Bookmark and Share
Share
Home » Guides » Mortgage Subordination

Mortgage Subordination

When a mortgage predates an easement on a property, the easement could be extinguished in a foreclosure if the owners default on their mortgage payments. Subordination eliminates this risk and other possible complications presented by mortgages.

Introduction

When a property owner mortgages their property, this doesn’t present a problem for the holder of a conservation or trail easement on the property. However, when an easement is placed on a property that is subject to a pre-existing mortgage and this mortgage isn’t addressed during the easement planning, serious risks arise:

  • If in the future the property owner defaults on mortgage payments (or otherwise fails to comply with the mortgage terms), the mortgage holder may foreclose and the easement may be extinguished.
  • If a donation of an easement is to be used as a charitable deduction for federal tax purposes, tax law requires that the permanence of the easement must not be threatened by possible foreclosure on a pre-existing mortgage.

There are two ways to eliminate these risks:

  1. The property owners could pay off the mortgage and seek a new mortgage after the easement is put in place. This would put the easement holder’s interest ahead of the mortgage holder’s. This is the simpler solution but not always practical from the owners’ financial standpoint.
  2. The property owners could request and the mortgage holder could agree to allow the easement to survive a potential foreclosure and to resolve other potential sources of conflict between the two interests so as to satisfy the easement holder’s need for permanence. The agreement providing this protection to the easement holder is called a mortgage subordination.

Mortgage servicing companies lack industry-wide standards or practices for addressing requests for mortgage subordinations to conservation easements. Sometimes servicers refuse such requests because they lack knowledge regarding conservation easements. Often servicers are bound by agreements with the holders of investment portfolios of first mortgages that prohibit subordination. Thus, it’s hardly ever quick or easy to obtain a subordination (and this can be discouraging to the owners granting an easement). However, careful preparation that is attentive to the concerns of the mortgage holder can expedite the process.

Items typically needed when requesting subordination (which are described more fully later in the guide) include a draft easement document, an appraisal evidencing the impact of the easement on the property’s value, and a proposed form of mortgage subordination, such as the Model Mortgage Subordination.

This and other documentation requires a substantial investment of time and money with no guarantee that the request will be approved. Success in obtaining a mortgage subordination to an easement has depended largely on two factors: 1) whether the mortgage continues to be held by a local bank where the landowners—and their creditworthiness—are known; and 2) whether the loan balance is a relatively small percentage of the value of the property (factoring in the restrictions to be placed upon it).

The Mortgage Subordination's Role

First in Time, First in Right

Land ownership is sometimes described as a bundle of sticks, due to the number of interests that, bundled together, equate to fee-simple ownership. These interests can be separated and vested in different people or entities all at the same time. The right to use a portion of the property to transport power (a utility easement) may be held by one entity. The power to constrain the use and development of the property (a conservation easement) may be held by a conservation organization. The right to take ownership of a property for failure to pay a debt obligation (a mortgage) may be held by a third entity. The right to exclusively possess a portion of the property (a lease) may be held by a fourth entity, and so on. Because disputes can arise when these interests compete or collide with one another, courts have developed rules to sort out which interests will prevail. The basic rule is first in time, first in right.

A Rule Not to Be Ignored

If an easement is recorded on a property that is subject to a previously existing mortgage, the rights of the holder of the mortgage come before the rights of the easement holder. That is, unless the mortgage holder agrees to change the first in time, first in right rule.

The consequences of not securing such agreement can be severe:

  • If the owner fails to make mortgage payments, the mortgage holder has the power to order the county sheriff to sell the property at a public sale to recoup the debt owing to it. If the mortgage holder has not agreed to allow the conservation easement to survive such action, the sale will be ordered free and clear of the conservation easement.
  • If the property owners claim a donation of the conservation easement as a charitable deduction for federal tax purposes, the Internal Revenue Service can disallow the deduction and subject the owners to interest and penalties. Treasury Regulations Section 1.170A-14(g) states that: “[N]o deduction will be permitted under this section for an interest in property which is subject to a mortgage unless the mortgagee subordinates its rights in the property to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity.”

