregular lot sizes and the survey may be questionable. Both the front feet (frontage) in running feet and the acreage, which determines square footage, are important and both should be verified before quoting figures to a buyer. In some cases improvements, such as fences or garages, encroach on boundary lines and only a survey will reveal the problem. A broker may be liable in such situations because brokers are assumed to have a knowledge greater than that of buyers and sellers. The broker should recommend to both buyer and seller that a survey be made. 6. Dual Contracting and Loan Fraud. Another matter now covered by law involves presenting a false contract with a larger purchase price to the lender than the price shown on the contract under which the parties intend to consummate the transaction. This is called dual contracting to induce a loan and is prohibited by the Colorado Criminal Code, C.R.S False or inflated down payments, second trust deeds, gift letters or any other matter which is not fully and accurately reflected in a sales contract can result in severe disciplinary and sometimes even criminal action against a licensee. 7. Installment Land Contracts. (a.k.a., land contract, installment contract, or contract for deed) The installment land contract is a contract for delayed delivery of a deed that provides for periodic payments over a term of years as does a promissory note. The installment land contract must be distinguished from the real estate sales or earnest money contract. The sales or earnest money contract does not usually contain provisions for installment payments and is merely intended to hold the deal for a short period until the condition of title is accepted and title is delivered to the buyer. Note that the former Real Estate Commission s Statement of Policy Concerning Rule F stated, Installment land contracts for the sale of real estate do fall within the purview of Commission Rule F, but until the Commission approves such forms, the Rule will not be implemented in this area. This means that licensees must use a standard, Commission-approved form when dealing with Installment Land Contracts. However, the Commission has not approved a form for Installment Land Contracts. Therefore, the licensee may not deal with Installment Land Contracts. This is partly because Land Contracts are often used in desperate times, and are fraught will legal peril. (Prior to the update of Rule F in 2004, this passage was heavily tested on the state license exam. Now it is less likely to appear, but the student should nevertheless be aware of this concept.) A preliminary sales contract may also be used to hold a deal until the execution of an installment land contract. In this case, the preliminary agreement will of 18

19 course not refer to delivery of a deed but rather to the subsequent signing of a land contract. The installment land contract is often used during periods of tight money or when the property is difficult to finance conventionally. Often a person with little or no cash for a down payment will be permitted to go into possession of property under a land contract providing for monthly payments to the seller, who will still hold legal title. The seller under an installment land contract, although holding legal title, is not presumed to be an actual owner of real estate. The seller's interest in the contract is considered personal property. In the event of the seller's death their interest would be treated as personal property in the seller's estate. However, when the seller wishes to sell their interest in the contract, the seller would use a formal assignment of the contract. If the third party buyer of the seller's interest does not receive an original copy of the assigned contract, they should make sure that the contract being assigned is of public record. Sometimes the seller merely has a contract interest and is not presently the holder of legal title. If so, the contract or assignment to the third party should specify this. The installment land contract usually provides that the deed to the property will not be delivered until the full purchase price or a specified portion such as onethird or one-half has been paid. The problem that arises now is whether or not the seller will be able to execute and deliver the deed when it is due. A certain amount of trust would have to be placed in the seller because at a specified time in the future, the seller must be able to convey a deed clear of all encumbrances. If the seller dies before the time that the buyer has fulfilled their obligation, other difficulties may arise. The seller's contract interest may be tied up in estate proceedings. Therefore, when the seller is a natural person rather than a corporation, it would be best if the deed were placed with an escrow agent at the time of sale and with proper instructions to deliver when the buyer has complied with the contract. If a deed is in escrow and an assignment of the contract is made, the assignment must be accompanied by a new escrow agreement, escrowing the deed of the assignor to the assignee with the original escrow agent. This is necessary to substantiate the chain of title to the property. Whether the installment land contract is used as an instrument of conveyance or a security device, it is strongly advised that legal counsel be sought. For the above reasons the Commission has rescinded approval of an installment land contract form and recommends that such contracts be prepared by an attorney representing one of the parties to the transaction. MANUFACTURED, MODULAR AND MOBILE HOMES In 1992 the Colorado Legislature allowed the Manufacture Housing licensing board to terminate, thus ending regulation of the sale of manufactured, modular and mobile homes in this state effective June 30, No Colorado license or 19