Tom Gimer

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.