Buying Divorce Liens

If you’re getting a divorce, or know someone who is, it helps to know about divorce liens.

A divorce lien can avoid the usual turmoil of selling the house and splitting the money, and the home is often a divorcing couple’s largest single asset. With a divorce lien, one spouse keeps the house and the other gets a note and deed of trust (or mortgage) secured by the property. One gets real estate; the other gets paper.

How a divorce lien works for both spouses

The spouse who keeps the home, often the wife, keeps the same familiar surroundings for herself and the children. The children don’t have to change schools, and there are no relocation costs. She keeps a fair share of the equity and can hope the home goes up in value. In return, she’s obligated to pay the departing spouse on an agreed schedule.

The departing spouse, usually the husband, signs a deed to the house over to the wife and gets a note and deed of trust secured by the home: a divorce lien. He can hold the note until it pays off, or sell it for cash.

• If he doesn’t need cash right away, he can receive a balloon payoff, in many cases in about five years or when the youngest child turns eighteen.
• If he needs cash now, he can sell the note and ordinarily receive tax-free money. That can fund new living quarters, attorney fees, child support and a new start. If he sells the note, his financial connection to the house ends.

When a divorce lien makes sense

This win-win arrangement can ease the pain of a divorce a little, but it isn’t right for every case. The couple’s situation has to meet some guidelines:

1. The family must have substantial equity in the home.
2. The spouse who keeps the home must be able to afford maintenance and the payments on the first mortgage. A divorce lien is usually a second mortgage.
3. The spouses need a minimum of cooperation. Some divorcing couples simply won’t agree to this approach.

When it’s possible, a divorce lien gives both parties benefits they couldn’t otherwise get.

Creating the lien: deed, note and deed of trust

Structuring a divorce lien properly takes specialized knowledge, and both parties need to understand the basics. A divorce lien rests on three documents: a deed, a note and a deed of trust (or mortgage).

The departing spouse deeds the property to the remaining spouse, who keeps living in the house. The remaining spouse signs a note payable to the order of the departing spouse and gives a deed of trust secured by the property. Structured properly, the note is a valuable asset that can be sold for cash.

First and foremost, the note must be salable, and both spouses must be told it’s meant to be an asset that can be sold for cash. Once everyone understands that, attention can turn to making sure it actually is salable. Many technicalities can make such a note unsalable or less valuable.

The process starts with the husband (in this example) signing a deed conveying title to the wife. The couple must provide every document the law requires to record the deed. Depending on the state, that could include affidavits, excise tax forms or other items. While the deed is being prepared for recording, the note and deed of trust are prepared for the wife to sign in the husband’s favor.

Making the note salable

Take special care with the note, because its salability depends on a few crucial factors.

Keep the original note safe

Warn the husband that the original note must be kept in a safe place in his possession. If it’s lost, stolen or destroyed, a copy won’t do, and he won’t be able to sell it. Even if he never sells, not having it may hurt his ability to enforce his rights.

Make it a negotiable instrument

Whenever possible, write the note as a negotiable instrument.

The first rule of negotiability is that the note must be due at a time certain. A time certain is an exact date, such as December 31, 2002. It is not an event, such as “when the house sells,” “when the wife remarries,” “when the youngest child is eighteen” or “upon the death of the wife.” If the note names an event instead of a date, it isn’t a negotiable instrument and will have little or no cash value.

The next rule is that the note must not be governed by or subject to any other agreement, terms, conditions or events. In divorces it’s common to write the note subject to the dissolution agreement. If the note is subject to any other document, it becomes non-negotiable.

It’s especially important not to make the note subject to claims, modifications or offsets by the wife. The most common problems:

• Making the note depend on the husband’s future performance, such as letting the wife collect unpaid child support from the balance due on the note.
• Giving the wife a first right of refusal to buy the note at a discount if the husband wants to sell it.

If the note is subject to any claims, modifications or offsets, it won’t be negotiable and will have little or no cash value. If a case truly requires a non-negotiable note, it will most likely be unsalable, though in some circumstances it may still sell for a much lower amount.

Terms that raise the cash price

You should also know how to create a note that brings the highest price. Three principles based on the time value of money apply. A note is worth more if:

1. It has monthly payments instead of one lump sum.
2. It has a short term to the payoff date.
3. It has a high interest rate.

If the wife can afford monthly payments rather than one large balloon at the end, the note will bring a higher price. Most divorce lien notes don’t have monthly payments, though, because the wife’s finances don’t allow it. A term of no more than five years also brings a higher price than a longer one.

A higher interest rate means a higher cash price. A note with no interest may satisfy the divorce settlement, but it will be deeply discounted if it has to be sold. At the other extreme, the highest legal rate may be more than the wife can pay off when the house sells: the interest could eat up all her equity, so the sale price couldn’t cover the note. The best rate for top value is the highest practical rate, given the economic realities of the case.

If the note runs more than a year without any payment, it must say exactly how interest is calculated: simple, or compounded annually. Simple interest is figured on the original amount of the note. Annually compounded interest adds each year’s interest to the principal, so it earns interest on interest. If the note doesn’t specify, a note buyer will value it on simple interest, which lowers the price.

Closing the transaction

When the documents are complete and signed, record the deed first, then the deed of trust. The note goes to the departing spouse.

• Title insurance. Now is the time for each party to buy it: an owner’s policy for the wife and a mortgagee’s policy for the husband. They usually don’t want the expense, but it’s vital protection. Divorces routinely make couples secretive about money, and title insurance makes sure neither has conveyed or encumbered the property without the other knowing.
• Fire insurance. Change the policy to make the wife the insured and the husband the mortgagee. This usually costs nothing.
• The first lien holder. Both spouses are still obligated on the first mortgage. The husband can ask to be released from liability, but the lender isn’t likely to agree unless the wife qualifies on her own income. Sometimes it will agree after her payments have come in promptly for a while, for example two years. The wife should sign permission for the husband to get information about the first mortgage until the divorce lien is paid off.

Divorce liens can be created on other assets besides the family home. Investment properties and businesses can be divided in a similar way.

Above all, attorneys for both the husband and the wife should review the divorce lien, to make sure the house is deeded properly and the lien is structured properly.