This article explores the procedures available to an EP investor taking over an existing loan.
Loan takeovers by buyers
The existing financing on any property can remain of record and be taken over by an equity purchase (EP) investor under any one of four procedures:
subject to without any type of loan assumption agreement;
formal assumption agreement entered into by the lender and the EP investor;
a subject-to assumption agreement entered into by the seller and the EP investor; and
a novation agreement entered into by the lender, seller-in-foreclosure and EP investor.
Consider a seller-in-foreclosure of encumbered real estate who enters into an equity purchase agreement and sales escrow, providing for the EP investor to take title subject to the existing loan.
The EP investor/buyer plans to close escrow on the subject-to transaction without entering into an assumption agreement with the lender. The EP investor intends to negotiate with the lender after closing, but only if the lender calls the loan or demands an assumption. Otherwise, the EP investor will then seek new financing elsewhere.
The interest rate on the existing loan encumbering the property owned by the seller-in-foreclosure is at or above current market levels. The experience of the EP investor and the broker involved indicates the lender will not call the loan and demand a payoff. If the loan is called, the lender will lose either its servicing fees or the high portfolio yield on the loan, depending on whether the lender owns the loan or is servicing the loan for another lender.
A beneficiary statement is requested by escrow. The lender properly complies with the request by sending the statement of loan condition within 21 days of receiving the request, together with a $30 billing for processing. [Calif. Civil Code §2943(e)(3), (6)]
However, the lender additionally instructs escrow not to close until the EP investor has been approved to assume the loan.
Can the lender interfere with the closing of a subject-to transaction when the EP investor and seller-in-foreclosure do not require lender approval?
No! Escrow instructions for the sale of property subject to the existing loan are a contract entirely between the EP investor, the seller-in-foreclosure and escrow. The lender is not a party to the escrow and has no legal ability to interfere with or prevent the closing.
Further, and more critical, escrow has no authority from its principals to follow any lender instructions coupled with the beneficiary statement. The lender is limited to calling the loan under its due-on clause in the trust deed after the subject-to transaction is closed – if the lender so chooses. [Moss v. Minor Properties, Inc. (1968) 262 CA2d 847]
The subject-to transaction
A subject-to transaction is agreed to by the seller-in-foreclosure when he enters into a purchase agreement containing a financing provision that calls for the existing loan to be part of the purchase price paid for the property. The financing provision states “the buyer is to take title subject to the existing loan.” [See first tuesday Form 156 §§4 and 5]
The representation of the terms and conditions of the loan by the seller-in-foreclosure is confirmed in escrow on receipt and review of the lender’s beneficiary statement. The EP investor can rely on the beneficiary statement for future payment schedules, interest rates and loan balances, in spite of the lender’s attempt to condition the use of the beneficiary statement on the EP investor’s assumption of the loan.
Some EP investors, fearing the lender will discover the sale and call or modify the loan, do not order a beneficiary statement. The most recent loan payment receipt or loan statement held by the seller-in-foreclosure is then used as the source of loan information. However, the EP investor needs to be aware the lender is not bound by the content of the payment statements.
Other EP investors acquire their ownership rights under unrecorded sales documents, such as lease-options or land sales contracts. Thus, the seller-in-foreclosure and the EP investor totally avoid conveyances, escrow, title insurance, disclosures and other customary transfer activities until they can either work out an assumption or originate new financing. However, these unrecorded sales still trigger due-on clauses (and reassessment).
During periods when current market interest rates are comparable to or lower than the note rate on the existing loan:
a beneficiary statement should be ordered to confirm the loan amount and loan terms;
the change of ownership conveyance should be recorded and insured; and
the conveyance should be brought to the lender’s attention so the lender will have waived its right to later call the loan when rates rise and it then claims the transfer went undisclosed.
Conversely, during periods of rising or high interest rates as compared to the note rate on the existing loan, the lender is often not notified of a subject-to transaction since the lender would gain financially from either a call or recast of the loan.
