Summary:
Imagine the financial power of owning a note and a deed of trust as an economic asset. Now, picture using that asset to borrow money by conveying the ownership security interest to a third party in exchange for a loan of money now. The third party would then have the right to receive a stream of monthly cash flow payments until the loan is repaid to them. This is the transformative potential of note hypothecation, a concept that can open new avenues of wealth creation and investment, empowering you to make strategic financial decisions.
The owner of the financial asset conveys title to another party in exchange for a loan of money for a specific period, until the borrower repays the loan in full to the lender/investor. At that time, the paper holder in possession of the documents will convey title back to the original owner as proof of satisfaction that the loan is paid off.
Article:
What is note hypothecation?
Here's how it works: A hypothecation involves the offering and transfer of an asset of value owned by a party, typically a promissory note and a deed of trust (as collateral) attached to real property, in exchange for a loan from an unrelated third-party investor. The original property owner/seller, as part of the sales transaction, agrees to carry back the loan and, at closing, becomes the beneficiary or owner of a promissory note and a deed of trust. This seller's role is crucial in initiating the note hypothecation process.
The first scenario occurs when the propertys original seller, Party #1, becomes the beneficiary of the carry-back note and the deed of trust. Party #2 is a separate investor who agrees to lend money to the individuals who own the note and deed of trust, Party #1. These folks will decide to convey their interest to the investor party as consideration for a loan. TheParty #3 investor will hold 100% title and interest in the promissory note and deed as collateral until the loan is repaid; thereafter, the Party #3 investor will convey their interest back to the original owners, Party #2.
Which documents are part of the property sale transaction?
The original sale transaction documents include a written offer, acceptance, escrow instructions, satisfied contingencies, and insurance. These documents form the foundation of the property sale transaction and are crucial for a smooth process.
Endorsements for the lender, named as the loss payee on the property insurance policy, a closing statement, issuance of a title insurance policy, and the seller carrying back a promissory note and a deed of trust. The recorded deed of trust is filed at the county recorders office as part of the sale transaction.
The original documents for sale will be held in possession by the sellers, now the sellers carry-back loan beneficiaries, Party #2. The beneficiary will also personally hold the original title policy.
Who are the parties to each separate and distinct transaction? Second reminder of the process:
Party #1 owns a property free and clear. They sell the property to a purchaser and agree to become the lender in a seller carry-back transaction.
The purchaser of the real property, Party #2, takes the title and becomes the trustor/obligor on the sellers carry-back money loan"the trustor signs a promissory note and a deed of trust. The trust deed is recorded and reflects a security interest in the loan. Party #2 must make payments to Party #1 until the loan is fully repaid.
Party #3, an independent investor third party, plays a crucial role in note hypothecation. Their understanding of the difference between making a loan on real estate and making a loan secured by an assignment of a note and deed of trust provides a layer of security and trust in the system, ensuring that the transaction is conducted fairly and transparently.
The insurance company, as with the original sale transaction, will agree to provide title insurance for the appropriateness of the documentation and the property recording sequence. The title insurer will issue a 104. 1 endorsement insuring the conveyance from party #2 to #3. The title company does not offer insurance for the success of the speculative investment or guarantee that the parties will recover their money.
Real property owners typically sell to buyers who finance their purchase with a bank or institutional lender.
The bank/lender records the documents at a municipal records office, creating a deed of trust or mortgage to establish a security interest in the property. The recorded instruments become a matter of public record, the property owner has a fee title to the real property, and the bank/lender has a security interest.
Assume that a long-time property owner decides to sell their property.
In the negotiation, the buyer and the seller decide that, rather than a seller cash-out, the seller should carry back a first trust deed as part of the purchase. The seller will become the lender for the new purchaser/owner. At the closing, the seller will sign a grant deed granting title ownership to the new owner. The new owner will sign a promissory note, which constitutes a promise to pay, and a security instrument known as a deed of trust or mortgage. The deeds of trust or mortgage will be recorded and become a matter of public record.
Real property is generally sold at fair market value when a seller wants to sell and a buyer wants to buy, at a negotiated price and terms.
If a seller becomes the lender at the transactions close, they can exchange real property for a security instrument(s), a promissory note, and a deed of trust. The promissory note and related deed of trust are considered personal rather than real property. The seller who becomes the lender will take possession of the security instruments. The seller will receive monthly payments or financial benefits until the maturity date, as stipulated in the agreement.
The seller, now the lender/beneficiary who owns the carry-back paper, has three options.
Keep the paper and enjoy the cash flow until maturity.
