Transferring Mortgaged Property into a Revocable Living Trust

Mortgaged property may be transferred into a revocable living trust as a measure to avoid probate and provide greater control over how the property is distributed to beneficiaries. Unlike property which the grantor owns free and clear of encumbrances, mortgaged property requires additional considerations prior to placing it in a trust.

The process for funding (i.e., transferring assets into the trust) a mortgaged property to a revocable trust can be confusing, as the process depends on the type of property being transferred. Funding a primary residence can be very different from funding a rental property. One of the reasons for the difference is the Garn–St. Germain Depository Institutions Act of 1982 (the “Act”) and its effect on the “due-on-sale” provision found in most mortgages.

The “due-on-sale” (aka “acceleration clause”) is a provision in a mortgage document that gives the lender the right to demand payment of the remaining balance of the loan when the property is sold. It is a contractual right, not a law. This means that if title to the property is transferred, the lender may (or may not), at its option, decide to “call the loan due.”

However, when the property is transferred into a living trust, homeowners whose mortgage contains a due-on-sale provision receive protection from the Act, which is a federal law that creates several exceptions in which a lender may not enforce the due-on-sale provision. Certain limitations are imposed by the Act on the validity of a due-on-sale provision found in many mortgage contracts; no lender may accelerate in the event of any of the following transfers, regardless of what the particular due-on-sale provision states, whenever the loan is secured by residential real property containing less than five dwelling units:

(1) a junior lien is created on the property.
(2) a purchase-money lien is created for household appliances.
(3) a transfer occurs by devise, descent, or on the death of a joint tenant.
(4) a leasehold is created for a term of three years or less not containing a purchase option.
(5) a transfer to a relative resulting from the death of a borrower.
(6) a transfer where the spouse or children of the borrower become an owner of the property.
(7) a transfer resulting from a decree of dissolution of marriage, a legal separation agreement, or an incidental property settlement agreement by which the spouse of the borrower becomes an owner of the property.
(8) a transfer into an inter vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property.
(9) any other transfer or disposition described in regulations prescribed by the Federal Home Loan Bank Board.

Transfers of Commercial or Investment Property

The ability of a lender to enforce a due-on-sale provision for transfers to a revocable living trust becomes more unclear when the property transferred is not the borrower/beneficiary’s personal residence. California law does not contain the same requirements as the Act – that the borrower must remain the occupant of the property in order to prevent enforcement of the due-on-sale provision. On the other hand, the Act expressly states that it was intended to override state law. In general, when federal and state laws conflict, the federal law controls. Thus, the Act appears to allow for the enforcement of a due-on-sale provision when the borrower/beneficiary does not occupy the property.

In light of this uncertainty and the potentially high stakes involved, if the property transferred to the trust is not occupied by the borrower/beneficiary, the best course seems to be to get the lender’s written permission before transferring the property. A lender typically charges a modest fee for this consideration, but there is no guarantee – especially if the interest rate on the loan is significantly lower than the current market rate. At any rate, while funding your revocable trust with real property is critical to avoiding probate and making the most of a revocable trust, transfers of commercial and non-owner-occupied residential property must be handled with care.

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