Lien Priority Determines Who Gets Paid & How Much
When you first start to list a short sale property, you need to figure out how much is owed on the property. Most homeowners can give you the mortgage statements and you can calculate the balance due. However, I have had some “special” clients, who have mortgages, liens, judgments, unpaid property taxes, IRS tax liens and all sorts of items to keep my life interesting.
Unless you are absolutely certain you know all the debts secured by the property, do a title search to find out how what needs to be paid to close the sale i.e. find out how many liens there are and how much each one is. A lien is something that is attached to the property that must be dealt with when you transfer the title. Normally, you pay the debt and the lien is released. The type of lien you may be familiar with is a deed of trust that secures the payment on a mortgage loan. If there is a lawsuit that results in a judgment against the property owner, it can be recorded in the county where the property is located, and the judgment becomes a lien against the property. If people who do work on the property are not paid, they can file a mechanic’s lien. If the homeowners association is not paid, they have the ability to file a lien under the terms of the declaration of covenants, conditions and restrictions that cover the neighborhood. The taxing authorities can file a lien if the property taxes, state income taxes or other assessments are not paid. Similarly, if the Internal Revenue Service is not paid, they can file a lien.
It probably does not surprise you that the IRS has special rules. No matter when they record their lien, they are in first position. But, you may be able to work out an arrangement with the IRS to get the property released from the lien if the seller enters into a payment plan with the IRS. As you might expect, the IRS is slow, so you need to start work on this lien as soon as the property is listed by presenting whatever paperwork the IRS wants. Sending the hardship letter discussed in the post “Do a Compelling Hardship Letter” is a good way to start. One of the reasons to start early is to open a file on this request and have it assigned to the right department in the IRS. In this manner, when you get an offer, you are ready to submit the closing statement and other documents to the right person. Just like all the other creditors, the IRS wants to see that the owner is walking away with nothing, because if there is any money left over, they want it.
If there are more liens than there is money, who gets paid and who doesn’t? Normally, it is based on the priority of the liens. The standard rule is that the date the lien is recorded with the county recorder determines its priority. So, the one filed first is first, the one filed second is second and so on. But, if it was that easy, lawyers would not have to spend all that time dealing with title issues. Also, the rules of priority change from state to state.
The effective date of a mechanics lien is usually the date work was started on the property. So, if a custom home was built starting on January 2, 2008 and the landscaper was not paid for work done in June, 2008, and a mechanics lien is filed in July, 2008 the effective date of the lien is January 2, 2008, which would give it priority over a judgment filed in April, 2008.
How do you figure it out? You let the professionals do it. In my short sale addendum, I specify one closing attorney that will close the sale if a buyer wants to purchase a short sale property listed with me. That closing attorney may as well do the title work early, as nearly all of my short sales sell and close. The attorney can do the search and tell me the priority of the liens. Once you know the lien holders, order the payoffs on the mortgages as early as possible. You will need accurate numbers to put in the draft HUD so that you can determine how much money you will need. It is always interesting to see just how much it would take to fully pay everybody. After you know the totals, you work backwards to decide how much you can pay each lien holder.
Why does priority matter? Because if the first lien is foreclosed, all the lower priority liens are no longer attached to the property i.e they get wiped off by the foreclosure. The creditors may be able to chase the former homeowner after the foreclosure, but they will not be able to get money out of the property (unless it sells at the foreclosure sale for enough to pay the first debt with money left over, which will go to the next debt until it is used up, which is about as rare as a chicken with lips). So, the first loan will normally get paid much more in a short sale than the second, third and fourth. This is particularly true if the first loan has started a foreclosure proceeding, because all the other loans will get nothing if the foreclosure occurs.
Are there any rules of thumb? All kinds of them, and each lender tries to make them up as they go along. Many of the first lenders will insist on getting fully paid before they will let the second lien holder get anything. Many first lien holders will let you give the second lien holder up to $3,000 when they are not fully paid. Others have administrative rules that are a reflection of their business model. For example, Bank of America has decided it is not worth their while to process a short sale on a second or lower priority lien unless they get 10% of the outstanding balance. Their claim to logic is the cost of the staff time would exceed the amount they could recover on extremely small payoffs. I happen to disagree, because it takes no time at all to say you will take something instead of nothing particularly if you change your review process to minimize the number of documents you want in the short sale package. So, this is just a negotiating technique referred to as “higher authority”.
The other fun thing in negotiating with junior lien holders is the “south end of a north bound horse” effect. Some lien holders are so upset with the seller that they will not settle for less than full payment. If they mess up the seller’s short sale, there is an emotional satisfaction that is worth the financial loss. So, they will force the foreclosure unless you find a way to get them paid.
When you are negotiating with each lien holder, try to get a full release of the entire debt in return for the payment. You can negotiate a settlement where the lien holder will release the lien and apply the payment toward the debt, but not release the rest of the debt. It gets the property sold, but the creditor can chase the seller after the sale. If you can get the lien released and get the rest of the debt satisfied and released, the seller walks away clean. So, you have accomplished the full payment of a debt with the limited proceeds from the sale. You will not always be successful in getting a full release, but if you do not ask, you do not get. If you only get the lien released, you have succeeded sufficiently for the task at hand.
My policy is to deal with any type of lien holder and any number of liens. One of the more complex short sales had first, second and third mortgages, a judgment and unpaid property taxes. You have to realize that the more liens the more complex the sale. A sale with four liens is much more than four times the complexity and more than four times the work. If you are smarter than I am, you might want to refer complex short sales with multiple liens to another Realtor who is set up to handle difficult cases.
If all this gets too complicated, sit down with your favorite closing attorney and let them figure it out for you.