To guard against such outcomes, an owner could pay off the mortgage prior to entering into the easement or refinance in conjunction with the easement. However, if this is not financially feasible, the owner will have to secure agreement from the mortgage holder to place some of its rights in a subordinate position to those of the prospective holder of the conservation easement.

Why Should a Mortgage Holder Cooperate?

Mortgage holders frequently and voluntarily agree to subordinate some of their rights to another interest. Why? Often a mortgage holder sees an economic advantage in accommodating the other interest.

For example, the mortgage holder may agree to subordinate to avoid the loan being paid off or refinanced. The mortgage holder wants to keep the loan on its books because the loan bears a higher interest rate than it can obtain on new loans and the borrowers have been paying down the loan without a problem.

Another example: although not necessarily relevant to conservation easement scenarios, in the case of a proposed second mortgage, the new mortgage may fund improvements, increasing the value of the property and thus reducing the risk of default on payments on the first mortgage.

Obtaining a Mortgage Subordination

Identifying the Mortgage Holder

The first step to obtain a mortgage subordination is to find a person who has the capacity to review and approve the request. That may be an easy task if the mortgage is held by a bank or other lender with whom the owners have an ongoing relationship. Direct the request for subordination to a senior-level officer or another person who regularly services the owners.

If the mortgage has been sold to FNMA (Fannie Mae), FHLMC (Freddie Mac), or a conduit for investment, the decision of whether to subordinate to the easement is made by the company servicing the mortgage. (The lack of guidance as to how to handle requests for subordination to a conservation easement has sometimes led these servicers to reject them out of hand.)

In cases where the mortgage has been sold, especially when the assignee of the mortgage identified on the public record is MERS (Mortgage Electronic Registration Systems, Inc.), direct the request to the mortgage servicing company that collects monthly payments from the owners. Try to find out which department handles requests for subordination and direct the communication to the head of that department.

Initial Communication

The initial communication should come from the owners. Regarding a specific loan, most if not all mortgage servicing companies have a policy of not communicating with anyone other than the borrowers. If agreeable to the owners, the initial communication should authorize one or more representatives of the future holder of the conservation easement to discuss the subordination arrangements with the mortgage holder. The representatives of the easement holder authorized to contact the mortgage holder will need both the loan number and social security numbers of the borrowers.

Arguments for Subordination

A central goal of the initial communication is to avoid rejection out of hand. Consider using, as applicable, the following arguments in favor of subordination in the first and subsequent communications with the mortgage holder:

  1. This loan is a valuable asset, which the mortgage holder will not want to have paid off or refinanced. The loan bears an advantageous interest rate compared to current market. The customers have an excellent record of regular payment.

  2. The mortgage holder’s security for the loan will not be materially impaired by the conservation easement. In other words, the loan-to-value ratio[1] after the value of the property is diminished by the conservation easement will be equal to or less than the loan-to-value ratio at the time the loan was made.

  3. (Alternative to #2) The mortgage holder’s security after taking into account the diminution in value resulting from the conservation easement is ___%, which maintains conformity with the maximum 80% loan-to-value ratio required by industry standards.

  4. The conservation easement will not materially impair marketability of the property. There is a robust market for lands protected by conservation easement in the vicinity.

  5. The easement holder will, if the mortgage holder has no objection, publicly acknowledge the mortgage holder’s cooperative role in advancing the protection of natural and scenic resources in the community.

Documentation Needed

Items that the mortgage holder will typically need when addressing a request for subordination include the following:

  • Draft easement document (including exhibits, if any)
  • Appraisal evidencing the impact of the easement on the property’s value—a “before and after appraisal"
  • Information on the outstanding principal balance of the debt secured by the mortgage
  • Mortgage subordination form, such as the Model Mortgage Subordination, that the mortgage holder is requested to sign
  • If Fannie Mae owns the mortgage, FNMA Form 236 “Application for Release of Security"

FNMA Form 236

If the mortgage was originated as a residential mortgage loan and is held by a mortgage servicing company, it is likely to have been sold to Fannie Mae and securitized into an investment conduit. In that case, FNMA Form 236 must be submitted with the accompanying information required by the form.

