Liens and Encumbrances Affecting Real Property Ownership
Dan Harkey, at DanHarkey.com writes great articles about real estate on his website. You can read more articles by visiting his website. In this article, he discusses “Liens and Encumbrances Affecting Real Property Ownership”
What is a Lien?
A lien is a legal right or claim against property, referred to as a security interest in the same real property. The lien is given or conveyed to a creditor to possess and hold as consideration for a loan.
A creditor/lender is a person or company who willingly makes a loan secured by the security interest in the property. The creditor/lender has a charging interest and claims against the collateral property. In the event of the borrower’s nonpayment or default, the lender may elect to seek possession of the subject property through a foreclosure procedure.
A property owner/borrower willingly grants or conveys a security interest in the real property by signing an instrument called a deed of trust or mortgage. This document must be recorded in a public records office to establish a recorded lien position as a lien attached to the real property in consideration for the loan.
A lien refers to a monetary (money) claim that will be attached to a property by a recording instrument and becomes an encumbrance on one or more properties.
In the event of a default by the borrower and a subsequent foreclosure procedure, the lender’s intent is to take ownership and physical possession. After ownership has been reclaimed, the lender will usually try to resell the property on the open market to recover the lender’s capital. Relying on an identifiable equity cushion and having a lien or security interest in the property is usually the lender’s method of protecting their capital. Equity is defined by market value minus all liens.
What is an Encumbrance?
An encumbrance refers to a legal claim or agreement to enforce rights and obligations relating to a real property. The claims are against the property by an independent party who is not the property owner. The claims restrict the free use of the property until the encumbrance is lifted, reconveyed, or modified. There are dozens of items, instruments, or agreements that may be recorded in public records that create either a lien or an encumbrance on the property. Here are a few:
- Originally recorded tract map for the entire neighborhood.
- Utility easements, other easements, government-mandated requirements such as historical registries, leases, encroachments, air and subsurface rights, height, and view restrictions.
- Association by-laws, covenants, ownership and partnership agreements, and tenancy leases; various public notices such as notice of weed abatement, notices of a substandard condition.
- Lis pendens, property settlements, divorce decrees, subordination, non-disturbance, and attornment agreements (commonly abbreviated as an “SNDA”), parking easements, reciprocal parking agreements, signage easements, memorandums of agreement.
- Property taxes, federal or state tax liens, zoning laws, environmental regulations, Etc.
The lending industry sometimes uses terms lien, and encumbrance interchangeably. However, a lien is generally a recorded monetary (money) charge against a property. All liens are encumbrances, but not all encumbrances are liens. They both create a claim against the property that impacts the transferability. Both restrict the free use until the claim is lifted, reconveyed, or modified in writing.
The other option is for a new buyer or lender to accept specific liens and encumbrances on the property as part of the agreed transaction and take ownership subject to the items or issues. Those liens and encumbrances will remain on title, and the property ownership is conveyed to another party “subject to” those items remaining on the title.
Some encumbrances negatively affect the usage, desirability, and marketability of a property. In some cases, the negatives might be significant enough that the title may not legally be conveyed or transferred to another party. The issue may be conflicts in limited partnership ownership rights, claims of processionary rights, or other problems with the inability to convince a title insurer to provide a title policy on the conveyance.
An encumbrance may be financial such as a money lien or non-financial claim to enforce private agreements or public rights, prohibitions, and restrictions.
How does a lien or encumbrance become attached to a property?
In the United States, we have a standardized government records system referred to as the municipal recorder’s office. Whether city or county municipality, the recorder’s office, has the task of maintaining public records and documents relating to real estate ownership, and individual public notices. Their job includes recording and preserving historical records and making those records available to the public.
The recording process and the management of public records have been made more convenient with current technology.
The purpose for recording documentation:
The purpose is to covey constructive notice of recording documents and instruments that affect the of the chain of title. The purpose is also to provide accessibility of public records and a traceable chain of title documents attached to real properties. Interested parties may trace the documents for many years to determine ownership, liens, encumbrances, and whether they are voluntary or involuntary. Generally, recording statutes permit (not require) the recording of instruments that historically affect the chain of title to or possession of the real property.
