How does a lien affect a real estate closing?

A lien affects a real estate closing in one way above all: the sale cannot close with clear title until every lien on the property is paid from the proceeds, released by its holder, or otherwise dealt with to the satisfaction of the title insurer. In practice the closing agent collects a payoff figure for each lien and pays it out of the buyer's money before the seller receives anything. A lien delays or stops the closing only when it is found late, disputed, or larger than the money available.

This article covers real estate closings in the United States. It is general information, not legal advice: lien law is mostly state law, and the rules on priority, deadlines and releases change from one state to the next.

What is a lien on real estate?

A lien on real estate is a creditor's legal claim against a property that secures a debt, so that the debt can be collected out of the property if it is not paid. The lien does not make the creditor an owner and does not, by itself, stop the owner from living in the property or listing it for sale. What the lien does is follow the land: it stays attached to the property when the property changes hands, unless it is cleared first.

That is why liens matter at a closing. A buyer who takes title with a lien still on the property has bought it subject to someone else's claim, which the creditor can enforce against the property even though the buyer never owed the debt. No mortgage lender will fund against that, and no title insurer will insure the title without either removing the lien or listing it as an exception to coverage.

A lien is also different from the debt it secures. Paying the debt removes the reason for the lien, but the public record still shows the lien until a release is recorded. The reverse is true as well: a creditor can release one property from a lien while the debt itself remains owed.

Which liens does a title search turn up?

A title search on a property in the United States most often turns up a mortgage or deed of trust, and less often property tax, federal or state tax, judgment, mechanics, homeowners association, child support and utility or municipal liens. Each one has its own creditor, its own way of arising and its own way of being cleared, set out in the table below.

The federal tax lien is unusual because it exists before anyone can see it. According to the IRS, the lien arises once the agency has assessed the tax, sent a notice and demand for payment, and the taxpayer has neglected or refused to pay in full on time. The public document, the Notice of Federal Tax Lien, comes after that, and the IRS describes it as a filing that alerts creditors to the government's legal right to the taxpayer's property. The notice is what the title search finds.

Child support liens exist in every state for a federal reason. Federal law on child support enforcement, at 42 USC 666(a)(4), requires each state to have procedures under which liens arise by operation of law against real and personal property for overdue support, and to give full faith and credit to such liens arising in another state.

Mechanics liens are the ones most likely to surprise a seller, who may have paid the general contractor in full without knowing that a subcontractor or supplier was left unpaid and recorded a claim under state law.

What is the difference between a voluntary and an involuntary lien?

A voluntary lien is one the owner agreed to by signing a document that pledges the property, while an involuntary lien is placed on the property without the owner's consent, by a statute or a court. The mortgage, the deed of trust and the home equity line are the voluntary ones. Everything else in the table above is involuntary.

The distinction matters at a closing for three practical reasons.

• Predictability. A seller knows about the voluntary liens and roughly what is owed. Involuntary liens are the ones a seller has forgotten, disputes or never heard of.
• The payoff process. A mortgage servicer produces payoff statements routinely, and for a consumer loan secured by a dwelling, Regulation Z gives it a deadline. A judgment creditor, a small contractor or an out-of-state agency has no such routine, so a written payoff figure and a signed release can take much longer.
• Room to negotiate. A lender whose loan is fully covered by the price has no reason to take less. A judgment creditor or a contractor with a disputed claim may accept a reduced amount for a prompt, certain payment.

Involuntary liens split again into statutory liens, which arise because a law says so (taxes, mechanics, child support, many association liens), and judicial liens, which come out of a court case. A lien is also either specific, attached to one property, or general, attached to whatever the debtor owns where it is recorded. A judgment lien and a federal tax lien are general.

Who gets paid first when a property has several liens?

When a property has several liens, the general rule in the United States is that the lien recorded first is paid first, with statutory exceptions that move certain liens ahead of the line. Priority only decides anything when the money runs short; when the price covers every lien, each holder is paid in full and the order is academic.

The exceptions are where the state-by-state differences sit, and they are stated here in general terms only.