If the mortgage has not been acquired by Fannie Mae, the form is not necessary and submission might confuse the mortgage holder. Nevertheless, owners and easement holder are advised to review Form 236 as a guide to what information the mortgage holder is likely to want to review in order to make its decision to approve subordination.

Form 236 is entitled “Application for Release of Security,” which sounds inappropriate because subordination, not release, is being requested. Nevertheless, for reasons known only to FNMA, it is the form used for requests for subordination.

Suggestions for completing some of the questions on FNMA Form 236 are provided below:

Type of release required. Select “Easement (temporary/permanent).”

Purpose of proposed release. Insert, for example: “No change is proposed in existing use. Purpose of conservation easement is to protect natural and scenic resources”.

Future use of remainder of security property. Insert short description such as “property can continue to be used for ....” Focus on the uses that continue to be permitted rather than what has been prohibited. Use an attachment to expand on permitted uses.

Restrictions on security property as a result of new easement. Insert, for example: “Except for ___ acres designated Highest Protection Area, the remainder of the property (___ acres) can continue to be used for agriculture, forestry, and other open space uses. One or more areas totaling ___ acres are available for residential use. Existing uses and improvements are not impaired.”

Cash consideration to be received through transaction. If this is a purchase or bargain-sale transaction, the purchase price must be disclosed. Consider deducting under subsection (c) of this heading other transactional costs such as survey, appraisal, and funds contributed to the easement holder to defray costs and expenses incurred in connection with the conservation easement.

Describe any other consideration received by the borrower(s). Probably none. (Federal income tax deductions for charitable contributions are not considered consideration.)

Agreement of borrowers. Owners should read carefully. They will be obligated to reimburse Fannie Mae costs and expenses in connection with the request for subordination.

Attachments. The instructions list documents that must accompany Form 236. In the case of subordinating an easement, you may also want to include additional information expanding on the responses to numbered items on the form) and items listed in the “Documentation Needed” section above that aren’t otherwise required with Form 236.

The Subordination Document

Inadequacies of Typical Forms

It is not difficult to find documents designed to subordinate debt obligations or liens. Debt subordinations, mortgage subordinations, and other types of inter-creditor agreements are commonly used in commercial finance. However, repurposing such documents, which are aimed at sorting out debt collection issues between lenders, while a common practice, is not the ideal path. An easement holder is not a lender and a conservation easement is not a mortgage. The typical subordination document asks more of the mortgage holder than is strictly necessary to assure the viability of easement in perpetuity and, as such, creates added and unnecessary risk that a mortgage holder might reject what could be a very reasonable request.

A more narrowly drawn document could satisfy the need to assure conservation easement survival because, for the most part, the lender’s interest in administering the loan does not impinge on the easement holder’s interest in conserving natural and scenic resources. The point where these separate interests collide is if the borrower defaults on the loan and foreclosure or other judicial sale follows. It is this particular circumstance that the easement holder needs the mortgage subordination to address.

Commercial finance subordination forms also fail to address head-on an issue of concern for conservation easement donors and holders: preserving the right to receive the proportionate share of condemnation proceeds allocable to the conservation easement interest. Commercial finance forms tend to put one lender ahead of another as to proceeds derived from the mortgaged property. In the easement context, neither has to be superior to the other. Proceeds can be divided between the mortgage and easement interests so long as the easement holder receives the proportionate share properly allocable to its interest.

Model Subordination

Illustrating how a more narrowly drawn document can meet everyone’s needs and providing a template for doing so, the Pennsylvania Land Trust Association offers a Model Mortgage Subordination and Commentary.

Users of the Model Mortgage Subordination or other forms of subordination should consult with counsel to be sure that the subordination document will accomplish what is intended.

Is Mortgage Subordination Always Necessary?

While always desirable, obtaining the subordination of an existing mortgage may not be strictly necessary if the grant of conservation easement does not need to qualify as a charitable contribution for tax purposes.

Consents Can Provide Foreclosure Protection

Utility companies and other prospective holders of easements request and often receive consents from mortgage holders that operate to protect the later recorded interest in the event of a foreclosure. If the mortgage holder is satisfied that the easement is a benefit to the property or, at least, does not diminish the marketability or value of the collateral below an acceptable level, the mortgage holder records a document consenting to the creation of the interest and promising not to divest the interest upon a foreclosure.

