Lien Priority Explained – Who Gets Paid After A Foreclosure
By Sean D. Allen, Associate, SwedelsonGottlieb. Edited by David C. Swedelson, Partner, SwedelsonGottlieb
We have all heard the terms “Senior Lien”, “Junior Lien”, “First Mortgage”, “Second Trust Deed” and whatever other variations of those terms are out there. Here I am going to explain exactly what those terms mean and how they relate to a foreclosure action.
A lien is simply a way to secure a debt to a piece of property so that the association has some priority especially over the delinquent owner's unsecured debts. When someone owes money to another, that debt can be secured by recording a lien. That debt is then attached to the property, and the lien must be paid before the property can be sold. The property becomes collateral for the debt. If the borrower fails to pay the debt when due, the lien holder can force the sale of the property in a foreclosure action in order to get paid.
Of course, there can be several liens on a property at the same time. The question then becomes, if one lien holder forecloses, what happens to the other liens, and who is entitled to the excess money from the sale?
Simply put, lien priority in California is based entirely on who records their lien first. The first in time to record their interest gets priority over all subsequently recorded liens. And this is codified at Civil Code Section 1367(d) which states: (d) A lien created pursuant to subdivision (b) shall be prior to all other liens recorded subsequent to the notice of assessment, except that the declaration may provide for the subordination thereof to any other liens and encumbrances.
Here is a simple example of how this works:
An owner purchases a home or condo for $500,000. To accomplish this, he or she takes out a loan for the full $500,000. This loan is secured by the property and is first in time. The lender properly and promptly records their lien, in California usually a “Deed of Trust” commonly referred to as the first trust deed. This is the senior most lien.
The homeowner later takes out a line of credit against his property for $30,000. This line of credit is secured by the property and is recorded after the purchase-money loan first trust deed. This lien is therefore junior to the $500,000 loan.
Finally, the homeowner later falls behind in his condominium or HOA assessments and his association records a lien for $7,000, the amount of the delinquent assessments. This assessment lien is junior to both the $500,000 purchase-money first trust deed and the $30,000 line of credit.
As you can see, the order of priority looks like this:
$500,000 purchase-money first trust deed recorded first.
$30,000 line of credit recorded second.
$7,000 assessment lien recorded third.
The purchase-money mortgage is senior to both of the other liens. The line of credit is junior to the purchase-money mortgage, but it is senior to the Association’s assessment lien. And the assessment lien is junior to both the prior liens. Any later liens to be recorded will take priority according to what order they are recorded in. Whoever records before another would be in "senior" position and the other would be "junior", hence the terms senior or junior lien holders.
Now that we understand how lien priority is determined, let’s look at what happens when a lien is foreclosed upon.
FORECLOSURE OF SENIOR LIEN
First, let’s assume the lender on the first trust deed is foreclosing, i.e. the senior purchase-money lender. What will happen to the junior lien holders?
The foreclosure of a senior lien extinguishes or “wipes out” all junior liens secured by the property. Therefore, if the homeowner fails to pay his first mortgage and that senior lien holder forecloses, both the line of credit and the Association’s liens will be wiped out. This does not eliminate the debt, only the security for the debt. The line of credit and the association can still sue the former homeowner for the amounts they are owed, but they can no longer foreclose to collect on that debt. They are now unsecured creditors.
FORECLOSURE OF JUNIOR LIEN
Now, lets assume the line of credit/second trust deed is foreclosing. Remember, the line of credit is in a second position. It is junior to the purchase-money mortgage/first trust deed, but it is senior to the Association’s assessment lien. What effect does the foreclosure of a junior lien have?
The rules will remain the same for any lien recorded after the line of credit. Therefore, the foreclosure of the line of credit/second trust deed will wipe out the Association’s assessment lien. However, the foreclosure of a junior lien has no effect on any senior liens. The purchaser of the property at the foreclosure sale takes the property subject to any senior liens. Therefore, in this situation the association’s assessment lien would be wiped out, but the buyer at the foreclosure sale would take the property subject to the senior $500,000 mortgage. That mortgage/trust deed is still attached to and secured by the property.
