Additional collateral of personal property
Consider a seller’s real estate agent who lists a furnished apartment complex for sale. The sale includes interior and exterior furnishings, such as:
- refrigerators; and
- maintenance equipment.
The seller is willing to carry a mortgage secured by a note and trust deed on the property.
The seller’s agent advises the seller the furnishings and maintenance equipment they are selling as part of the price will be additional security for any carryback mortgage. Thus, the seller will minimize their risk of loss in the event the buyer defaults and foreclosure is required.
Likewise, loan brokers arrange short-term loans with private lenders. Since brokered loans made by private lenders usually are secured by second mortgages on real estate, junior lenders often want additional security. Additional security might take the form of personal property, such as:
- business inventory;
- machines; or
- business revenue (accounts receivable).
Documenting debt secured with personal property
Two documents are involved to properly secure a debt with personal property:
- a security agreement which creates a lien on the personal property; and
- a UCC-1 Financing Statement which is recorded to give public notice of the lien.
To create a lien on personal property transferred in a sale or as additional security for lender financing of real estate, a security agreement is entered into which grants the mortgage holder a security interest in personal property described in the agreement.
To put the public on notice of the lien created by the security agreement, a UCC-1 Financing Statement (UCC-1) is prepared and filed. The filing is a recording of the UCC-1 with the Secretary of State or with the county recorder, depending on the type of personal property and its relationship to the real estate. This process is called perfecting the lien. [Calif. Commercial Code §§9310; 9501]
Perfecting the lien establishes the mortgage holder’s interest and priority over all other security interests in the personal property acquired by others after the UCC-1 is recorded.
Editor’s note — A carryback seller does not use a trust deed as a security device to create a lien on personal property. A recorded mortgage imposes a perfected lien on real estate, not personal property.
Personal property defined
All property is divided into two categories:
- real property, commonly known as real estate; and
- personal property, also called personalty.
Real estate includes land and anything permanently affixed or appurtenant to it, such as buildings, trees or rivers. [Calif. Civil Code §658]
Every kind of property which is not real estate is classified as personal property. [CC §663]
Thus, personal property includes:
- tangible goods, such as furniture, equipment and vehicles;
- general intangibles, such as the goodwill of a business, accounts receivable and business income;
- instruments and documents, such as notes, whether or not they are secured by a mortgage; and
- other items, such as cash and contract rights.
Rentsform a separate category of personal property. Rents become security for a debt under a lien called an assignment of rents provision typically included in a mortgage.
Real property vs. personal property
A real estate fixture is personal property which is permanently attached or affixed to the land or buildings located within the parameters of a parcel of real estate and is part of that real estate. [CC §660]
For example, an air conditioning unit in an apartment complex is a real estate fixture since it is a necessary, integral part of the building. On the other hand, furniture is not a real estate fixture since it is not permanently attached to the building.
Fixtures which are used as part of a trade or business are called trade fixtures, such as the equipment and sinks in a restaurant, or chairs and plumbing fixtures affixed to the floor and walls in a beauty salon.
Trade fixtures, like real estate fixtures, are often affixed to the real estate. However, they remain personal property items since they are necessary to the operation of the business on the premises, not the use of the real estate itself.[Beebe v. Richards (1953) 115 CA2d 589]
Whether an item is a real estate fixture or personal property is resolved by the application of a three part test:
- the permanence of the item’s attachment to the real estate;
- the degree to which the real estate was constructed to support the fixtures; and
- the parties’ intentions when the items were attached to the real estate. [Security Data, Inc. v. County of Contra Costa (1983) 145 CA3d 108]
Intent is the crucial, overriding factor in determining whether an item is to be classified as personal property or a real estate fixture. [Seatrain Terminals of California, Inc. v. County of Alameda (1978) 83 CA3d 69]
Intent to establish a fixture as real estate or personal property is usually manifested in a written agreement.
Thus, in a real estate transaction, the buyer and mortgage holder demonstrate their intent to treat an item as personal property, not a real estate fixture, by creating a lien on the item under a security agreement and recording a UCC-1 Financing Statement to perfect the mortgage holder’s security interest.
Editor’s note — The parties’ intent as to whether an item is personal property or a fixture does not control for property assessment purposes. [Kaiser Co. v. Reid (1947) 30 C2d 610]
Personal property secures the carryback mortgage
Consider a broker who advises the seller of an apartment complex to additionally secure their carryback mortgage with personal property in the form of furnishings, refrigerators and maintenance equipment included in the purchase price.