Suppose a person fails to use the public recording method. The penalty in that case is that the person could have difficulty with any subsequent conveyance action desired relating to proving up ownership or status of the position of interest. Even though a recorded deed is not essential for a valid transfer, an unrecorded deed leaves the property available for other unrelated documents to be recorded and possibly take a senior lien position.
I recall a time in the past when only paper records existed. Then came what was considered a substantial improvement called microfiche records databases. Microfiche as a flat piece of film that contained microphotographs. These images were reduced from the original. The materials were made of plastic (acetate) between the 1930’s-1980’s then polyester from 1960’s to the present. The film has a silver-gelatin emulsion coating on it. A single 4 x 6-inch sheet of the film may have many separate frames. A copy would be obtained by use of a scanner and photo and editing device. By today’s standards, this is an obsolete method.
Public records may contain notices of encumbrance for both voluntary and involuntary rights and claims. Liens and encumbrances create clouds on the title that must be acknowledged and dealt with by the transaction procuring broker, purchaser, or lender. A purchaser or lender may either accept the property with the conditions, removing them from the title, modify it, or reject it the property because the risk is too significant.
Each document recorded against the property may contain agreements, considerations, prohibitions, and risks that the borrower/lender must consider. A recorded trust deed may have 20-40 pages of legalese that the borrower should review as should the borrower’s counsel, borrower’s agent, and the prudent lender. The document may contain clauses such as a “due-on-sale,” “due-on-further encumbrance,” “default provisions,” or “representations and warranties” by the borrower.
Because of the tremendous complexity, the subject relating to various clauses in loan documents, which generally create restrictions and prohibitions, should be addressed in a separate article. An option would be for interested parties to seek out competent counsel.
The real estate or lending broker/agent has a fiduciary responsibility to assist the buyer/borrower in understanding the documents. Below is a good review summary of fiduciary duties.
Sometimes a property owner may record notices of changes in public records that amend ownership status. An example would be changing or conveying the title of a property from “husband and wife as joint tenants” to a “revocable family trust.” Another example may be recording a divorce decree or a quitclaim relinquishing one’s interest in the property to another party as part of a negotiated settlement.
What is a first, second, and third lien priority position?
Lien priority is related to the precise time when the document is recorded in the recorder’s office to become a matter of public records. When a document is recorded, it is date-stamped and affixed with a sequential recording reference number. If a borrower or their title company recorded three liens simultaneously on a single property, that would create a first, second, and third lien, regardless of the dollar amount of each lien. The first-lien, or earliest recorded, is considered a senior lien, the second and third liens are junior liens, with the second lien senior to the third. After the documents are recorded and scanned into the public records computers, the title company, lender, or borrower will receive the original date-stamped documents with reference numbers for confirmation of validity and safekeeping.
What ensures the order of the recording to be considered a first, second or third? How do you know that the recorder did not mistake and record the documents out of order? You may order and pay for an insurance policy referred to as title insurance from an insurance carrier. The title insurance policy is intended to guarantee your lien priority position, without which the carrier may be required to pay an insured claim.
If you were to go to the recorder’s office, stand in line, and have your documents recorded, you could check the sequence of recording yourself. But, generally, the recording of documents is done by a title company carrier for sales or loan transactions.
Let’s assume that there was a first lien of $500,000, the second lien of $100,000, and a third lien of $50,000 all recorded on the subject property. If the first lien is paid off and reconveyance is recorded by the trustee, that procedure will remove the first lien off public records entirely. The second lien would become a first lien, and the third would become a second lien.
A reconveyance is a written form signed by the trustee when the lien is fully satisfied. The reconveyance instructs the recorder to remove and release the lien from public records.
