February 16, 2012

Deed of Trust or Mortgage

Many clients own real property which are encumbered with a deed of trust. In other words, a person owns a home that was purchased with the assistance of a bank-issued loan. The following are some basic questions that address the rudimentary features of a deed of trust.

1. What is a deed of trust?

A deed of trust is a financing instrument where the borrower pledges real property, the security, in exchange for a loan from the lender in order for the borrower to satisfy the unpaid purchase price of the real property. Yes it sounds confusing at first blush, but conceptually it is not that difficult to grasp.

For example, Bobby wants to purchase 1348 Shawn Drive # 4 San Jose, CA 95118 from Samuel. The listing price for the condo is $175,000. Bobby is unable to make an all-cash offer for the home as he can only come up with $50,000. Therefore Bobby must obtain financing in order to purchase the home. Bobby decides to ask a local credit union for a loan to purchase the home. The local credit union approves Bobby for a loan of $125,000 that will be secured by the condo. This means that if Bobby is unable to repay the loan, the credit union may foreclose on Bobby's condo in what is known as a trustee sale. Bobby then submits his offer and is successful in purchasing the home. Samuel transfers title to Bobby via a grant deed and Bobby executes a deed of trust in favor of the credit union. 

2. What about mortgages? All I ever hear is talk about mortgages rather than a deed of trust?

For reasons that scream "boring" I will spare you the legal history of California's preference for the deed of trust instead of the mortgage.

The key takeaway is that a mortgage and deed a trust create essentially the same legal obligations.  It is just that in California, a loan secured by real property is referred to as a "deed of trust" instead of a "mortgage." 

3. What is the difference between a mortgage and a deed of trust?

Structurally a deed of trust has 3 parties whereas a mortgage has 2 parties. In a deed of trust, there is a trustor, trustee and beneficiary. The trustor is the debtor or borrower. The trustee is the party entrusted to reconvey the property to the trustor if the loan is repaid or to foreclose at the beneficiary's election, if a default occurs. It should be noted that the trustee is not a trustee in the usual legal sense. For instance, a trustee of a trust is held to certain fiduciary standards and a bankruptcy trustee is also held to certain legal standards. A trustee in a deed of trust is not held to such legal standards and serves a passive administrative role. The beneficiary is the lender.

In a mortgage, there is the mortgagor and mortgagee, i.e. the borrower and lender.

Legally speaking though, there is little distinction between the two.

4. How does a deed of trust relate to a revocable trust?

Since many clients own property that is encumbered with a deed of trust, they are concerned about transferring property into a trust. The reason being is that a deed of trust has, or should have, an acceleration clause which says that the lender has the right to accelerate the loan if certain transfers are made. This is known as a due-on-sale clause. This clause is present to prevent the borrower, the homeowner that is, from transferring the property to another person without first paying off the loan.

The good news is that federal law carves out a rather large exception to the general rule that a lender can enforce a due-on-sale clause. The law, the Garn–St. Germain Depository Institutions Act of 1982, says that a due-on-sale clause cannot be enforced on "a transfer into an inter vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property." 12 USC §1701j-3(d)(8). Hence, even if a person has encumbered real property, they are free to transfer the property into their trust without concern about their entire loan being due immediately.