Perpetuity

This consent is not technically a subordination because the priority of the mortgage vis-a-vis the other interest has not changed. Subordination is ordinarily not needed unless the desired result is a re-ordering of the same type of interest (the first mortgage is put behind the later recorded mortgage, for example). Holders of interests other than liens simply want to protect their investment by seeking assurance that their later recorded interests survive a foreclosure sale. Conservation easements are no different from other servitudes in this regard. Foreclosure protection via a consent will ensure enforceability in perpetuity the same as a subordination.

Condemnation Proceeds.

Typical forms of consent do not address proceeds of condemnation because, in most cases, the holders of various types of easement are free to assert a separate claim for the taking of their easement interests. However, conservation easements drafted to meet the requirements of a qualified conservation contribution adopt the single claim procedure mandated by the federal tax code: the interest of the conservation easement holder is treated as if it were terminated by the taking and, instead of a separate claim, the easement holder has the right to a percentage of the proceeds (the “proportionate value”) of the taking otherwise payable to the landowners. Thus, to meet the requirements of a qualified conservation contribution, a typical consent document used for other easements is not sufficient for conservation easement purposes unless it is adapted to provide for payment to easement holder of its proportionate value of the proceeds of a condemnation.

No Subordination and No Foreclosure Protection

If the mortgage holder is intransigent and neither subordination nor a consent to provide foreclosure protection are available, the prospective easement holder may—for a highly desirable easement and one not intended as a qualified conservation contribution—evaluate the risk that landowners will default on the existing mortgage, consider approaches to minimize that risk, and proceed as appropriate in the holder’s best judgment.

Risk Evaluation

To evaluate the risk of default, the prospective easement holder must inquire into the status of the existing mortgage: Are the landowners creditworthy? Have they been paying the mortgage regularly for a considerable period of time? What percentage of the loan has been paid or, by application of the proceeds of the easement purchase, will be paid down? What is the loan-to-value ratio after application of proceeds? Why is a refinance of the existing loan either unavailable or undesirable? Gathering this information allows the prospective easement holder to assess the risk and make a reasonably prudent business decision about whether or not to move forward.

Additional Assurances

If the prospective easement holder decides to move forward with the easement, it may want the landowners to furnish additional assurances to minimize the adverse consequences of a default on the mortgage. These assurances may include the personal guaranty of landowners secured by a mortgage on the property or other real estate interests; a security interest in bank, securities, or other investment accounts; proceeds of policies of life insurance; or any other assets. The purpose of the guaranty and collateral is to be sure that, if easement holder has to invest funds to preserve its conservation easement in the property, it has recourse to other assets of the landowners to recoup that investment.

In the Absence of Subordination or Foreclosure Protection, What Happens in the Event of a Default?

If a mortgage becomes in default, the mortgage holder is required, prior to public sale of the mortgaged property by the county sheriff, to identify all interests to be divested by the sale, which would include a conservation easement accepted under and subject to the mortgage. The sale may occur as soon as 30 days after notices are issued. Terms of sale are usually cash or bank check equal to 10% of the bid on the sale date and the balance within 30 days after. Upon payment of the bid price, the sheriff deeds the property to the successful bidder free and clear of all the interests identified in the notice of sale.

If the easement holder is the successful bidder, the easement holder becomes the owner of the property free and clear of all interests identified as to be divested in the sale. The easement holder is then in a position to resell the property under and subject to a conservation easement crafted to achieve the conservation objectives of the original easement.

(The easement holder could request the sheriff to issue the deed under and subject to the conservation easement existing prior to the sale, but in addition to adding complexity to the matter, this precludes an opportunity to update the easement document to the holder’s latest form.)

Risks of Bidding at Sale

The minimum bid by the easement holder at the sale must be sufficient to pay the prior mortgage plus unpaid property taxes, transfer tax on the recording of the deed, and the sheriff’s costs of sale, which typically include a percentage of the bid price as a commission. The short timeframes for notice of the sale and delivery of the bid price may be difficult to meet unless the holder has the ability to use its own resources or draw on a line of credit to fund the acquisition. The feasibility of quick action in case of a default is an important factor when evaluating the risk of accepting a conservation easement under and subject to an existing mortgage.

