Defects in the title of a residential property refer to any issues or problems that affect the legal ownership or rights associated with the property. Such defects result in what is called a “clouded” title. The opposite of the clouded title is a “marketable” or “clear” title, which refers to a title free from reasonable doubt or defects.
A marketable title reduces the legal risk associated with the property in several ways. First, it assures the buyer that the seller has a legal and undisputed right to sell the property. It also gives buyers confidence that they are acquiring a property without hidden claims or encumbrances, minimizing the likelihood of future legal challenges. If you plan to finance the property with a lender, all lenders, including hard money lenders, will require a marketable title before providing financing. A clear title assures them that the property is sufficient collateral for the loan, reducing the lender’s risk.
Identifying title defects is crucial before purchasing a property to avoid legal complications. Title issues that occur during your ownership of the property can also cause trouble preventing you from selling or refinancing that property. This is why real estate investors should be vigilant of possible title defects and be aware of their impact on the ability to sell, refinance, or enjoy and profit from the real estate investment.
Here are some possible defects in a property title:
Existing mortgages are typically recorded on the property’s title. Since mortgage lenders use properties as collateral, they want to ensure that the borrowers can only sell or refinance it after paying their loan off. In fact, such liens are so common that it’s hard to think of them as “title defects”… as long as all parties involved are aware of them. If it’s a purchase transaction, such mortgage liens must be paid before transferring the title to the new owner’s name. If it’s a refinance transaction, the existing mortgage liens will need to be paid off unless, of course, a new lender agrees to be in the subordinate position.
Outstanding mortgages only become an issue when unexpected, and a property’s seller or a new lender did not factor them when structuring the transaction. Though it’s hard to believe that someone might not be “aware” of a mortgage they have taken against the property, we periodically run into such scenarios. Undisclosed second mortgages are the most common. I am still unsure if those borrowers are trying to hide something intentionally or being exceeding naïve. Still, these mortgages are bound to show up on the title search, throwing a massive wrench in the transaction.
Another title defect of a relatively benign nature is unreleased mortgages. Unreleased mortgages are mortgages that have yet to be officially discharged or released from the property records even though the underlying debt has been repaid. When a homeowner pays off their mortgage, the lender is responsible for filing the necessary documents to release the mortgage lien off the property. If this release is not recorded correctly, it can create a cloud on the title, impacting the property’s marketability.
The first step to address unreleased mortgages is to contact your former lender. Most likely it’s a clerical error that is easy to correct. In a rare case when your former lender doesn’t have documentation proving that your mortgage has been paid off, you will need to provide them with additional documentation, such as the mortgage satisfaction letter or the settlement statement. If the lien has been truly paid off, you are likely to resolve the issue relatively painlessly. Your title company can greatly assist in this effort. However, it might take a couple of weeks to get a release, so if time is of the essence, the unreleased mortgages can be stressful.
Missing Heirs or Undisclosed Interests
The title defects might also arise if there are missing heirs or undisclosed parties with a legal interest in the property. We recently had a potential hard money loan in Maryland that never came to a close because our borrower could not prove that he was the only beneficiary of the trust the property was held in. Though he appeared to be the primary beneficiary of that trust, the trust also mentioned his step-siblings as other beneficiaries. Though they were not set up to control the trust or benefit from it as much as our client, the trust’s documents were not sufficiently clear whether he had full discretion to mortgage or sell the property. Effectively, this lack of specificity resulted in the clouded title that most hard money lenders were reluctant to use as the collateral for a million dollar loan.
Encumbrances can significantly affect the marketability of a property title. An encumbrance is a legal right or interest in a property held by someone other than the owner, which may restrict the owner’s ability to use or transfer the property freely. The presence of encumbrances can create uncertainty and potential complications, making the title less marketable.
For example, encumbrance in the form an easement may grant a neighbor the right to access part of the property for specific purposes. These restrictions can reduce the property’s appeal and affect its market value.
Potential buyers may be discouraged from purchasing a property with encumbrances, especially if these encumbrances significantly impact the property’s functionality or are concerned about possible legal issues in the future. At the same time, lenders might have concerns since obtaining title insurance for a property with encumbrances may be more challenging.
Unlike unreleased liens, encumbrances are more challenging to resolve and often require consulting with a real estate attorney on the best action to take.
Liens Other Than Mortgages
Unpaid judgments or tax liens against the property owner can also result in defects in the title. An IRS lien is one of the most common reasons for the clouded title. An IRS lien is a legal claim by the U.S. government against a taxpayer’s property due to unpaid federal taxes. When the IRS files a lien, it becomes a public record and can impact the marketability of the property title. An important element to remember about IRS liens that they generally have a priority position over other liens and encumbrances on the property. This means that the IRS has a legal right to the proceeds from the sale of the property before other creditors or parties with claims against it, including mortgages in the first position.
A judgment lien is a legal claim against a property when a court grants a judgment in favor of a creditor or litigant. This lien serves as security for paying a debt or legal obligation. There are different types of judgment liens, including medical bills, unpaid car loans, business debts, child support and alimony, and last but not least, a mechanic liens.
One way you can protect yourself from the impact of these liens is to do business in an LLC’s name. You can read more about it in our previous blog on why hard mone lenders love LLC’s and why you should too.
These liens and encumbrances might sound overwhelming but don’t worry too much. The title company involved in the transaction takes the lead in researching them and making sure the property’s title is clear to be transferred. In addition, both hard money lenders and conventional lenders would require title insurance. Title insurance protects the policyholder from financial loss arising from defects, errors, or issues with the property’s title that may have existed before the policy was issued. However, real estate investors need to understand the risks associated with property titles so they can proactively work with professionals to resolve or minimize them.
Hard money lenders like New Funding Resources might be more flexible to accept some title uncertainties than traditional lenders. It’s essential, though, to discuss any title defects at the beginning of the process so your private lender can structure a loan to match their risk appetite and your borrowing needs.