By Jennifer Young, Esq.
Geraci LLP

Introduction

Trust deed investments have gained popularity among investors seeking to diversify their portfolios. For trust deed investors, understanding the licensing requirements and legal considerations associated with this investment strategy is crucial to making informed decisions and safeguarding their interests. As an investor venturing into the realm of trust deeds, it’s essential to navigate the regulatory landscape effectively. In this article, we will demystify the intricacies of licensing, explore potential exemptions, clarify the threshold of becoming a ‘lender,’ and address the impact of accreditation on trust deed investing.

Understanding Trust Deed Investing

Generally, trust deed investing involves investors lending money to a borrower to purchase or refinance a property. In return, the borrower signs a promissory note to repay the loan, and the trust deed is recorded as a lien on the property. The investor becomes the “beneficiary” of the trust deed and is granted a legal interest in the property until the borrower repays the loan. The trust deed serves as collateral, and in the event of a borrower default, the investor may have the right to initiate foreclosure proceedings to recover its investment through the property’s sale.

Trust deed investing is a common way for individuals to participate in real estate financing and earn a return on their investment through interest payments (including the potential appreciation in property value in the event of borrower default and foreclosure). Like other lenders, trust deed investors are subject to the relevant laws and regulations governing lending activities in California.
It’s important for trust deed investors to understand the legal implications and risks involved in such investments and to comply with applicable state regulations.

Do You Need a License to Invest in a Loan?

In California, a lender may originate and fund mortgage loans through one of three licenses: a Real Estate Broker License from the California Department of Real Estate (“DRE”), a California Finance Lender License (“CFL”) from the California Department of Financial Protection and Innovation (the “DFPI”), or California Residential Mortgage Lending Act license (“CRMLA”) from the DFPI. An unlicensed individual or entity may only make one commercial loan a year, unless one of the exemptions discussed below applies.

Trust deed investors are those not directly engaged in the business of lending or originating loans; instead, they provide funding for loans at closing and hold a beneficial interest in the trust deed securing the loan. Therefore, it’s important to note that although trust deed investors may not require a license to make loans under certain circumstances, the entities or individuals who are actively involved in the business of lending or originating loans (such as mortgage brokers, lenders, or loan servicers) do need to be licensed under California law.

In the same vein, once a trust deed investor actively participates in loan originations, mortgage lending, or related activities, the investor will fall under the scope of licensing requirements and regulations. In such cases, they should consult with an attorney familiar with California’s lending laws and regulations to ensure compliance. Non-CA investors or those investing in non-CA loans should also seek legal advice to ensure compliance with relevant state regulations.

Understanding Exemptions

Under the California Financing Law, there is a “de minimus exemption” from the licensing requirements which allows an unlicensed individual to make no more than one commercial loan (a loan with a principal amount of $5,000 or more, the proceeds of which are intended by the borrower for use primarily for other than personal, family, or household purposes) in a 12-month period. The more commonly used exemption available for an unlicensed lender are loans arranged by a licensed California DRE Broker.
These exemptions can vary depending on the specific circumstances involved. Additionally, it’s important to note that exemptions can change over time, so it’s essential to consult with legal experts to confirm the current status of exemptions available.

CA DRE Brokered Loan – Individual Trust Deeds/Whole Loans

Typically speaking an unlicensed investor will need to work with a licensed CA DRE Broker to help identify potential loans to fund. In California, if a mortgage loan is originated and brokered by a CA Real Estate Broker to an unlicensed individual, the unlicensed individual can fund the loan without a license and retain the usury exemption for California. However, California real estate law requires an unlicensed person to obtain a DRE Broker license if that person makes more than eight loans secured by real property in California within a 12-month period (and is not otherwise licensed under the DFPI).

CA DRE Brokered Loan – Fractional Loans/Co-Lending

While co-lending arrangements can offer advantages such as participating in larger transactions, potential securities issues must be considered. Trust deed investors exploring co-lending arrangements must be aware of potential securities issues. If the co-lending structure qualifies as a security under federal and state laws, it may be subject to registration, disclosure requirements, and compliance obligations. Verification of accredited investor status becomes crucial, and providing a private placement memorandum (PPM) may be necessary. Additional complications will also arise in instances where nonaccredited investors are involved and where investors reside outside of CA or reside in multiple different states.

Mortgage Funds

Participating in a pooled investment fund managed by a licensed professional may also grant investors an exemption from individual licensing requirements. Investing in a fund can provide diversification and expert management of a trust deed portfolio.

The benefits of investing in a mortgage fund are that the investment is passive, so the investor does not need to manage funding new loans, payoffs, or potential defaults, and the investment is diversified across all the loans held in the fund. The fund manager handles all the details with the loans in the portfolio, taking an annual management fee in addition to the upfront origination fees they charge to the borrower. Most funds are structured to allow investors to reinvest dividends back into the fund, which most investors elect to do. Private lenders managing mortgage funds enjoy greater flexibility in carrying out their lending/investment activities, which enables them to offer improved economic terms and consistent returns for their investors.

Accredited Investor Status: Does It Affect Licensing?

Being an accredited investor, as defined under Regulation D of the Securities Act of 1933, can open doors to certain investment opportunities. However, it’s crucial to understand that accreditation status does not automatically exempt you from licensing requirements for trust deed investing. Licensing is primarily determined by investment activities, regardless of your accreditation status. Emphasizing the Importance of Professional Guidance Throughout the trust deed investment journey, new investors should prioritize seeking professional guidance. Engaging legal counsel experienced in trust deed investing and securities matters can help
navigate the complexities of licensing, regulations, and potential securities implications.

Conclusion

For new trust deed investors seeking to understand and potentially grow their wealth, trust deed investing in California offers an exciting opportunity. By grasping licensing requirements, exploring exemptions, addressing securities implications, and considering the transition to private lending, you can embark on your trust deed investment journey with greater confidence and security. Staying vigilant about the ever-evolving legal landscape and seeking professional advice will ensure compliance and minimize legal risks. With the right guidance, investors can confidently pursue their investment strategy and aim for success in this dynamic market.