Another risk is that other bidders may continue bidding over the easement holder’s minimum bid. If the conservation easement were a mortgage or other lien, the holder would continue to bid up to the amount secured by its lien because each dollar bid over the minimum is distributed by the sheriff after the sale to holders of other liens on the property in order of priority. But the conservation easement is not a mortgage lien; thus, it is not entitled to payment from proceeds of sale above the minimum bid but it is nevertheless subject to divestment from the sale if anyone other than the easement holder is the successful bidder. A discussion of strategies to avoid or mitigate undesirable outcomes of competitive bidding at the sheriff sale is beyond the scope of this guide; however, one protection that can be obtained prior to easement acceptance is an assignment to the easement holder of any rights landowners may otherwise have to receive proceeds of a sale of the property due to a default on the prior mortgage.

Land Trust Standards and Practices

Practice 9.F.2. of Land Trust Standards and Practices addresses mortgage subordination. It provides as follows:

Evaluate the title exceptions and document how the land trust addressed mortgages, liens, severed mineral rights and other encumbrances prior to closing so that they will not result in extinguishment of the conservation easement or significantly undermine the property’s important conservation values.

The information on foreclosure protection furnished above is consistent with Practice 9.F.2. The course of action above that addresses when foreclosure protection is not available may not strictly comply with the practice but is offered as a potential path to be considered when a highly desirable conservation easement is thwarted by an intransigent mortgage holder.


[1] The “loan-to-value ratio” is the outstanding principal balance of the loan divided by the value of the property, the resulting number being expressed as a percentage.

Average
Your rating

Download as


See more...

Experts

Pregmon Law Offices
610-834-7411
Pregmon authored the Model Mortgage Subordination and Commentary and has considerable experience in obtaining mortgage subordinations on behalf of her clients.

Featured Library Items

A model legal document and accompanying guidance to help users in obtaining the "subordination" of a mortgage to a conservation easement. Download both the model and the commentary.
The Model Grant of Conservation Easement and Declaration of Covenants provides users with a state-of-the-art legal document together with an expansive commentary. Built on practitioner experiences and feedback, no easement document in the nation has benefited from more cycles of peer review. Downlo…
Use to provide public access to or along a waterway for fishing, boating or other recreational and educational uses. This model legal instrument may be used as a stand-alone document or may be coupled with a Grant of Conservation Easement to provide natural resource protections as well. The comment…
The Model Grant of Trail Easement is brief--one page (exclusive of signatures)--as compared to the Model Trail Easement Agreement. The shorter document is useful where brevity is the paramount concern. If you want to establish certainty as to landowner and holder rights and responsibilities and oth…
This model was crafted for the specific purpose of permanently protecting riparian buffers along waterways. The model is based on the 7th edition of the Model Grant of Conservation Easement and Declaration of Covenants, also published by the Pennsylvania Land Trust Association.
This widely used model is coupled with an expansive commentary that explains the reasoning behind every provision, instructs on applying the model to particular circumstances, and provides alternative and optional provisions to address a variety of situations. Users can easily customize the documen…
Sample subordination of mortgage document used by The Compact of Cape Cod Conservation Trusts in Massachusetts.
Some donations of conservation easements qualify for a federal income tax deduction; others do not. (Print version of ConservationTools.org guide)
A conservation easement limits certain uses of the land in order to advance one or more conservation objectives while keeping the land in the owner’s control. It is established by mutual agreement of a landowner and a private land trust or government. (print version of ConservationTools.org guide)

Acknowledgements

Patricia L. Pregmon, attorney at law, and Andrew M. Loza are the authors.

The Pennsylvania Land Trust Association published this guide with support from the Colcom Foundation, the William Penn Foundation, and the Growing Greener Program of the Pennsylvania Department of Conservation and Natural Resources, Bureau of Recreation and Conservation.

Disclaimer

Nothing contained in this or any other document available at ConservationTools.org is intended to be relied upon as legal advice. The authors disclaim any attorney-client relationship with anyone to whom this document is furnished.

comments powered by Disqus