• Property taxes are generally given priority over mortgages and other private liens by state law, whenever they were assessed.
• Mechanics liens in many states take their priority from a date earlier than the day they were recorded, such as the start of work, which can place them ahead of a loan recorded while the work was under way.
• Association liens usually rank by recording date, but some states give a limited part of an association's lien priority over a first mortgage.
• Federal tax liens are subject to a federal rule. Under section 6323 of the Internal Revenue Code, the lien is not valid against a purchaser, a holder of a security interest, a mechanic's lienor or a judgment lien creditor until the notice has been filed. The same section protects real property tax, special assessment and public utility charge liens that state law ranks ahead of earlier security interests.

Lienholders can also change the order by agreement. A subordination is a recorded document in which a senior holder agrees to rank behind another lien, as when a home equity lender stays in second place behind a new first mortgage in a refinance. The IRS has its own version: the agency states that a subordination does not remove its lien but allows other creditors to move ahead of it.

How is each kind of lien cleared before or at closing?

A lien is cleared at closing in one of six ways: payoff from the sale proceeds, a release without full payment, a bond, a negotiated settlement, a subordination, or an escrow holdback agreed with the title insurer. Payoff is by far the most common; the others serve the cases where payoff in full is not possible or not yet justified.

The payoff mechanics are the same whatever the lien. The closing agent asks each holder for a written payoff statement good through a stated date, pays that amount from the buyer's funds on the day of closing, and follows up until the release is on record.

The lien was paid long ago. An old mortgage from a lender that has since merged or closed, or a judgment the seller settled years earlier, can still show on record because nobody recorded the release. Nothing is owed, but the record has to be cured: the closing agent traces the lender's successor or the creditor's attorney and obtains a release, which is one reason a search is ordered early.

The lien is disputed. A seller who believes a contractor's claim is wrong does not have to choose between paying it in full and losing the sale. Where state law allows, a bond can take the lien off the property so the dispute continues against the bond. Alternatively the title insurer may agree to close with a sum held back in escrow, typically more than the face amount of the claim, until the dispute ends. Both are the insurer's decision, since the insurer carries the risk.

The lien is a federal tax lien. The simplest route is the same as for any other lien: pay the tax debt from the proceeds, after which, according to the IRS, the lien is released within 30 days. When the proceeds will not cover the tax debt, the route is a certificate of discharge, which the IRS describes as removing the lien from specific property. The application is Form 14135, explained in IRS Publication 783, and the agency asks for it at least 45 days before the transaction date. The publication lists what goes with it: an appraisal by a disinterested third party, the title report or a list of the liens that rank ahead of the IRS, and the proposed closing statement.

The grounds for discharge follow section 6325(b) of the Internal Revenue Code. In outline, as Publication 783 presents them: the taxpayer's other property is worth at least double the liability; the IRS is paid an amount equal to the value of its interest in the property being sold; that interest has no value because the liens ahead of it exceed the property's value; or the property is sold and the proceeds are held in an escrow fund subject to the government's claim in the same priority as before.

What does a closing with liens look like in numbers?

In a closing where the price covers the liens, each lien is a deduction on the seller's side of the settlement statement, and the seller receives what is left.

In a worked example with illustrative figures, a house sells for $410,000. Selling costs are a commission taken at an illustrative 5% of the price, $20,500, plus $4,100 of other seller closing costs, for $24,600 in total. That leaves $385,400 to deal with liens. The title search finds four of them:

• a first mortgage with a payoff of $318,400;
• $6,850 of property tax, counting an unpaid instalment and the seller's share of the current period;
• a mechanics lien of $9,750 from a roofing contractor;
• $3,900 of unpaid homeowners association dues.

The four liens total $338,900. The closing agent pays each one from the buyer's funds, and the seller receives $385,400 less $338,900, which is $46,500. The liens changed what the seller took home and added a few payoff letters to the file.

What happens when the liens add up to more than the sale price?

When the liens add up to more than the sale price, the closing cannot go ahead on a simple payoff basis: either the seller brings the difference in cash, or one or more lienholders agree to release the property for less than they are owed, or the sale does not close. The proceeds are not shared out pro rata; in any negotiation the starting point is the order of priority.

Take the same $410,000 sale with the same $385,400 available after selling costs, and add three liens the seller had hoped would not surface: a home equity line with $46,200 drawn, a judgment lien of $14,300 from an old business debt, and a Notice of Federal Tax Lien for $38,500. The three add $99,000, and the liens now total $437,900. The closing is underwater by $52,500.

The table below applies the money in one plausible ranking: taxes, then the liens by recording date, with the judgment recorded before the federal notice. A real file takes its order from state law and the recorded dates.

