By Jones Osborn II

When property with a pre-existing mortgage is sold, one of five things can happen:

1. Prepayment. The mortgage can be paid in full at the time of sale. Under this scenario, the buyer either pays cash from his own funds or obtains a new mortgage to finance all or a portion of the purchase price. The buyer, of course, is liable for the new mortgage unless the new mortgage is non-recourse. The seller, obviously, is not liable, since he has nothing to do with the new mortgage, and the old one is paid off at the closing. If there are prepayment fees, they are paid by the seller unless the parties agree otherwise.

2. Subject To. The pre-existing mortgage can be left in place without the buyer assuming personal liability for payment. In this case, the seller remains liable for the mortgage. The buyer, on the other hand, has no personal liability for the payment of the mortgage, but may lose his property to foreclosure if he doesn't pay it. This arrangement is usually characterized by language in the contract stating that the buyer takes title "subject to" the existing mortgage. For clarity, the contract should also explicitly state the buyer is not assuming personal liability to the seller or the mortgage holder for the payment of the mortgage. This sort of arrangement is possible only when the mortgage does not have a "due-on-sale" clause.

3. Assumption. The buyer can expressly assume liability for the payment of the mortgage. In this case, both the buyer and the seller are personally liable to the mortgage holder for payment. However, if the seller is forced to pay it as a result of the buyer's default, he has a claim for indemnification against the buyer. These transactions are usually characterized by language stating that the buyer assumes the mortgage or that he agrees to pay it when due. This arrangement is possible only when there is no "due-on-sale" clause.

4. Novation. The mortgage holder can leave the mortgage in place, releasing the seller and accepting the buyer as the only responsible party. This requires the mortgage holder to sign a novation agreement whereby he agrees to accept the buyer in place of the seller as the responsible party. In most cases, mortgage holders are reluctant to release anyone from personal liability so these arrangements are not often seen.

5. Wrap-Around. The buyer can execute a new mortgage to the seller that includes the amount of the pre-existing mortgage, in which case the seller remains liable for and agrees to pay the pre-existing mortgage. The buyer would be liable to the seller for the full amount of the new mortgage, but would have no liability for the pre-existing mortgage. This is often referred to as a "wrap-around mortgage," a "wrap," or an "all-inclusive mortgage." It is a complex arrangement with many dangers and pitfalls that needs to be structured carefully and with full knowledge of the risks and benefits.

Conclusion. In any sale of real estate encumbered by a mortgage it is necessary to carefully review the mortgage and all related documents to determine whether the mortgage is assumable, whether it contains a "due on sale clause," whether it contains a transfer or prepayment fee, or whether there are other restrictions or provisions which must be considered. This should be done before the deal is struck so that you aren't stuck with any unanticipated fees or legal problems. However the parties structure the transaction, they should draft clear and explicit provisions concerning the duties and liabilities of the parties with respect to any pre-existing mortgage. Much needless litigation has been generated by relying only on such shorthand phrases as "subject to" or "to be assumed." Regardless of the phraseology used, the courts say that the guiding principle is the intention of the parties — it is therefore essential to make this intention clear and unmistakable in the contract documents.