One topic that does not get much coverage is how to protect the seller in a subject-to transaction. There are several ways.

1 – A wrap. A wrap mortgage (also known as a “wrap-around” mortgage) is a type of lien that gets recorded in the land records as security for the seller. It’s a junior lien, meaning it is subordinate to the existing financing that has been left in place but it is called a wrap because it wraps around or includes the current note. The wrap often consists of the balance of the original loan plus an amount to cover the new purchase price for the property if that difference (which equals the seller’s equity) is not paid at settlement. Wraps can be either at the exact same interest rate as the existing financing or at higher rate. In the latter scenario the seller would make monthly money on the spread. In this context, see my message below regarding note servicing companies.

2 – A subordinate lien with balloon payment. If the sub-to purchaser does not have the cash to pay for the seller’s equity at settlement, the seller may instead decide to take its equity in the form of a second trust with a balloon. For example, let’s say the seller has $50,000 in equity at the time of the subject-to purchase. To get the deal done the seller may agree to finance that $50,000 at a reasonable interest rate but with a balloon payment due in 1-3-5 years. This arrangement enables a purchaser to get into a property with less out of pocket and enough time to renovate or improve the property. The plan would then be to either sell or refinance to get the seller paid when the balloon becomes due. The difference between this and a wrap is the wrap would typically be payable over the full term of the underlying mortgage… i.e., there would be no balloon payment. This method gets the seller paid out earlier.

Whether a wrap or stand-alone subordinate lien are used to secure the seller, a note servicing company should be engaged. This is very important. Note servicing companies handle the collection of funds, make loan and other payments, and take care of reporting. The use of a third party also allows the seller to monitor things at a distance and make sure the underlying mortgage is being timely paid.

3 – A performance deed. A performance deed (also known as a “pocket” deed) is a deed from the buyer back to the seller that is executed at settlement but held in escrow. The deed is not delivered to the seller — delivery being a requirement for a valid conveyance in most jurisdictions — unless and until the buyer defaults. If the buyer never defaults, the deed is destroyed in accordance with the agreement between the parties and the escrow agent. While I don’t recommend this method because it creates issues relating to the future insurability of the property (from a title insurance perspective), it can achieve at least one desired result. Ordinarily a seller would need to bring an action to foreclose their lien against a defaulting sub-to purchaser in order to repossess the property. Foreclosures take time and foreclosure attorneys cost money. Using a performance deed enables a seller to retake title to the property without going through that process and spending those funds. That can of course save the seller big on costs but it can also lead to other problems. I plan to post on this soon in the context of deeds in lieu of foreclosure executed prior to default.

While the above seller protections are certainly useful, none of them will help if a lender invokes the due on sale clause and accelerates the full balance of the underlying mortgage. The only solution in that unfortunate event is money. I discussed that issue in my prior posts on the dangers of subject-to. I recommend you read those posts.

Let’s face it. If a seller is willing to sell a property to a buyer subject to an existing mortgage (which will remain on their credit), they probably have some financial problems they are trying to solve. And the unaffordable mortgage may not be the only thing troubling them. The prospect of that financially-plagued seller filing for bankruptcy at some point in the future must be considered by a subject-to purchaser.

The third risk I identified in my 2022 article about subject-to transactions was the seller filing for protection under the bankruptcy code. But why would a seller BK affect the buyer? The property has already been sold and therefore it’s not part of the debtor’s BK estate.

Unfortunately that doesn’t matter.

When the seller files for bankruptcy, he or she will have to inform the lender holding the mortgage note. In order to protect its interests, the lender will file as a secured creditor in the bankruptcy case. It is at this point that the lender will almost certainly discover that the property has been transferred out of the seller’s name… the liability shows on the debtor’s schedules but the property is not shown as an asset. The restriction on alienation (due on sale clause) has obviously been violated, and when faced with that scenario most lenders will choose to foreclose for the reasons pointed out in the prior post. Because the borrower covenants in the mortgage / deed of trust have been breached, the lender has the right (and perhaps the obligation, depending upon the lender’s circumstances) to pursue foreclosure.

