Subject-To Transactions: Nuts and Bolts
By: Michael J. “Mick” McGirr, Esq.
Times they are a-changin’. Well, Bob Dylan had that mostly right. Actually, what we’re seeing right now is that the interest rates are the ones doing the changing.
One of the great things about being a real estate investor is that no matter the market conditions, there is always a deal to be found. When rates are low, investors use cheap money to increase their margins. When foreclosures are high, investors scoop up properties on the cheap. Well, what we are seeing right now is that conditions are such that rates are high and foreclosures are becoming increasingly likely as a result of inflation driving up the cost of living. So, given those conditions, what deal type is going to be the most advantageous to you as an investor?
One deal type that should ring near the top of your priority list is what is known as a ‘subject-to’ transaction. Most folks reading this are already well educated on what a subject-to-deal is, but for the few that may not know, I’ll provide a quick overview. A subject-to transaction is one where, in exchange for you, the buyer, taking over the payments on the seller’s existing mortgage, and, in some instances, in exchange for some additional monetary compensation from buyer to seller, the seller assigns all of their interest in a piece of real property to the buyer. The property remains subject to the existing mortgage and the buyer then makes payments on the seller’s existing mortgage, hence why this transaction type is referred to as a ‘subject-to’ transaction. Importantly, the buyer does not ever qualify for a loan as part of the transaction, and typically, the lender isn’t even aware that the transaction has occurred.
As you can imagine, with the cost-of-living expenses going up, there will be more folks teetering on the edge of defaulting on their home loans, especially those folks who stretched themselves especially thin buying a home when the market was hot and who will have their finances pinched as their earned dollars don’t go as far. So, the market condition exists that there may likely be more properties becoming available to investors. Also of great importance is that interest rates have jumped drastically in the last eight or so months, meaning that it will be more expensive for you, the investor, to obtain financing. The subject-to transaction is so beneficial in this scenario because the cash-strapped seller does not want a foreclosure on their credit report, and you want to take advantage of the favorable rates that the seller locked in before interest rates went crazy.
My job is to advise investors on how to minimize risk in their business life. Subject-to transactions, while clearly advantageous, are also rife with pitfalls that an uninformed investor may encounter. Here are a few:
Nearly all conventional mortgages include ‘due on sale’ clauses, meaning that if the borrower sells the subject property, the lender can accelerate the loan, demanding that the loan be paid off immediately. This is a risk that you, the investor, need to be aware of.
As part of your subject-to transaction, you should receive a deed of conveyance from the seller, vesting in you all right and title to the property. Whether you decide to record that deed is a decision that should be made after weighing the benefits of securing your interest in the property against the risks that come with recording, namely that your recordation may put the lender on notice that the property has been sold, triggering a due-on-sale provision.
By entering into a subject-to-purchase agreement with the seller, you are creating a contractual obligation between yourself and the seller that you’ll make payments on the mortgage. It’s important to properly protect your assets from the risks involved in the investment by properly structuring the entity into which you’ll purchase the property.
There are many other legal and strategic considerations for the investor when entering into a subject-to transaction. With the great benefits, such a transaction can provide in this market, the reward likely outweighs any risks, but that doesn’t mean you should not do all you can to minimize your risk by becoming aware of the risks involved and protecting against them.
I love advising investors on the legalities involved in their transactions. If you’d like to discuss how I can help you, please don’t hesitate to reach out to me. I can be reached by email at Mick@PhocusCompanies.com or by phone at 602-457-2191.
This article was originally published in the Arizona Real Estate Investors Association September 2022 Newsletter. You can view it in its original format here.