LIENS AND ENCUMBRANCES
By Dan Harkey
Real Estate & Private Money Finance Consultant
m: 949 533-8315 | e: email@example.com
What is a Lien?
A lien is a legal right or claim against real property, referred to as a security interest. The lien is given or conveyed to a creditor (lender) to hold and possess until the loan is paid off. A debtor (borrower) will agree to convey a security interest as consideration for a loan.
Creditors/lenders are persons or companies who willingly make loans secured by a security interest in property. The creditor/lender has a recorded charging interest and claims against the collateral property.
A property owner/borrower agrees to willingly grant or convey a security interest in their real property by signing an instrument called a deed of trust or mortgage. As an agreed consideration for the loan, this document must be recorded in a public records office to establish a recorded lien position as a lien attached to a particular real property.
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.
What is an Encumbrance?
An encumbrance refers to a legal claim or agreement to enforce rights and obligations relating to a property. The claims are against the property by an independent party such as a mutual property association, a court ordered lien, a 2
municipal notification for substandard conditions, or a government agency. The claims restrict the unrestricted use of the property until the deficiencies are satisfied or negotiated into an equitable agreement of future actions. An encumbrance may be lifted, reconveyed, or modified.
There are dozens of events, instruments, actions, or agreements that may be recorded in public records creating either a lien or an encumbrance on the property. Here are a few:
1) An originally recorded tract map by the state of jurisdiction for the entire neighborhood.
2) Utility and other easements, government-mandated conditions such as historical property registries, long-term leases, agreed-on encroachments, air and subsurface rights, height, and view restrictions.
3) Mutual association by-laws, covenants, conditions and restrictions, entity ownership and partnership agreements, tenancy leases; and various public notices such as weed abatement, notifications of substandard conditions.
4) Lis pendens, property settlements by adverse parties, divorce decrees, subordination, non-disturbance, and attornment agreements (commonly abbreviated as an “SNDA”), parking easements, reciprocal parking agreements, signage easements, and memorandums of agreement or understanding.
5) Property taxes, federal or state tax liens, zoning laws, environmental regulations, Etc.
The lending industry sometimes uses the terms lien and encumbrance interchangeably. However, a lien is generally a recorded monetary charge against a property. All liens are encumbrances, but not all encumbrances are liens. They both create claims against the property that impact the ownership rights, processionary interest and transferability. All three restrict the free use until the claim is lifted, reconveyed, or modified.
Another option is for a new buyer or lender to accept certain identifiable liens and encumbrances on the property as part of the risk assessment attached to the agreed transaction. The buyer party may decide to take property ownership subject 3
to the items or issues. Some liens and encumbrances may stay on the title and remain with the property. The property ownership may be conveyed to another party, by a negotiated purchase contract, “subject to” certain items remaining on the title. A new owner may or may not take steps to have some of the encumbrances removed.
Generally, lenders will not accept irrational restrictions. Some restrictions cloud the title and may be void as a matter of law. I once witnessed a deed that had a condition that the property could not be sold to a person of Asian descent. I also witnessed a deed that restricted future property owners from selling or serving alcohol. Fortunately, I did not make a loan or purchase that property.
Some encumbrances negatively affect free usage, desirability, and marketability. In some cases, the adverse effects might be significant enough that the title cannot be conveyed legally or transferred to another party.
Dozens of issues may create conflicts, such as disagreements in limited partnership ownership rights, claims of processionary rights, and many other problems. The purchasing party may not be able to convince a title insurer to provide a title policy on the conveyance. In some cases, a court process called a declaratory relief action might need to be filed so that the court can mediate and decide on the validity of the contested claim. In a court process, never expect a rational outcome.
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 other public notices. Their job includes recording and preserving historical records and making them available to the public.
The recording process and public records management have been made more convenient with modern technology.
What is the purpose of recording documents? 4
The purpose is to covey constructive notice to the public of recording documents and instruments that affect the chain of title. The objective is to access public records and provide a traceable chain of title documents attached to real properties. Interested parties may trace recorded documents for many years to determine ownership, liens, encumbrances, and whether they were 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 record an instrument that should have been recorded. Even though a recorded deed is not essential for a valid transfer, an unrecorded deed leaves the property vulnerable to other unrelated events and documents that can be recorded. Ignorance could cause another unrelated recorded document to take a senior lien or encumbrance position. The penalty is that the person may have difficulty with any subsequent conveyance action desired to prove ownership or status of the possessory interest.
I recall a time in the past when only paper records existed. Then came what was considered a substantial improvement called a microfiche records database. Microfiche was a flat piece of film that contained microphotographs. These images were photographed and reduced from the original. The materials were made of plastic (acetate) between the 1930s and 1980s, then polyester after the 1960s. 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. Copies of documents would be obtained using a scanner and printing device. By today’s standards, this is an obsolete method in our world of instant information.
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, 5
purchaser, or lender. A purchaser or lender may accept the property with questionable conditions, remove it from the title, modify it, or reject it 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, agent fiduciary, and 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 will generally create restrictions and prohibitions, should be addressed separately. I encourage interested parties to seek competent counsel advice.
The real estate or lending broker/agent has a fiduciary responsibility to assist the buyer/borrower in understanding all documents relating to a purchase or loan transaction. Below is a good review summary of fiduciary duties.
Sometimes a property owner may record notices of change of ownership 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 ownership interest in the property to another party as part of a negotiated settlement.