Sell the paper on the open market at a discount to free up capital. Another unrelated investor may find value in purchasing the note or deed of trust, which is used to establish a cash flow stream. If the holder of the promissory note and trust deed sells, they will endorse the promissory note and assign the deed of trust to the new buyer. The properly recorded assignment enables the new owner to hold and control the note and deed of trust. Additionally, a title company endorsement is required to extend the original insurance coverage to the title transfer, ensuring the same coverage as the initial policy.
The third option is for the note holder to borrow a portion or percentage of the principal balance from another lender/investor, endorses the note, and assigns a deed of trust or mortgage as collateral for the loan. The seller/owner of the note becomes the borrower (pledgor), and the new investor becomes the lender/investor (pledgee). In practice, the original note holder retains ownership but is required to surrender physical possession of the note to the new lender/investor or the investors loan servicer, subject to the terms and conditions of a pledge agreement. This process is commonly referred to in industry as note hypothecation.
The required documentation for note hypothecation is as follows.
Collateral pledge agreement to pledge an interest in the note and deed of trust as security for the loan.
Secured a promissory note, between Party #2 and Party #3, separate from the seller carry-back note.
Assignment of the promissory note and deed of trust from Party #2 to Party #3, assigning interest to the third-party investor
Offset statement & estoppel certificate to prove the outstanding balance and terms on the underlying loan between Party #1 and #2.
The property insurance broker contacts to ensure that the hypothecation investor,3, is the named insured on the property insurance policy.
Uniform Commercial Code filing, UCC-1, provides public notice of the personal property lien.
104. 1 title policy endorsement, insuring the conveyance of interest in the note and deed of trust.
Each of the above documents has a unique purpose.
The assignment of the note and deed of trust secures the new loan. The pledge agreement states the terms and conditions of the loan. The content of the pledge includes loan payments, due dates, advancement of costs and expenses, provisions for default and foreclosure, servicing rights, and the method of reconveying the paper back to the original note holder, now the borrower (assignee), upon satisfaction of the loan payoff. The pledge agreement may have a series of representations and warranties by the pledgor.
Suppose a loan servicer is responsible for collecting payments from the property owner. Those proceeds will pay the investor/pledgee and then send any overage to the pledgor. A crucial distinction is that if the lender forecloses on the property, customary fundamental real property foreclosure law generally prevails.
Suppose the pledgee was to foreclose on the pledgor to perfect ownership of the promissory note and deed of trust. In that case, it is a matter of personal property and falls under the Uniform Commercial Code.
The foreclosure process for personal property transactions is much quicker and easier than for real property.
A secured promise-written agreement and promise to pay from the pledgor to the pledgee will be deposited with a foreclosure trustee to start a personal property foreclosure procedure.
Assignment of notes and deed of trust. The assignor becomes obligated to the assignee, according to a particular secured promissory note, transfers, assigns, pledges, conveys, hypothecates, and delivers to the assignee all the rights, powers, and privileges of the assignor. Once the loan obligation has been satisfied, the pledgee will re-convey the title back to the pledgor, the original note holder.
An offset statement by the property owner has been signed. This document memorializes the declaration of facts relating to the property owners loan obligation, including outstanding principal amount, interest rate, payment schedule, payment history, due date, and any other agreements between the parties. This document is an estoppel certificate.
Some lenders file a UCC-1 filing with the Secretary of State, which constitutes notice to the public that a security interest in a specified personal property asset is the underlying promissory note and deed of trust. The creditor will file a UCC-1 form to provide public notice that they have a security interest in the debtors personal property. Upon satisfaction with the debt, the debtor would file aUCC-3 termination statement with the Secretary of State.
What are the financial benefits to the parties?
In most cases, the seller was initially motivated to carry back paper, earn a cash flow, and enjoy a deferred tax incentive.
The tax deferral incentive is known as an installment sale. The owner of the carry-back paper will pay capital gains taxes on the principal portion received annually and ordinary passive income taxes on the interest portion. Capital gains taxes may be deferred or spread out over the life of the loan. This strategy requires the counseling of a competent enrolled agent or CPA.
Sometimes, a seller will finance the sale because they cannot obtain buyers who will pay cash or are otherwise unable to get institutional financing.
Later, the seller, the note holder, discovers that they need to free up cash for some reason. They own an asset that can be hypothecated or used as collateral for the loan. In many cases, the seller miscalculated the amount of capital gains taxes required and must free up cash to satisfy the thirsty IRS.
This is a complex transaction that requires an expert in the field to guide the parties through the process. The documents are specialized usually requiring an attorney or an expert in the field. Do not attempt to complete this form of transaction without professional guidance.