However, the lender can enforce its due-on clause and call the loan on its future discovery of any sale – no matter how the sale was structured. Also, on later discovery of the transfer, the brokers, attorneys or accountants who induced the seller-in-foreclosure to avoid the due-on clause may be liable to the lender (in tort) for any retroactive interest differential (RID) the lender lost based on market rates at the time of transfer. A “hold harmless agreement” from the seller or EP investor would be appropriate for those agents and advisors assisting in the undisclosed transaction.
The seller of property, sold either subject-to or by an assumption of the existing loan, should be concerned about his liability for the loan after it is taken over by the EP investor. Seller liability depends on whether the loan is a recourse loan or a nonrecourse loan.
The seller-in-foreclosure is not liable for deficiencies on purchase-money, nonrecourse debts taken over under any procedure by the EP investor.
Purchase-money obligations secured by real estate include:
seller carryback financing on the sale of any type of real estate that is the sole security for the carryback note;
all loans made in part or entirely to finance the purchase of an owner-occupied, one-to-four unit residential property [Calif. Code of Civil Procedure §580b]; and
loans made for the construction of an owner-occupied, single-family residence – and perhaps loans made to further improve the structure, the legal status of dwelling improvement loans being presently uncertain.
A lender is limited to foreclosing on the secured property to recover the balance due on a defaulted purchase-money loan. [CCP §580b]
Even if the secured property has insufficient remaining value to satisfy the balance of the purchase-money loan, the lender cannot hold the original borrower or a subsequent (assuming) buyer personally liable on the nonrecourse note for any deficiency in property value (unless the owner inflicted waste on the property).
On a sale and loan takeover by an EP investor, a purchase-money loan remains a purchase-money loan, regardless of whether the EP investor takes title subject-to or assumes the loan, or a novation occurs. [Jackson v. Taylor (1969) 272 CA2d 1]
Thus, a non-occupying buyer who takes over a purchase-money loan under any procedure is entitled to anti-deficiency protection. In contrast, a purchase-assist loan that originated with a non-occupying buyer of one-to-four unit residential property is a recourse loan, not a purchase-money loan.
However, while the lender has no recourse to the borrower, if the loan is insured by the Federal Housing Administration (FHA) or the Veterans Administration (VA), recourse exists to the FHA or the VA for their losses on a foreclosure.
Recourse real estate loans
Recourse loans are all loans except those classified as purchase-money loans – as identified above.
Consider an EP investor who purchases the residence of a seller-in-foreclosure and takes title subject to an existing home equity loan that is a recourse (liability) loan, since the loan proceeds were not used to purchase or improve the residence.
Later, the EP investor defaults on the loan.
The lender eventually completes a judicial foreclosure on the property, not a trustee’s foreclosure. The fair market value of the property on the date of the judicial foreclosure sale is insufficient to fully satisfy the loan, resulting in a deficiency.
The lender seeks a money judgment against the seller for the deficiency in the value of the property in order to fully satisfy the loan. The seller claims he is no longer responsible for the loan since it was taken over by the EP investor.
Is the seller liable for a deficiency on a recourse loan after the EP investor takes title to the secured property subject to the existing loan?
Yes! When property is sold and title conveyed to a buyer subject to an existing recourse loan, the seller remains liable for any deficiency on the recourse loan should the EP investor fail to pay. [Braun v. Crew (1920) 183 C 728]
Further, the EP investor who takes title subject to the existing loan, and does not enter into an assumption agreement with the seller-in-foreclosure or the lender, is not liable to either the seller or the lender on the loan – unless the EP investor substantially damages the property, and by doing so causes the property value to drop below the loan balance, called waste. [Cornelison v. Kornbluth (1975) 15 C3d 590; CC §2929]
However, if the subject-to EP investor and the lender enter into an assumption agreement in which they significantly modify the terms of the recourse loan without the seller-in-foreclosure’s consent, the seller cannot be held liable for the modified loan. [Braun, supra; CC §2819]
A seller-in-foreclosure can reduce his risk of liability on the EP investor’s takeover of a recourse loan by negotiating an assumption agreement with the EP investor as a provision in the purchase agreement.
