Knowing the lien holder pecking order

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Lien holders all lay claim to a property, but all liens are not created equal. By assessing the strength of each lien holder's position in line for receiving payment, you place yourself in a superior position to negotiate. Think of lien holder positions as the value of each card in a deck of playing cards:

1 Ace: The property tax collector generally holds the Ace, because foreclosure can wipe out all other liens except the property tax lien. If you can purchase the tax lien, you almost always hold controlling interest in the property. The tax lien holder, however, must adhere to some strict regulations regarding the notification of other lien holders.

1 King: The lender with the first mortgage on the house holds the King. The first-mortgage holder can always pay any back taxes that are due, purchase the property at auction if nobody bids on it, wait for the redemption period to expire (and wipe out the junior liens), and then sell the property.

1 Ten: The lender who owns the second mortgage (if a second mortgage is in place) holds a Ten, but if the lender stands to lose a great deal of money, the lender may be motivated to buy the first lien and pay any back taxes to strengthen its position. The holder of a second mortgage, however, is in a very weak position if the house isn't worth the combined value of the first and second mortgages but is worth the value of the first mortgage. In such a case, the lender who owns the first mortgage has little motivation to negotiate with the owner of the second mortgage.

i Three: Construction (mechanic's) lien holders typically are the big losers in foreclosure. Because foreclosure wipes out their position, they become more and more motivated to negotiate a short sale as the foreclosure sale or the end of the redemption period looms. If the homeowners agreed to put up the construction asset as collateral for the loan, however, the lien holder may qualify for a step up in position. For example, if the homeowners took out a loan to build a new room on the house, that new room may be what's called a PMSI (Purchase Money Security Interest) that the construction lien holder can lay claim to. This is a very complicated situation, so if you encounter such a situation, consult your attorney.

i Two: Legally speaking the IRS may have a stronger position than the second mortgage or construction lien holders, but they rarely step in and buy the property, so they hold the weakest card in the deck. The IRS must be notified and offered the chance to purchase the property, but that's not likely to stop an auction from going forward. If you are not confident that the IRS received a proper notice prior to the auction, you may want to hold off on buying the property.

The lien hierarchy is determined primarily by the dates on which loans are recorded against a property. The property tax lien is the strongest position, typically followed by a first mortgage, because that's the loan the homeowners took out to buy the property, and then followed by other loans in order of the date on which loan was recorded. In other words, if the homeowners took out a first mortgage to buy the house, then financed new windows, and then took out a second mortgage, you would probably be looking at the following hierarchy (listed from strongest to weakest):

i Property tax lien (strongest). i First mortgage.

i Construction loan (new windows). i Second mortgage (weakest).

Of course, you can always have exceptions. The window company, for example, may have and often does subordinate its position to the second mortgage holder, or the holder of the second mortgage may pay the window company to "step up" into its position. Check the dates of recording on the mortgages and look for any wording that specifically states whether one mortgage is subordinate to another.

j»NG/ Don't confuse the date the mortgage was taken out with the date it was recorded. If a mortgage is taken out in June 2005 and isn't recorded until June 2006, and in between those two dates another mortgage is taken out and recorded, the mortgage taken out in June 2005 loses its priority position. Other conditions and exceptions may come into play, so when you're just starting out, consult a real estate attorney who has plenty of experience deciphering titles and mortgages.

The lien holder pecking order is important because it determines the winners and losers after the auction — who gets paid and who doesn't. Say a $200,000 property has a $6,000 tax lien against it, a $140,000 first mortgage, a $20,000 second mortgage, and a construction lien of $10,000. At the tax sale, an investor may bid $160,000 for the $6,000 tax lien. The tax collector gets the first $6,000, the first mortgage lender gets $140,000, the second mortgage lender gets $14,000, and the holder of the construction lien walks away with nothing.

Of course, this example is a little odd, because the first mortgage holder would probably pay the $6,000 in back taxes to protect their position rather than let an investor buy the tax lien. I provide the example only to illustrate who ends up with money and who doesn't based on the strength of their claim to the property.

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Tax sale rules vary from state to state. In some states, the tax sale wipes out all other liens, so if you buy the property at a tax sale, anything you pay in excess of the taxes owed on the property goes to the state, and the other lien holders receive nothing. Of course, prior to the tax sale, the other lien holders must be notified that their claims to the property will be wiped out by the tax sale, so any lien holder with a major interest in the property is likely to pony up the unpaid taxes. Consult your real estate attorney to find out more about how tax sales are handled in your area.

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Responses

  • tesmi
    What is the lien pecking order called?
    4 years ago
  • grimalda
    What would a pecking order of claims on a property be?
    7 months ago

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