We have recently had inquiries about foreclosures. Given the current economic climate, this is probably going to become more common. The good news is that home prices are up, particularly in the Philadelphia suburbs. But for those who have a house that’s underwater (debt exceeds sales price less commission/transfer taxes) there are things worth knowing.
First, what we like to term a “mortgage” is usually two different legal documents. A mortgage is actually a legal document filed in the Recorder of Deeds telling the public that the owner’s rights come subject to the claims of a lender. The mortgage is the product of a document, which you won’t find in the Recorder of Deeds called a promissory note or simply a “note.” The note says essentially, “I have borrowed money in a certain amount (or up to a certain amount), and here is how I agree to pay it back.” The mortgage itself just references the note and indicates that if someone tries to buy the property the note and the mortgage will have to be paid in full. The legal name for this is “due on sale.”
Today, people in relationships often have very different credit histories. Suppose I am married and I own a house with my spouse. My spouse has a horrible credit history. I want to borrow money but the lender looks at my spouse’s credit history and says “We will lend to you but we want nothing doing with that spouse.” I respond “OK, just loan me the money.” Lender says “We want security for the loan. We want a mortgage on your house.” “But I own the house with my spouse and you don’t like her.” Lender says, “You still need to get her to sign a mortgage because she is on the deed.”
Note well: In this transaction, spouse is not an obligor on the debt. But what spouse actually is doing is agreeing that if I default on the debt, the lender can foreclose on the jointly owned house even though my spouse is not actually a borrower. In other words the spouse signing the mortgage is effectively saying, “Even though I don’t owe the lender any money, I am prepared to see my interest in a house I own lost to foreclosure if the borrower spouse does not pay.” It doesn’t matter whether the non-borrower ever got a dimes worth of benefit from the transaction. Also, once the lender forecloses and even before the lender’s only recourse against the the non-borrower spouse is the equity in the house. In short, if the lender forecloses but the proceeds from the sale are insufficient to pay off the debt, the spouse is not on the debt but pledged the property via a mortgage is off the hook.
So, I borrow the money to start a business and my spouse agrees to pledge whatever interest she has in our house to secure my debt. Then I default on the note by not paying it on time. The lender sues me to recover the debt and takes action to foreclose on the jointly titled house. My spouse typically has no defense. By signing the mortgage (not the note), she pledged the house as security for what was my debt alone.
The house goes to foreclosure. That’s a slow process and in many instances, the home sells at a distressed price. Often, the borrower and the lender will agree to a private sale to a third party even though the proceeds are less than the lender is due. However, that requires agreement between the borrower and the lender – and in a world of big banks with vast bureaucracies, getting lenders to agree to anything requires hours/weeks of time trying to secure their cooperation. Let’s assume that the house is worth $200,000. I owe the lender $205,000. I have a buyer at $185,000. In simple terms, the lender is going to come up $20,000 short if they let the transaction go through. They could force the property to be sold by the sheriff at foreclosure. Then they risk the possibility that the sheriff’s top bid is $175,000; now we have a $30,000 shortfall. The lender has the right to a deficiency judgment against the spouse who signed the loan (the borrower) for the $30,000, but the lender now wishes it had consented to the private sale, which would have produced more money.
Title insurance issues can complicate the problem. Almost every homebuyer wants and should have title insurance. Most lenders on home purchases insist the property have title insurance to protect them as well as the buyer. No title insurer has to insure a transaction and like most insurance companies, they are risk averse. Lenders can release liens of mortgage meaning that even though they are entitled to more money than the house will yield at sale; they would rather take a private deal than see the property sold by the sheriff. However, unless they file a document with the Recorder of Deeds releasing their lien interest, the private sale cannot be concluded. Understand that if a lender releases as lien to permit a sale, they are not releasing the balance of the debt but retaining its rights against the borrower alone. A sale by the sheriff can effectively dissolve the lien on the property even where the debt is greater than the value. Nevertheless, that’s because the sheriff is selling it in an open bid auction. If the debt is larger than the value of the home, the lender has the right to take the property in lieu of the debt repayment. Most lenders avoid that because they don’t like having the responsibility to manage property and deal with utilities, taxes and securing the property.
Tax authorities, including the IRS and many municipalities can be another headache. They have liens for unpaid taxes as well. You and your husband own a house worth $200,000. The mortgage you both signed is for $100,000 of which $50,000 is still unpaid. But your husband owes $200,000 in federal income taxes for which the IRS has recorded a judgment. That debt could prevent a title company from insuring the sale even though the taxes are not yours and the proceeds would otherwise be $200,000 minus $50,000 to pay off the mortgage or $150,000. In theory, the husband’s income tax lien in his name alone should not “attach” to a property that is held as tenants in common or some form of joint tenancy. But title companies don’t have to insure every transaction; only the ones they want and many would rather not risk that the IRS comes after the buyer for buying a property where a tax lien was “of record” when the transaction took place.
Even more alarming is the situation where a divorcing couple agree to sell a property. One spouse agrees to pay the mortgage and occupy the property until it is sold. He/she doesn’t do that causing the debt to increase. Then that same spouse has a $50,000 IRS lien that arises after the agreement to sell the house. The couple’s divorce severed the tenancy by entities and made them tenants in common (each owning 50%). But the $50,000 tax lien due from husband is now clouding the title. In theory, it should come out of husband’s half of the proceeds and if his half of those proceeds can satisfy the $50,000 debt, a title company may insure the transaction. But they don’t have to. Effectively, husband’s poor handling of money after divorce is barring wife from getting her half even though that is what was agreed to. Effectively, wife’s equity has been trapped in the house even though she bargained to get it and its husband’s subsequent bad act (not paying the mortgage or his income taxes) that bar her from getting to what was to be her money.
If the parties are in a divorce, there is a noteworthy legal doctrine called custodia legis. Under an appellate case called Klebach v. Mellon Bank, NA, the Superior Court said that in Pennsylvania, property subject to court orders is not subject to attachment by judicial liens. Lappas v. Brown, supra. See also Weicht v. Automobile Banking Corp., 354 Pa. 433, 47 A.2d 705 (1946) and Buchholz v. Cam, 288 Pa. Super. 33, 430A.2d 1199 (1981) (property in custodia legis is not subject to attachment until purpose for which Commonwealth holds it has been effectuated). See generally, Ross v. Clarke, 1 Dall. 354, 1 L. Ed. 173 (1788) (inception of rule in Pennsylvania that property in the custody of the law is not subject to attachment); Bulkley v. Eckert, 3 Pa. 368 (1846) (early formulation of Pennsylvania rule that property held by a public official in his authorized capacity is not subject to attachment by creditors). The exact limits of this doctrine are not clear. Property settlements are typically orders of court by operation of law (23 Pa.C.S 3105). They sometimes takes years to effectuate. Does that mean that property subject to such an agreement is also immune from attachment for years at a time?
The author thanks Ronald Kalyan of the firm’s Real Estate group for his corrections and additions to this post.