We ended our last blog with a land mine many investors face during a purchase of a property in foreclosure – unknown or unforeseen liens such as past HOA dues.
Because foreclosures present good purchase opportunities for investors, it’s important for investors to understand basic concepts in the foreclosure process. All foreclosures are actions are filed upon some kind of lien. A lender’s mortgage foreclosure is by far the most common type of lien. Here’s how it works.
A plaintiff initiates a foreclosure by filing a legal document called a “complaint” in court. The complaint states the basis for the case and sues “defendants.” Defendants include the property owner (who is usually one and the same as the borrower, but sometimes not) and other lien-holders alleged to stand in line behind the plaintiff due to the lower priority of those liens. To extinguish those other liens, the plaintiff must sue the junior lien-holders who usually lack a legal defense to fight back.
Creditors with liens lower than first position may also foreclose, but they name as defendants only the lien-holders beneath them and don’t sue the ones above them. This is where we find some of the most dangerous mine fields for investors. Perhaps the most common investor mistake in the foreclosure space is to bid on a property in a foreclosure sale for a non-first position lien while not knowing a superior lien exits. This happens most often at an HOA foreclosure court sale.
Because the mortgage is superior to the HOA lien, the HOA won’t sue the lender in its complaint. Without performing due diligence such as a “pencil” or “o and e” search (discussed in Part 1 of this blog series), the investor doesn’t realize there is a mortgage lien on the property. At that point, they become the new title owner by paying off the HOA debt at the court sale, but then find out there’s an outstanding mortgage debt to be paid or that lender will foreclose. The new owner doesn’t assume personal liability for the former owner’s debt, but does stand to lose title and the money sunk into the court sale unless they can pay the mortgage debt.
This situation described above is the best illustration of the importance of investors going in with eyes wide-open. Just like it’s ok to buy that 7-11 hotdog when that’s what you want and you know what you’re buying, it can be a smart strategic move to bid at a foreclosure sale based on a junior lien. The following is an example.
A homeowner may have much equity in a property due to a low mortgage balance in relation to the property value. The owner may fall behind on the HOA dues, leading to a foreclosure. Chances are, if the owner isn’t paying the HOA, they’re also not paying the mortgage lender. Either because the mortgage payments are current or the lender is slow to sue, the HOA could take the initiative to file a foreclosure before the lender does. When the winning bidder takes title by paying off the HOA lien at the court sale, they still have a mortgage lien to address. If there is a wide berth of equity, the new owner can sell the property, pay off the lender and keep the balance as profits.
Every investor should approach a lien-infested property cautiously. This means doing thorough due diligence including a pencil search, review of public records and review of the foreclosure complaint.
By reviewing the complaint, you can see who are the named defendants and cross-refence that to the pencil search results. If there are lien-holders not being sued in the complaint, it’s either because that lien stands ahead of the plaintiff’s interest and there’s no basis to sue them or that lien was missed in a title search done by the plaintiff’s attorney leading up to the case filing. Most likely, it will be the former rather than the latter. If there’s a junior lien not named in the complaint, it will remain intact following the foreclosure and the new owner could be forced to pay it to clear title.
It’s also important to know that certain government liens may not be wiped out during a foreclosure. Property taxes owed are an example of a debt that takes priority over a mortgage lien. Others include municipal liens, utility liens for gas, sewer and water and other special assessments. These can be found through an inexpensive municipal lien search, which is often part of the pencil search.
A mortgage lender may foreclose against county code enforcement liens, but fines incurred for ongoing violations after the foreclosure become the responsibility of the new owner. Another danger investors should be aware of involves “cross-contamination” of code enforcement liens on other properties.
If you take title of a property with code enforcement liens, you face the risk of those liens attaching to every other property you own in that county. An effective strategy to avoid this outcome is to use separate land trusts to hold title to each of your properties so that each will have a separate legal title owner and this lien epidemic may be avoided.
There may also be an IRS lien on a property for failure to pay taxes. An IRS lien is considered junior to the mortgage lender’s rights and lenders will name the IRS as a defendant in its foreclosure complaint. The wrinkle with an IRS lien is that following the foreclosure, the government has a 120-day redemption period to claim its rights to the property. The IRS rarely takes the initiative to make this claim, but this remains a risk and prevents an investor from flipping the property within that time frame.
Ultimately, real estate investors should not be deterred by liens on properties as acquisition targets. It’s been written that the Chinese character for “crisis” is a combination of the characters for “danger’ and “opportunity.” Whether that’s real or urban legend, it’s a concept applicable to investing. When a property owner is in a state of crisis due to liens, this presents both danger and opportunity to any potential buyer. With a good understanding of the legal concepts surrounding liens and legal counsel, great results may be realized.
If you have questions or need assistance with real estate related matters such as liens, contact attorney Charles Castellon today.