As a matter of law, only the trustees of a revocable family trust can hold legal title to real property, not the family trust itself. A revocable family trust is a legal entity but cannot act on behalf of the trust without the trustee. The trust document is an agreement between the key parties of the trust.
What is a first, second, and third lien priority position? 6
Lien priority is related to the precise date and time when the document is recorded in the recorder’s office and when and where it becomes a matter of public records. When a document is recorded, it is date and time-stamped and affixed with a sequential recording reference number.
Example: 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, the person who recorded the document will receive the originals back in their possession. A title company, lender, or borrower who recorded the documents receives the original date and time-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 request 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 incorrect insured claim.
If you were to go to the recorder’s office, stand in line, and have your documents recorded, you should check the recording sequence yourself. But, generally, the recording of documents is done by a title company carrier as part of a sale or loan transaction.
Assume that a property is encumbered with a first lien of $500,000, a second lien of $100,000, and a third lien of $50,000! Assume all were recorded on a subject property properly. If the first lien is paid in full and the trustee records a reconveyance, that procedure will remove the first lien from public records. 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 that is recorded when the lien is paid in full and fully satisfied. The reconveyance shows publicly that the lien has been released and removed from public records. At the point of recording, the 7
security interest is extinguished. Recording the reconveyance is usually done by a title company that is handling the title work for sale or refinance transaction.
Some states refer to the satisfaction of mortgage documents rather than a reconveyance, but they are essentially the same.
If you were to refinance the same property and replace all three liens into one new single loan, all three liens would be reconveyed by the trustees and removed from public records. A new recording of the single loan 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 that guarantees the lien positions.
Voluntary vs. Involuntary liens:
A voluntary lien is a claim that a person or a lender has against a property of another as security for payment of a voluntary debt as agreed to by a borrower. The lien is attached to the property rather than the person. A trust deed or mortgage lien is voluntary. The lien involves legal claims on assets such as real property. An owner may not sell the property or convey title to a third party without acknowledging, dealing with, or extinguishing the lien.
The recorded notice that a lien exists is with the county or municipal recorder’s office. Recording any lien or encumbrance against the private property will cloud the title.
A party may cloud the title for involuntary claims by recording a lien against private property. The owner did not agree to the lien. But encumbering the property is a method to enforce claims for involuntary debts. This claim includes obligations such as local, state, and federal tax liens, a notice of substandard conditions, contractor claims for mechanics liens, Homeowners association dues, child support payments, and judgments from civil suits.
Liens may be consensual such as a real estate loan, statutory such as property taxes, or based upon court order. A judgment lien is the most dangerous because a judge can order a recording of a lien on one’s property, whether for rightful reasons or subject to objection. 8
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 recording with a precise date and time-stamped 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 regulations 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.)
However, there are limits 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 when the mechanic’s lien appears to have been “wiped out or extinguished” 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 consult 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 in some states, homeowners, or mutual property associations.
A written lease agreement has a “first-in-time, first-in-right” priority. Lessees (tenants) who have written lease agreements recorded at the county recorder’s office that are date and time-stamped before recording the new trust deed will have a right to enforce the terms of the lease agreement and right of continued occupancy. The lessee’s rights will run with the property until the lease terms (rights) expire or are modified in writing by mutual agreement. Below is an instructive example.
Lien priority may be modified through written agreements:
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.
A real estate lender may condition the approval of a loan upon a written modification of the statutory priority. A written agreement between the borrower, the tenant, and the lender may be required as a condition of approving and loan closing. A straight subordination agreement or a subordination, non-disturbance, and attornment agreement (SNDA) may be advised. Both agreements, when recorded, are encumbrances on the property.
In some cases, it is in the lender’s best interest to terminate the tenancy in the event of borrower 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 lessee’s priority to be lost. If the lessee’s priority is lost, he could be given the notice to vacate and be 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 capitalized value. A subordination, non-disturbance, and attornment agreement “SNDA” may be the appropriate document to record. SNDAs are agreements between a lessee (tenant), the lessor (landlord), and the lender defining certain rights and responsibilities. The SNDA will protect the lessee or tenant from being evicted if the owner (landlord) stops paying the loan payments to the lender(s), resulting in a completed foreclosure. Other parties may be affected, such new a purchaser of the property.
Modifying the rights and responsibilities of senior and junior lien parties: 10
An intercreditor agreement may be advised. The use of this agreement does not modify the lien positions between junior and senior lender creditors.
An intercreditor is a written agreement between two creditors intended to memorialize how their competing security interests are to be handled when each possesses liens (a claim or money charging interest) in a common borrower and secured property. This agreement is used between two (or more) senior/junior lenders to establish rights and responsibilities between each lender. The agreement typically provides that one lender’s lien is senior to the other regardless of when and in which order the liens were recorded.
In some cases, the actual agreement is a “subordination and intercreditor agreement.” This document allows two different lenders to “split up” the collateral so that both will be secured in an equal first or junior lien position for their collateral, subject to the terms and conditions of the agreement.
The intercreditor agreements, when recorded, are an encumbrance against the property.
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This article is an overview for a general educational purpose only. The information presented should not be relied upon without the advice of counsel.
Dan Harkey is a contributing author to Weekly Real Estate News and is a Business & Financial Consultant. He can be contacted at 949-533-8315 or firstname.lastname@example.org.