Similarly, if the association forecloses on its assessment lien, neither the purchase-money lender nor the line of credit are affected. The buyer at the foreclosure sale will take the property with both the $500,000 mortgage and the $30,000 line of credit still attached.
Note, this does not mean that the buyer (and it could be the association if no one bids at the association's foreclosure sale) is “personally” obligated to pay the first or second trust deeds, as the association or other buyer at the foreclosure sale did not enter into the loan agreements nor sign the promissory notes that were signed as part of the loan. But it does mean that if the new owner who buys the association's lien interest takes title subject to the senior liens we discussed above and if they do not pay, then the senior liens can foreclose on their secured interest and take title to the property.
SURPLUS FUNDS AFTER FORECLOSURE
So, what happens when the property is sold at foreclosure and the sale generates more money than what is owed on the lien? These are called “surplus funds” and the rights to these funds are clearly defined by California Civil Code § 2924k. That section states as follows:
The trustee, or the clerk of the court upon order to the clerk pursuant to subdivision (d) of Section 2924j, shall distribute the proceeds, or a portion of the proceeds, as the case may be, of the trustee's sale conducted pursuant to Section 2924h in the following order of priority:
(1) To the costs and expenses of exercising the power of sale and of sale, including the payment of the trustee's fees and attorney's fees permitted pursuant to subdivision (b) of Section 2924d and subdivision (b) of this section.
(2) To the payment of the obligations secured by the deed of trust or mortgage which is the subject of the trustee's sale.
(3) To satisfy the outstanding balance of obligations secured by any junior liens or encumbrances in the order of their priority.
(4) To the trustor or the trustor's successor in interest. In the event the property is sold or transferred to another, to the vested owner of record at the time of the trustee's sale.
Did you follow that? Let me break it down for you.
First, the costs and expenses of conducting the foreclosure sale are paid. Second, the lien that was foreclosed on is paid off. Third, if there is any money remaining after the foreclosed lien is paid, then any liens junior to the foreclosed lien are paid in their order of priority. Finally, if any money remains at this point, then the remaining funds are paid to the former owner of the property.
Let’s put this into perspective according to our example above.
Let’s say the senior purchase-money lender forecloses on the property and the property sells for $540,000. First, the costs of the sale are paid. We will assume that these costs equaled $5,000, leaving $535,000 remaining. Next, the senior lien of $500,000 is paid in full, leaving a surplus of $35,000. From those funds, the $30,000 line of credit is paid in full, leaving $5,000 to be paid to the Association toward their assessment lien. As you can see, this is only a partial payment to the Association, and the former homeowner is still liable for the remaining $2,000 owed to the Association. However, the assessment lien has been wiped out by the senior foreclosure, so the Association will need to sue the former homeowner if they want to collect this $2,000.
So, how does that same scenario play out if a junior lien is foreclosed instead of the senior lien? Let’s say the line of credit forecloses and the property is sold at the auction for $50,000. First, the costs of the sale are paid (again we assume $5,000) leaving $45,000 remaining. Next, the line of credit is paid off in full for $30,000, leaving $15,000 in surplus funds. The association is then paid off in full for their $7,000 lien. This leaves $8,000 remaining, which is paid to the former homeowner. As you can see, no payments are made to any senior lien holder because their status is completely unaffected by the foreclosure of a junior lien. The property only sold for $50,000 at the foreclosure sale/auction because the buyer is taking the property subject to the existing $500,000 first mortgage.
This scenario will play out quite similarly if the Association forecloses on their assessment lien. However, any surplus funds left over after the costs of the sale and the Association are paid will go directly to the former owner of the property. The senior mortgage and the line of credit will remain intact and secured by the property, and the buyer at the foreclosure sale will take the property subject to these liens.
Of course, this is a very generalized scenario and there are several exceptions. One exception any lien holder should be aware of is the priority of property tax liens. Essentially, property tax liens get automatic priority over all other liens no matter when they were recorded. So, even if the property taxes don’t become delinquent until after all the other liens are recorded, they are still considered first in time and senior to the existing liens. There are other scenarios too, which can play a major role in any foreclosure. One such scenario would be when a delinquent homeowner files for bankruptcy. That, however, is the topic for another article.
Sean D. Allen is an associate at SwedelsonGottlieb. For questions or comments, he can be reached at email@example.com.