20 Jul Today’s Subject? The Subject-to Transaction!
Mae owns a house, and she has fallen behind on her mortgage payments. Her lender states that she owes $165,000, and the amount she could pay to make the loan current is $15,000. The monthly mortgage payment is $1,000. The house needs about $10,000 of repairs, and the value of the house if these repairs were made would be $250,000. Mae can’t seem to come up with the $10,000 to perform the repairs. Mae knows that despite her mortgage default, she still has some equity. Mae is fed up with all the issues. She just wants some money to walk away and avoid foreclosure.
Along comes Pierre. Mae explains her problem to him, and Pierre wants to buy the house. While Pierre has $40,000 in savings, his problem is that he needs to improve his credit a little more to qualify for a purchase money mortgage. So Pierre can’t get a loan right now to buy Mae’s house the traditional way, and Mae can’t come up with the $10,000 to repair the house.
Pierre explores his limited options, and he thinks his best choice is to conduct a “subject-to” transaction with Mae. He wants to fix and flip the house, and all he has in savings is $40,000. Pierre thinks he can make the deal work in the following way:
- Pierre offers to pay $5,000 to Mae to sign a quit claim deed over to him, which he will immediately file in the public records. As part of the deal, Pierre would agree in writing to pay Mae another $10,000 when the house is flipped.
- As the new owner of the house, Pierre would immediately pay $15,000 to Mae’s lender to make the loan current. In his agreement with Mae, Pierre will then make every monthly payment of $1,000 PITI (principal, interest, taxes and insurance) until he sells the house. Pierre figures he will only have to make two to five monthly payments since he plans to flip the house.
- Pierre plans to spend $10,000 on renovations. The house would then be worth around $250,000. With a two-month renovation period, Pierre calculates that he would end up spending $33,000 ($5,000 to Mae up front, $15,000 to Mae’s lender, $10,000 on the repairs, $2,000 on mortgage payments, and $1,000 on other costs like filing the deed, buying his own insurance, and utilities).
- Pierre plans to put the renovated house up for sale with a real estate agent for $250,000.
- If a buyer pays $250,000, then Pierre figures that he will net $60,000. Of that $60,000, $33,000 would be his original investment and $27,000 would be his profit. See the breakdown below:
$250,000 Sale price
– $ 15,000 6% realty commission
– $ 10,000 Final payment to Mae
– $165,000 Payoff of Mae’s loan
$ 60,000 Proceeds to Pierre, of which $33,000 is his original investment and $27,000 is profit
With what Pierre proposes, Mae would avoid foreclosure, receive $15,000, and have her debt paid off. Pierre would earn $27,000 profit. Mae’s lender would be paid in full.
So, a subject-to transaction is one in which the buyer acquires the property subject to the existing liens. The buyer takes control of the property, yet there is a cloud on the title in that the seller’s lien still needs to be paid. The buyer can avoid having to obtain financing, since they’re essentially taking over the seller’s financing. The seller receives a quick solution to their problem, and they are able to extract some of their equity.
There are many pitfalls to a subject-to transaction. Most lenders have a due-on-sale clause in their fine print, which means that if any portion of the property were transferred, then the lender could call the loan due. The reality is that many lenders are happy to receive timely payments, yet there is always a risk to the buyer that the loan would be called due with only 30 days’ notice.
Another problem is that the buyer typically has to pay homeowner’s insurance twice. They would pay the seller’s insurance, which is still in place and paid via the lender’s escrow. The buyer should also obtain insurance for their property. Perhaps the buyer could be added to the seller’s insurance as a “named insured,” yet in the event of a claim being paid it’s possible that the seller might try to keep the insurance money. If there were a claim, it’s possible that either or both insurance companies would balk at paying the claim. After all, the seller would no longer be the owner so why should their insurance company pay anything?
Another issue has to do with title insurance. The seller’s title insurance covers them, yet they are no longer the owner. The buyer would not be eligible for title insurance yet since there is a cloud on the title. If there were a claim from the past, the buyer would be exposed to the claim.
Yet another challenge for the buyer is what if the seller has other liens against the property? The buyer should conduct a title search to ensure that there isn’t a second mortgage, mechanic’s lien, judgment, or other debt.
Since the property is still legally the seller’s liability, there is potential for it to be seized if the seller declares bankruptcy. There may be complications for the buyer if the seller dies before the loan is paid off.
If your state requires that realty transfer tax be paid when a deed is filed, then that’s another expense that presumably the buyer will have to pay.
It’s possible that the lender could figure out that the property has been transferred through any of a number of ways. The buyer would file their quit claim deed, and if the lender conducted an updated title search they would see it. If the buyer changes the mailing address for the seller’s mortgage statements, that could be a red flag. If the seller’s lender has already hired a law firm as part of the foreclosure proceeding, that law firm may discover the quit claim deed in the public records.
The subject-to transaction is a way for flippers with limited cash to avoid taking out another loan. It’s a creative form of short-term owner financing. Many subject-to transactions involve flips. Some of the time, a subject-to transaction could go on for years as the investor rents out the house and simply pays the seller’s loan every month.
If you have the means to purchase a property up front, that avoids the problems of a subject-to transaction. If you don’t have better options, then a subject-to transaction could work. Consult your legal and tax advisers before attempting a subject-to deal.
Tai DeSa is a graduate of The Wharton School of the University of Pennsylvania. He became a full-time real estate investor in 2004 after serving in the U.S. Navy. Tai has made colossal mistakes in investing (and learned some things along the way). He has helped hundreds of homeowners avoid foreclosure through successful short sales. Check out Tai’s books on Amazon.com. Tai may be available for coaching and speaking engagements on a variety of real estate topics. Send an email to tai@investandtransform.com.
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