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.
Mechanics of a Sub2
In a sub2, an investor-buyer takes title but makes no promises (either to the lender or to the seller) about assuming the existing debt. In fact, a properly worded sub2 deed expressly states that the buyer is not assuming any such responsibility. 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 any existing arrearage or default.
Core sub2 documents include a sub2 addendum to the TREC 1 to 4 contract; a sub2 agreement (details below); and sub2 deed (either general or special warranty).
Form of Sub2 Deeds
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 sub 2 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 deal 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 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.
The sub2 deed need not show the actual price 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 be shown if the parties desire to make this information part of the public record.
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 sub 2 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 Quitclaims
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.
Seven-Day Notice Requirement
As with wraparounds, a Section 5.016 seven-day notice is required. 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 representing sellers, we always advise full compliance.
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 the foreclosure costs solely for the purpose of lending those same funds out again at a relatively low rate. A significant rise in interest rates could alter this environment.
What is a Sub2 agreement and why is it advisable to have one?
A Sub2 agreement goes beyond the other documents and addresses specifics of the transaction, for example, the details of the existing note or notes; representations and warranties by seller (it is always a good idea to have these if you are the buyer); investor disclosures to the seller that the loan may go unpaid and that there is a due-on-sale clause; matters relating to Dodd-Frank and the SAFE Act; the mechanics of obtaining an eventual release of lien; an assignment of rents, escrow, and security deposit; and other important items. Any of these issues could become problematic later and create a headache for the investor.
If you are the buyer, a sub2 agreement is also a good place to include the online access information for the loan account. Sooner or later, the investor will want to sell the property and it will be necessary to get a loan payoff. If the investor is not the original borrower, then the lender’s privacy policies will prevent disclosure of this information.
As stated above an investor-buyer generally makes no promises about assuming the existing debt. But is this a rigid rule? Not at all, as it turns out. Recall, if you will, that sub2s fall into the category of creative transactions, meaning that all sorts of variations are possible. For example, the investor-buyer may make an agreement with the seller to catch up on part or all of any arrearage that may exist. Other options include a pledge to make payments until the property re-sells, or even to split gross profits upon resale, which incorporates elements of a joint venture. Extensive additional agreements of this nature are best placed in a stand-alone unrecorded sub2 agreement.
Resale of Sub2s
A sub2 may be resold several different ways. First, having put a property under contract, an investor may simply assign the contract to a new buyer. For this reason, the sub2 contract should be expressly made assignable without requirement for the seller’s prior consent. Another method is for the investor to close and then flip the property for a sum of cash, transferring the property on a sub2 basis to the new buyer. A third option is for the investor to close and then resell the property by means of selling financing, i.e., collecting a down payment and transferring the property utilizing a warranty deed, promissory note, and deed of trust. The latter option obviously involves a long-term commitment by the investor.
Generally speaking, the TREC 1-4 contract should be used for acquiring sub 2s, but it should be accompanied by a “Subject To Addendum.” Since neither TREC nor TAR offer such an addendum, a custom addendum drafted by an attorney will be needed.
A sub2 deed is a useful device that should be part of any investor’s tool kit, ready to be deployed when the opportunity arises. Sub2 documents, like other creative real estate documents, are not created equal. Consult a real estate attorney. Never use seminar forms, forms from other states, or Internet junk to do a sophisticated transaction like a sub2.
Information in this article is provided for general educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright © 2019 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.