“Subject To” Transactions in Texas

Introduction

In order to understand “subject to” transactions, one must separate the concept of title from the concept of debt. They are divisible. A deed is a signed and acknowledged document that conveys legal title to real property. A note is a signed document promising to repay a debt. The two can be split and frequently are. Transferring title to real property without transferring the obligation to pay the debt associated with it is a “subject to” transaction. Sub2s are often used by investor-buyers in order to buy, fix, and flip for a short-term profit, all before the loan gets so far in arrears that a foreclosure occurs. Presumably, upon resale, the buyer’s new loan eliminates all prior existing indebtedness and liens.

Mechanics of a Sub2

In a sub2 transaction, an investor-buyer takes title but makes no promises (either to the lender or to the seller) about assuming the existing debt. As with all real estate transactions, it matters if one is the buyer or the seller when it comes to drafting the legal documents.

Core documents for the buyer on sub2 transaction would include:

(1) custom lawyer-prepared sub2 addendum for the TREC 1-4 contract (since neither TREC nor TAR promulgates an addendum specifically for sub2s);

(2) a general warranty deed (no vendor’s lien) containing language specifically providing for a “subject to” transfer of title;

(3) a comprehensive “subject to” agreement (unrecorded) covering miscellaneous details of the agreement between the parties; and

(4) a special power of attorney granted by the seller authorizing the buyer to contact the lender directly and obtain loan payoff information.

Core documents for the seller on sub2 transaction would include:

(1) custom lawyer-prepared sub2 addendum for the TREC 1-4 contract (since neither TREC nor TAR promulgates an addendum specifically for sub2s);

(2) a general warranty deed with vendor’s lien containing language specifically providing for a “subject to” transfer of title;

(3) a comprehensive “subject to” agreement (unrecorded) covering miscellaneous details of the agreement between the parties;

(4) required seller notices including a 7-day notice to the purchaser of existing prior recorded liens (right to rescind) pursuant to Property Code Section 5.016 (not applicable where a policy of title insurance will be issued to the purchaser); a 7-day notice to the lienholder of a proposed sale of security property pursuant to Property Code Section 5.016; and a notice to the purchaser regarding potential property insurance coverage issues pursuant to Finance Code Section 159.101 (must be given at least 7 days before closing).

Form of Sub2 Deeds

The “subject to” deed is the heart of the whole arrangement. A properly-worded sub2 deed expressly states that the buyer will not be assuming responsibility for any debts or liens against the property. There is no standard form for a sub2 deed although Texas does have certain rules that apply if any deed is to be valid. This is a sample sub2 clause in warranty deed:

This conveyance is made subject to any and all indebtedness of Grantor and liens against the Property, including but not limited to that certain indebtedness and liens securing same evidenced by a note in the original principal amount of $____, dated ____, executed by Grantor and payable to the order of ____, which note is secured by a vendor’s lien retained in deed of even date recorded at Clerk’s File No. ____in the Official Public Records of Real Property of ____ County, Texas, and is additionally secured by a deed of trust of even date to ____, Trustee, recorded at Clerk’s File No. ____ in the Official Public Records of Real Property of ____ County, Texas. Grantee does not assume payment of this or any other indebtedness of Grantor.

Must the buyer sign a sub2 deed? Usually not. Most often, the investor-buyer is accepting title and making no promises or agreements at all, so there is no reason for a signature. However, if there are additional points of agreement, then these may be inserted into the deed and accompanied by the investor-buyer’s signature, making the deed serve the dual purpose of a conveyance and a contract. If these additional points are lengthy (or perhaps better kept confidential) then it is advisable to create a stand-alone unrecorded sub2 agreement, which is similar in many ways to the side agreement that is often executed as part of an assumption package—except, of course, for the obvious difference that in the case of a sub2 transaction the existing indebtedness is not being assumed.

As with other deeds, the sub2 deed need not reflect cash paid by the investor-buyer (presumably a buyout of the seller’s equity in the property, if any). It is customary for confidentiality reasons to recite that consideration paid is “ten dollars and other valuable consideration” although the actual amount paid can always be shown if the parties desire to make that information part of the public record.

Recording a Sub2 Deed

As with any other deed, there is no requirement that a sub2 deed be recorded in the county clerk’s real property records in order to be valid—only that execution occur before a notary followed by delivery to the grantee. When this is done, the title transfer is effective between the parties. It is nonetheless in the buyer’s interest to record the deed, not just to preserve the record chain of title but to avoid the possibility that the grantor may sell the property twice.

General Warranty Deeds Versus Special Warranty Deeds

The term “warranty deed” is loosely used to refer to a deed that contains both express and implied warranties. There is also a deed without warranties. A general warranty deed is the preferred form of deed for a buyer because it expressly warrants the entire chain of title, whereas a special warranty deed warrants title only from the grantor. Although special warranty deeds are more common in commercial transactions, receiving a sub2 deed with special warranty should not trouble an investor, particularly since the last transaction involving the property likely encumbered it with a purchase-money lien and therefore a title policy was issued at that time.

Sub2 Versus Quitclaim

Some investors consider it adequate to acquire a quitclaim from a seller rather than a sub2 deed with either general or special warranties. This is not the best practice. Why? A quitclaim is the weakest form of transfer and title companies often decline to insure a chain of title containing a quitclaim. A title company may ask that a deed with general or special warranties be obtained to replace the quitclaim. If a grantor is unable or unwilling to provide any warranties then a deed without warranties should be used.

Required Seven-Day Notices

As with wraparounds, two seven-day notices are required by Property Code Section 5.016 to be given by the seller (but only if the transaction is not closed through a title company). Specifically, the seller must: (1) give seven days’ notice to the buyer before closing that an existing loan will remain in place; (2) inform the buyer that buyer has this same seven-day period in which to rescind the earnest money contract without penalty; and (3) also provide a seven-day notice to the lender.

Lenders do not usually respond to Section 5.016 notices, nor is lender consent required under this law. As a consequence, the seven-day notice requirement is widely disregarded in sub2 transactions. However, when advising sellers, real estate lawyers will always recommend full compliance.

Due-on-Sale Issues

There is no such thing as breaching or violating the usual residential due-on-sale clause. Transferring title without prior lender consent does not constitute an offense—moral, civil, or criminal. Due-on-sale merely enables the lender to choose to act. If the borrower transfers title then the lender may demand immediate payment in full, but the lender would have to decide that such action is in its best interest, and most lenders will balk at accelerating an otherwise performing loan. Experience shows that the risk of acceleration is small while the loan remains current. This will likely continue to be the case so long as interest rates remain on the low side historically, since the lender lacks incentive to incur foreclosure costs solely for the purpose of lending those same funds out again at a higher rate. A significant rise in interest rates could alter this environment.