Foreclosure v. Deed in Lieu of Foreclosure

By Jonathan Richards

(Publisher, Noteworthy Newsletter)

In these turbulent economic times and declining property values, foreclosures are unfortunately commonplace events that all trust deed investors must consider. An alternative to a foreclosure is accepting a Deed in Lieu of Foreclosure. A Deed in Lieu may be submitted by the borrower by mutual agreement of the borrower and lender or sometimes the borrower will submit the Deed in Lieu f unsolicited. The ordinary effect of the taking of a Deed in Lieu is to extinguish the lender's deed of trust and vest the lender with title subject to all other existing liens and encumbrances. In effect, the lender becomes the new owner. The lender is not required to accept the Deed in Lieu and can show his/her refusal by filing a Notice of Non Acceptance with the County Recorder. In any event, a decision is required whether to accept the Deed in Lieu. Usually the owner is submitting the Deed in Lieu when he/she is unable to meet his/her obligations and the property equity has gone to zero. Care should be taken that proper consideration is given for the property received under the Deed in Lieu. It is possible for the borrower to come back anq reclaim the property accusing the lender of taking unfair advantage. Special wording should be added to the Deed in Lieu to document the understanding between the borrower and lender.

Before accepting the Deed, an examination of a Preliminary Title Report should be made to determine the existence of other liens previously known or not. As mentioned previously, these liens remain after the Deed is transferred. This is generally different from a foreclosure in which the liens junior to the foreclosing deed holder can be wiped out if the foreclosure sale comes up short-. Accepting the Deed in Lieu may leave the Trust Deed investor with substantially less if the existing junior liens eat up a substantial part of the property's equity. Legal experts generally advise the issuance of a new owner's title policy insuring that the lender will be acquiring marketable title.

The safest route is to have the transaction handled by an escrow company with new title insurance. If the transaction is handled informally outside an escrow, the lender leaves him/herself vulnerable to liens filed just before the filing of the Deed in Lieu of Foreclosure.

 

When The Senior Lien Goes To Foreclosure

As a note holder investor, you not only have to take steps to avoid a foreclosure' situation on your own note, but, with the existence of senior debt, you must be aware of the ramifications of any trouble that may befall the senior lien. With a senior lien foreclosure, the junior lien faces options that may be less than desirable. During the foreclosure/default process, the junior lien holder can advance monies to bring the senior lien current. He/she can then tack the advances on to the junior lien amount and consequently start foreclosure process at the junior lien level. Of course this requires the cash needed to make this happen. A more drastic measure is to attend the foreclosure/trustee sale and make sure the bids are high enough to pay the senior liens and the junior liens. Without this help, the bids may only be high enough to satisfy some or all of the senior liens and result in the junior liens being sold out. If the junior lien holder gets this far, he/she can sue for a deficiency judgment. This is available as long as the junior lien is not classified as a Purchase Money Loan, in which case no deficiency claim can be made.

 

As often is the case, the best results come with some investigation and preventative measures. When investigating your trust deed investment don't forget to look at the senior debt. Here are some things to look for:

  • Payment Terms: There are some HUD programs that allow the suspension of payments for a period of time if the borrower is having difficulty. These unpaid amounts are tacked onto the loan balance thereby increasing the senior lien and reducing the security of the junior lien(s). There are some negative amortization programs that have the same affect.
  • Payment History. The payment history on the senior debt is some indication of the credit-worthiness of the borrower.
  • Due on Sale Clauses. This can be good and or bad. The good: A sale can trigger a refinancing which can mean an early payoff on the junior trust deed. The bad: A foreclosure by a Junior Trust Deed may cause the due on sale to be invoked on the senior lien.
  • Prepayment Penalty. This can reduce the chances of a refinance and therefore an early payoff of the junior lien.
  • Blanket Encumbrances. The existence of multiple securities can complicate the security interest of the junior trust deed.
  • Unusual Loans. Certain CAL-VET, Ioans are not really loans at all but sales contracts. The borrower does not really own the property, since it is owned by the state. This makes it difficult to. collateralize a junior lien.

 

Here are some other important factors to keep in mind:

  • Generally, in a trustee sale, the junior trust deed holder cannot use any part of the junior trust deed principal in a credit bid but must use cash or a cash equivalent.
  • If the beneficiary (borrower) is the successful bidder in a trustee sale, the junior lienholders would reattach to the security.
  • Junior lienholders are entitled to any surplus from a trustee sale in order of priority.
  • If a deed is given the senior lien holder in lieu of foreclosure, the senior lien would generally merge into title. This would be an advantage to the junior lien holder. Priority would move up.

Source: Mortgage and Deed of Trust Practice Roger Bernhardt 1990 California Education Bar.

 

Foreclosure vs. Accepting a Deed in Lieu of Foreclosure

 

Here is an example of how the outcome can be dramatically different on these two alternatives to taking possession:

 

Our Example:

Property Value $900,000

Our Loan - First Trust Deed - Foreclosing

Lender $150,000

Other Liens Junior to Our Deed of Trust: $100,000

 

In a Foreclosure Sale with the successful bid being the Fair Value of $200,000, $150,000 would go to us and $50,000 to the Junior Liens. The balance of the liens would be sold out.

 

If a Deed in Lieu of Foreclosure is accepted, the Junior Liens stay on the property. This in effect leaves us, as the new owners of the property, an equity of $100,000 (Value of $200,000 minus the $ 100,000 in Junior Liens). We lose $50,000 by taking the Deed in Lieu over a Foreclosure.

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