The table shows where the money runs out, not what the creditors must accept: no lienholder is obliged to release for less than it is owed because a sale has been agreed. The seller has three options.

Bring the full shortfall. The seller pays $52,500 into the closing from other funds, every lien is paid in full, and the sale closes like any other.

Use the discharge for the lien that has no value. In this ranking the federal tax lien is reached by nothing: the liens ahead of it exceed what the property yields. That is the situation one of the discharge grounds in Publication 783 addresses, where the government's interest in the property has no value. If the IRS agrees and issues a certificate of discharge, the property is freed from the federal lien without payment, and the seller then needs $14,000 rather than $52,500 to finish paying the judgment. The decision belongs to the IRS, on its own appraisal of the figures, and the seller still owes the full $38,500 of tax afterwards.

Negotiate with the junior holders. The judgment creditor is reached by $300 in this sale. Some creditors in that position will release the property for a reduced sum; whether the rest of the debt is forgiven or merely left unsecured is a separate term that has to be written down. The closing agent needs every such agreement in writing before the settlement statement is final.

A short sale is the same problem one level higher: the price does not even cover the first mortgage. The Consumer Financial Protection Bureau defines a short sale as a sale of a home for less than what is owed on the mortgage, and treats it as a form of loss mitigation that needs the lender's or servicer's agreement. Suppose the same house sold for $330,000. At the same illustrative 5%, the commission is $16,500, and with $4,100 of other costs the selling costs are $20,600, leaving $309,400. After $6,850 of property tax, $302,550 remains for a first mortgage of $318,400, a gap of $15,850, and every lien behind it is reached by nothing.

In outline, a short sale then runs as follows. The seller applies to the servicer with the contract and a draft settlement statement. The servicer values the property and decides what net amount it will accept, which includes approving each cost on the statement. The junior lienholders each have to release as well. The difference left unpaid is called a deficiency, and the Bureau advises sellers in states where they remain liable for it to ask the lender to waive it and to get the waiver in writing. For that reason a short sale contract is usually written to be contingent on lender approval.

What happens when a lien is found late?

A lien found late, in the days before closing or after it, usually delays the closing rather than ending it, and the cure depends on how quickly a payoff figure and a release can be obtained. Late discoveries come mainly from a search update shortly before closing that picks up a new filing, from a seller whose common name matches other people's judgments, and from unrecorded items such as municipal charges.

A lien found after closing is a different matter, because the seller has been paid and the buyer owns the property. If the lien predates the policy and was not listed as an exception, it is a claim under the title insurance policy. If it arose between the last search update and the recording of the deed, it falls in what the industry calls the gap, and whether that interval is covered is a question for the title company before closing.

How do the title commitment and the title policy protect the buyer?

The title commitment protects the buyer by listing, before any money moves, every lien that must be cleared for the policy to issue, and the title policy protects the buyer afterwards by covering loss from a covered lien that was missed.

The commitment is the insurer's written offer to insure, issued after the search. A standard commitment has a list of requirements, the things that must happen before the insurer will issue the policy, and a list of exceptions, the things the policy will not cover. A lien that is to be paid off appears among the requirements: "payment and release of the deed of trust recorded on a given date" is typical wording. A lien that appears among the exceptions instead is one the insurer does not intend to remove, and the buyer would take the property subject to it. A buyer should read both lists when the commitment arrives and ask the closing agent about any exception that looks like a money claim.

There are two policies, and they protect different people. According to the Consumer Financial Protection Bureau, most lenders require a lender's title policy, which protects the amount they lend. An owner's policy is optional, and the Bureau describes it as protecting the homeowner if someone sues and says they have a claim against the home from before the purchase. The Bureau's examples are a previous owner's failure to pay taxes and contractors who say they were not paid for earlier work. A buyer with only a lender's policy in place has the lender's interest insured, not their own equity.

Neither policy covers everything. A title policy insures against matters that existed at the policy date and were not excepted; it does not cover liens the buyer creates or allows afterwards, nor the items listed as exceptions.

A search ordered early serves the seller as well. A federal tax lien discharge has a stated lead time of at least 45 days, so a seller who asks for a preliminary search at listing, and subtracts selling costs and every payoff from the price before accepting an offer, still has time to pay, dispute, bond or negotiate. The seller with a $46,500 cheque and the seller with a $52,500 shortfall in the worked example owned the same house at the same price.