If you were to refinance the same property and merge all three liens into one new single loan, then all three liens would be reconveyed by the trustees and removed from public records. A new recording with a fresh date stamp and recording number would reflect the new first lien position. The system works well if, for a fee, a title insurer provides an insurance policy which guarantees the lien positions.
There are many reasons to create written agreements that are intended to modify the lien priority by mutual understanding. One method is called a subordination agreement. This agreement makes the subject lien junior to another lien even though it was recorded earlier with an earlier date stamp.
Voluntary vs. Involuntary liens:
A voluntary lien is a claim that a person or a lender has over the property of another as security for payment of a voluntary debt. The liens are attached to the property rather than the person. A trust deed or mortgage lien is voluntary. The lien involves a legal claim on assets such as real property. The recording of a notice of the lien is with the county or municipal recorders office. An owner may not sell the property without acknowledging, dealing with, or extinguishing the lien.
An involuntary lien filed against your property will become a cloud on the title. Filing a lien against private property is a way for creditors or government agencies to force payments of involuntary debts. This includes obligations such as local, state, and federal tax liens, a notice of substandard conditions, contractor claims that are mechanics liens, Homeowner association dues, child support payments, and judgments from civil suits.
Liens may be consensual such as a loan, statutory property taxes, or based upon a court judgment. A judgment lien is the most dangerous because a judge has the authority to order a recording of a lien on one’s property, whether for rightful reasons or subject to objection.
Statutory skipping power in front of other liens:
California law regards lien priority as “first-in-time, first-in-right.” First in time refers to the time of recording with a corresponding precise time date stamp number. California laws also allow exceptions for some types of liens whereby certain liens are given “skipping power” to the front of the line regardless of recording time. Front of the line means giving lien priority position preference over other recorded liens and encumbrances.
Government mandates permit certain liens to be advanced, so they become the senior priority to other liens. Mechanic’s liens, meant to ensure that tradesmen and contractors are timely paid, is an example of a priority lien with “skipping power.” This right is protected by the California Constitution and further enumerated in the California Civil Code (Section 3110 et seq.)
There are limits, however, on the “skipping power” of mechanics liens. These relate to technical requirements such as when the construction began, and the claimant’s process to enforce that lien. Even in situations where the mechanic’s lien appears to have been “wiped out” by a senior lienholder at a foreclosure sale, the lien is not automatically expunged. For more specific requirements for mechanic’s liens, the lender should work with counsel knowledgeable about construction and mechanics lien law.
Other exceptions relating to “skipping power” may include issues relating to property taxes, special tax assessment districts, and sometimes homeowner’s or mutual property associations.
A written lease agreement has a “first-in-time, first-in right” priority. Lessees’ who have written agreements recorded at the county recorder’s office with dates before recording a new trust deed will have a right of occupancy and enforcement senior to the new lien. The lessee’s rights will run with the property until the rights expire or are changed in writing by mutual agreement. Below is an instructive example.
Lien priority changes through written agreements:
A real estate lender may require, as a condition of approving and closing a loan, a written modification of the statutory priority by using an agreement between the borrower, the tenant, and the lender. Sometimes it is in the lender’s best interest not to preserve the tenancy in the event of default and completion of a foreclosure procedure. In this case, a straight subordination signed by the tenant would be appropriate. Any action causing a change in the chain of title may cause the tenant’s priority to be lost. If the tenant’s priority is lost, the tenant could be given a notice-to-vacate and kicked out of the property.
In some commercial transactions, the lender may wish to preserve the tenancy of credit tenants to preserve the property’s cash flow, stabilized occupancy, and value. A subordination, non-disturbance, and attornment agreement “SNDA” may be the appropriate document to record. SNDAs are agreements between a lessee (tenant), lessor (landlord), and lender defining certain rights and responsibilities. Other parties may be affected, such new a purchaser of the property. The SNDA will protect the tenant from being evicted if the landlord stops paying the loan payments to the lender(s).
If you find value in this article for you and your associates, please forward it to others that may appreciate its contents. I think the reader will realize the importance of competent counsel.