The underlying issue common to all risks associated with sub-to is the buyer needs to be able to pay off the mortgage upon demand. And that demand can happen at any time… not always because of something the buyer did wrong.

Returning to this topic, the second issue of concern that I raised regarding subject-to transactions was the failure to have a good exit strategy in the event the loan balance is accelerated by the lender.

Once a lender discovers that the property has been sold without paying off their loan, they may decide to invoke what is known as the “due on sale clause”. Most mortgages/deeds of trust contain a DOS clause. It gives the lender the right — not the obligation — to demand payment in full.

A couple of questions might come to mind. First, how would a lender discover the transfer?

• name change on tax bill — since lenders monitor these records to be sure taxes are being paid, they would become aware of most title changes
• insured change on policy — lender would be notified since they are the mortgagee on the policy
• mailing address change
• monthly payment change that the buyer does not discover because they are not receiving notices
• automatic payments set up from an account named differently other than the original borrower
• seller admits the violation when contacted by lender

Second, why would a lender who is receiving timely payments care about the transfer?

• buyer is not bound to the covenants of the original loan
• compliance issues — loans pledged to FHLB would suddenly not be compliant; with loans sold to investors such as Fannie Mae or Freddy Mac the sub-to would violate seller/servicer agreements; fair lending scrutiny issues

So the issue of whether or not a lender invokes the due on sale clause and accelerates the loan balance (i.e., demands that the entire loan balance be paid within X days) often does not come down to simply whether a loan is performing (being paid on time) or non-performing. It’s a matter of the lender following regulations and contract terms.

What can a seller and buyer do when the due on sale clause is invoked? Pay the loan in full, either through cash on hand, refinance or resale. Don’t believe everything you read. There is no such thing as “due on sale insurance”. Nobody is going to step in and “fix” the situation once the lender demand has been made. It’s either pay off the loan or the property will be heading to foreclosure.

Last year around this time I wrote an article called “Subject to transactions on the rise” … and since that time mortgage interest rates have unfortunately continued to climb. As a direct result, subject-to as a strategy has exploded. Most deals that penciled a year ago just don’t work in today’s market. Values are still high, yet rates are the highest in ~40 years. But if you could keep the seller’s low rate in place, things still look great on paper. That means everything will work out perfectly, right?

My characterization “on the rise” was way understated. Many, many investors are trying to use the strategy. Plus it has become the shiny new thing REI gurus are teaching. Unfortunately, the gurus seem to be focused on sharing the strategy with inexperienced buyers as a way to get rich without having much cash. As a result, some of these inexperienced buyers are facing the potential problems I outlined in that post.

As promised, I’m circling back to discuss the main risks I identified with subject-to. Hopefully it will help you in your investing, or in dealing with a property you own.

I think subject-to is a great short-term strategy, even for new investors. It goes like this… buy subject-to existing financing, promptly take care of the improvements, and then resell at a higher profit than if you had to finance the acquisition. But that’s not how it’s being taught.

The first major risk I identified with subject-to was undercapitalization and buyer default. It’s just common sense that the buyer could default on payments, especially if the buyer intends to hold the subject property long-term as a rental. The longer the hold, the higher the risk. And if the buyer is undercapitalized – having little to no cash to respond if something were to go wrong, such is often the case for the new investors I referenced above – that’s where it can become a big problem.

If you’re an experienced landlord, you’ve learned to plan for and deal with tenant default. However, if you’re a new investor, tenant default may not be something you’ve adequately accounted for in your numbers. Evictions take time. Eviction attorneys are expensive. Clever tenants can hinder and delay the eviction process, especially in jurisdictions that are “tenant-friendly”. If a tenant defaults and eviction becomes the only solution, when the subject-to purchaser finally does regain possession of the property, it could be damaged. And after making any required repairs, finding a new tenant may not be quick and easy. Try finding a new tenant in the dead of winter! Of course through all of this, the mortgage payments still must be made. A single tenant default can create tens of thousands of dollars in unforeseen expenses and carrying costs with no rent coming in.