A buyer-seller assumption agreement should not be confused with a so-called “formal assumption” between a buyer and a lender.
A buyer-seller assumption agreement, provided for in the purchase agreement and prepared in escrow, is a promise given to the seller-in-foreclosure by the EP investor to perform all the terms of theloan the EP investor takes over on the sale of the seller’s property. [See first tuesday Form 431]
The assumption agreement must be in writing to be enforceable. [CC §1624(a)(6)]
The assumption agreement gives the seller-in-foreclosure the right to enforce collection from the EP investor for any deficiency judgment the lender is awarded in a judicial foreclosure against the seller.
Although the EP investor’s promise to pay the loan under a buyer-seller assumption agreement is given to the seller-in-foreclosure, the EP investor also becomes liable to the lender under contract law doctrines of equitable subrogation and third-party beneficiaries. [Braun, supra]
Even though the EP investor, on entering into any type of assumption agreement, takes over primary responsibility for the loan, the seller-in-foreclosure remains secondarily liable to the lender for any deficiency due to the EP investor’s failure to pay, unless the loan is modified without the seller entering into the modification agreement. [Everts v. Matteson (1942) 21 C2d 437]
Unlike the subject-to seller, the seller under a buyer-seller assumption agreement is entitled to be indemnified by the EP investor for any losses the seller later incurs because of his continuing liability for the loan taken over by the EP investor.
To avoid pursuing reimbursement from the EP investor under a buyer-seller assumption agreement, the seller-in-foreclosure can negotiate for the assumption agreement to be secured by a performance trust deed carried back by the seller as a lien on the property sold. [See first tuesday Forms 432 and 451]
With a recorded trust deed held by the seller-in-foreclosure to secure the EP investor’s promise to pay the lender as agreed to in the assumption agreement, any default on the lender’s loan allows the seller to:
call for payment from the EP investor of the entire balance remaining due on the assumed loan, subject to the EP investor’s right to reinstate the delinquencies; and
proceed with foreclosure to recover the property and cure the default on the lender’s loan.
A buyer-seller assumption, as a type of subject-to transaction, does not affect the lender’s right to enforce its due-on clause on discovery of the conveyance, unless the lender has waived its due-on rights by failing to act after acquiring actual knowledge of the transfer.
Consider an EP investor who is willing to cash out the seller’s equity and assume the existing recourse loan with the lender. However, the seller-in-foreclosure is unwilling to remain liable for the loan after closing the sale – when the seller will no longer have an interest in the property.
Can the sale be closed without the seller-in-foreclosure remaining liable for the recourse loan assumed by the EP investor?
Yes! The lender can enter into an agreement with both the EP investor and the seller-in-foreclosure for the EP investor’s assumption of the loan and a release of the seller’s liability. This agreement is called a novation or substitution of liability, for which the lender charges a fee, and which may include a modification of the loan terms.
On a buyer-lender assumption of a loan secured by an owner-occupied, one-to-four unit residential property, the lender is required to release the seller-in-foreclosure from liability for the loan assumed by the EP investor. [12 Code of Federal Regulations §591.5(b)(4)]
A novation agreement is comparable to the existing lender’s origination of a new loan with the EP investor, except the trust deed executed by the seller-in-foreclosure remains of record and the note unpaid.
Thus, the lender under a novation (or an assumption) will review the EP investor’s credit status, probably seek an adjustment of the interest rate to current levels, and definitely charge an assumption fee – all the benefits a lender receives on origination of a new loan made to an EP investor.
However, any lender collection of fees or any increase in the interest rate on the loan, called portfolio yield, defeats most of the financial advantages of taking title subject to an existing loan. Welcome to economic Darwinism!