Unless the personal property sold as part of an installment sale is security for the mortgage owed the seller, the buyer may sell the personal property at their discretion. The buyer receiving a bill of sale becomes the owner of the personal property, unencumbered by the debt owed the carryback seller, unless the seller is granted a security interest in the personal property. [See first tuesday Form 408]
More importantly, if the personal property sold is not included with the real estate as additional security for the carryback mortgage, the seller may only foreclose on the real estate. The personal property cannot be repossessed. [C.B. Cunningham v. Security Title Insurance Co. (1966) 241 CA2d 626]
However, even if the mortgage is additionally secured by personal property sold as part of the underlying real estate transaction, the buyer has no personal liability on the carryback mortgage for any deficiencies on a foreclosure. [Calif. Code of Civil Procedure §580b]
Documenting a perfected security interest
Three documents are required to properly structure a sale or loan transaction which includes personal property as additional security for a mortgage:
- a promissory note [See first tuesday Form 420];
- a security agreement [See first tuesday Form 436]; and
- a UCC-1 Financing Statement.
To process a sale involving personal property, a bill of sale is prepared by escrow and signed by the seller. A bill of sale transfers ownership of the personal property to the buyer, just as a grant deed conveys the ownership of real estate. [See first tuesday Form 408]
The promissory note evidences the buyer’s obligation to pay the mortgage created by the installment sale or loan.
The mortgage can be evidenced by one note and secured by both the real estate using a trust deed and the personal property using a UCC-1, called a mixed collateral transaction.
Alternatively, when a carryback mortgage is to be secured by both real estate and personal property, the mortgage holder and the buyer-owner may agree to divide the debt in two, each evidenced by a separate mortgage — one secured by real estate, the other by personal property.
If two separately secured debts are created, both the trust deed and the security agreement can contain a cross-collateral provision stating a default on one of the debts constitutes a default on the other, called a dragnet clause. [Wong v. Beneficial Savings and Loan Association (1976) 56 CA3d 286]
The security agreement
A security agreement creates a lien on personal property. It is the personal property counterpart to a trust deed used as the security device to impose a mortgage lien on real estate.
The security agreement contains the rights and obligations of the parties regarding the secured personal property, including:
- protection against waste;
- remedies on default; and
- transfer-alienation provisions. [See first tuesday Form 436]
The security agreement is retained by the mortgage holder and not recorded with any agency.
To create an enforceable security interest in personal property, the security agreement needs to:
- identify the debt or other obligation for which the personal property is security, typically evidenced by a mortgage;
- describe the personal property which functions as the security; and
- grant a security interest in the personal property from the buyer or borrower to the mortgage holder. [Needle v. Lasco Industries, Inc. (1970) 10 CA3d 1105]
An enforceable security interest or lien attaches to personal property when:
- the borrower or buyer signs and delivers a security agreement containing a description of the personal property;
- the borrower or buyer has ownership rights in the personal property, as on a bill of sale; and
- value is given in exchange for the security interest, such as an installment sale of property by a seller or a loan made by a lender. [Com C §9203(b)(3)]
If the personal property consists of standing timber or unharvested crops which the buyer intends to remove, the security agreement needs to also include a description of the real estate on which the personal property is located. [Com C §9203(b)]
The recorded UCC-1 perfects the lien
A security agreement, unlike a trust deed, is not recorded. Thus, the agreement used to create the lien on personal property is not the document used to perfect the mortgage holder’s security interest in personal property against future claims or transfers of that personal property. [Com C §9308]
To perfect a lien on personal property against later claims acquired by others, a UCC-1 Financing Statement is prepared and filed with the Secretary of State, or the local county recorder depending on the type of property. [Com C §§9310, 9501]
The UCC-1 Financing Statement, UCC-2 Change Form and UCC-3 Request for Information Form may be downloaded from the Secretary of State’s website at: //www.ss.ca.gov.
The UCC-1 is a statutory form which contains information about:
- the lender, called the secured party;
- the borrower, called the debtor;
- a description of the personal property, called collateral; and
- a description of the real estate where the personal property is located. [Com C §§9502, 9503]
Additionally, a UCC-1 which describes timber, oil, gas, minerals or unharvested crops as the security for a debt is required to contain:
- a statement the UCC-1 will be recorded with the local county recorder; and
- the name of the owner of the described real estate, if the owner is not the borrower. [Com C §§9502, 9503]
A holder of a mortgage secured by personal property needs to file a UCC-1 to put all parties who later acquire an interest in the secured property on notice of the mortgage holder’s priority interest.