Even without tenant problems, the need to make large capital expenditures can materialize. Major systems and appliances fail. Roofs need replacement. The undercapitalized and unprepared subject-to purchaser may not be able to continue to pay the mortgage as well as the necessary expenses. Of course this can lead to default on the mortgage. If so, the seller’s credit will take a hit and the lender will eventually pursue foreclosure. It’s a potential disaster for all involved. And that’s before the lawsuits fly.

As a seller, how can you reduce the chance of your subject to deal going down this path? Don’t sell to someone who doesn’t have the financial ability to prevent it. Do your research on the buyer’s finances. Don’t sell subject-to to a buyer that doesn’t have significant cash reserves or at a minimum quick access to private money. And sell on a wrap or with a junior lien that can be foreclosed. Research the cost of foreclosure as a worst case scenario and factor that into your analysis.

As a buyer, how can you prevent the above? Don’t overpay for the property just to obtain the low interest rate. Have sufficient cash reserves or access to funding. And perhaps most importantly, know when to accept the loss, exit properly before the seller is damaged, and move on to the next investment.

Seller financing sounds complicated but it isn’t. Think of like this: Seller = Bank. In a typical real estate transaction with financing involved, the buyer obtains a loan from a mortgage lender or bank. With seller financing, the buyer gets that loan from the seller instead. Seller financing is sometimes referred to as “owner financing” but since title changes at closing the owner is no longer the owner, so I prefer “seller financing” when discussing the concept.

OK but is seller financing better for buyers or sellers? Often it is better for both.

For a buyer, there are several benefits to seller financing. The top benefit to most buyers is the savings they enjoy on closing costs. Mortgage lenders typically have several different types of buyer charges at closing… origination (points), underwriting, processing, document preparation and attorneys fees, plus appraisal and other third party costs. None of these fees are required with a seller-financed transaction. Next, the process of obtaining seller financing is also often much less intrusive than obtaining a loan from a traditional lender. For example, a credit check may not be necessary and document requirements are usually minimal. Lastly, depending upon how the deal is structured, the buyer may be able to get into a property without the standard down payment… often 20%+ of the purchase price. If the deal makes sense to the seller (which it often does, see below), a buyer may be able to purchase the subject property with very little cash up front.

Not every seller can offer financing (well technically that is not true, but we’ll leave a thorough discussion on subject-to for another day), but for those sellers that can, there are many great benefits to financing a buyer’s purchase. By offering or agreeing to seller financing, sellers are more likely get their asking price (or more). The up-front cost savings that buyers enjoy along with terms they secure means they should be able to offer more for the property. Next, sellers who finance can likely also sell as-is without having to make any repairs to the property. With no institutional lender involved, there are no property condition requirements to meet. Further, sellers who offer financing might also see the tax benefits of avoiding capital gains and instead receiving installment payments. The amount realized over the life of the loan (even on a 5 or 10 year balloon, let along a 30 year carry) can be significantly higher than with a standard sale. Lastly, if the buyer does default, since the seller holds a deed of trust or mortgage on the property and can foreclose if necessary, this reduces the risk of loss considerably. If things go sideways they may either take the property back (after receiving years of payments) or get paid in full at the foreclosure sale. Once a seller discovers all the benefits of this method of sale (buyers may need to do some explaining here), they may feel comfortable enough about the structure of the transaction that it almost doesn’t matter who the buyer is!

So now that you can see that seller financing is clearly a win-win for both buyer and seller, how do the parties prepare a contract for a sale with seller financing?

That’s simple. You simply add in the purchase price/payment section the details of the loan. For example, “Seller agrees to hold a Note secured by first lien Deed of Trust in the amount of $X with an annual interest rate of Y% amortized over Z years, payable in equal monthly installments of [principal and interest/interest only] in the amount of $[], with the final payment of all outstanding principal and interest due, if not sooner made, on or before [maturity date].”