If the holder of a mortgage secured by personal property fails to file a UCC-1, they run the risk of their lien being wiped out if the borrower or buyer later sells or encumbers the property or files a bankruptcy petition.
Without filing a UCC-1, a later buyer or creditor will not have constructive notice of the lender’s unperfected security interest in the personal property. [Com C §9317]
In most cases, the UCC-1 Financing Statement is filed with the Secretary of State. [Com C §9501(b)]
If the UCC-1 covers standing timber, oil, gas, minerals or unharvested crops, it is recorded in the county in which the described real estate is located, usually concurrent with any mortgage recorded against the real estate. [Com C §9501(a)(1)]
A search for liens on personal property is initiated by filing a UCC-3 Request for Information (UCC-3) with the Secretary of State. The response from the Secretary of State to the UCC-3 request is comparable to a title search on real estate. [Com C §9523]
Editor’s note — Before closing a sale involving personal property items, the broker has escrow file a UCC-3 with the Secretary of State or the county recorder to obtain a lien report to verify the personal property is unencumbered.
Sale of a business opportunity
The sale of a business consists of the transfer of both categories of property:
- personal property assets such as goodwill, equipment, trade fixtures, receivables, and inventory; and
- the real estate interest held in the premises occupied by the business, whether fee simple or leasehold.
Usually, the sale of a business opportunity includes a leasehold interest in the real estate occupied by the business. Thus, the sale involves an assignment of the existing lease or a sublease is entered into.
The seller of a business located on leased property, in addition to filing a UCC-1 to secure the carryback mortgage, obtains and records a mortgage executed by the buyer describing the leasehold under which the business occupies the premises. A lease of the premises is an interest in real estate, and is not personal property requiring use of a UCC-1. [Lovelady v. Bryson Escrow, Inc. (1994) 27 CA4th 25; CC §761]
However, when a UCC-1 is used to describe real estate as the property liened, a mortgage on the real estate is created which needs to be judicially foreclosed, unless a power-of-sale provision is included in the UCC-1 or security agreement.
Thus, a mortgage with a power-of-sale provision is preferable to a UCC-1 for creating liens on any interest in real estate. Security interests in leases on real estate are governed by real estate and mortgage law, not commercial codes which govern personal property liens.
The sale of hotels and motels
The sale of hotels, motels and boarding houses involves substantial amounts of personal property, such as furniture, trade fixtures, appliances, maintenance and kitchen equipment. It also includes the sale of future revenues from the rooms, restaurants and shops owned and located on the premises.
Income from room revenue is classified as rent. Rent is recoverable by a secured creditor under an assignment of rents provision as contained in most mortgages.
Rent from real estate, even if generated by a hotel, is not considered business income and thus is not subject to UCC rules governing personal property security. [In re Days California Riverside Limited Partnership (9th Cir. 1994) 27 F3d 374]
Editor’s note — To include the hotel’s rental income as security for the carryback mortgage, the seller includes an assignment of rents provision in the mortgage carried back on the sale. An assignment of rents provision allows the mortgage holder to collect the rental income from a hotel, motel or any other type of income-producing building on the owner’s default.
However, income from other services rendered by the hotel or motel owner, such as food and beverage sales, is liened by a security agreement and perfected by filing a UCC-1. [In re Days California Riverside Limited Partnership, supra; Com C §9102(a)(2)]
Sale of a farm or timberland
The sale of a farm involves personal property such as:
- unborn livestock; and
- unharvested crops.
All of these personal property items may be pledged as security for a debt.
Although plants and trees are considered real estate until severed from the land, unharvested crops, also called future crops, and standing timber may be sold or encumbered as personal property, separate from the real estate. These items are sold or encumbered with a security agreement and a UCC-1. [Com C §9102(a)(34), (44)]
The UCC-1 is effective for five years after it is filed. [Com C §9515(a)]
To prevent expiration of the UCC-1 and retain priority, the lender files a continuation statement, called a UCC-2 Change Form, with the Secretary of State or county recorder within the six-month period before expiration.
The UCC-2 needs to identify the original UCC-1 and be signed by the mortgage holder. [Com C §9515(c), (d)]
Any number of later continuations may be filed, simply by repeating the process every five years. [Com C §9515(e)]