Arizona Court of Appeals Division One Holds that the Doctrines of Replacement and Equitable Subrogation Only Exist Up to the Amount Paid to Release a Senior Lien.

First Horizon Home Loan Corporation (“First Horizon”) loaned Destiny Holdings II, LLC (the “Borrower”) $438,750 to purchase real property (the “Acquisition Loan”).  The Acquisition Loan was secured by a blanket deed of trust on the property.  

The Borrower subsequently entered into an option contract with Destiny Homes Marketing, LLC (“Destiny”) and Destiny recorded the option in the second position behind the Acquisition Loan. 

A short time later, First Horizon extended a new loan to the Borrower for construction on the property (the “Construction Loan”).  The Construction Loan was also secured by a blanket deed of trust on the property recorded after the option.  The first $442,296.12 of the Construction Loan was used to pay off the Acquisition Loan.  The Borrower subsequently paid First Horizon $652,500 of the Construction Loan. 

The following year, Northern Trust (“Northern”) loaned the Borrower approximately $1.5 million to refinance the Construction Loan (the “Refinance Loan”).  The Refinance Loan was secured by a blanket deed of trust on twelve of the original eighteen lots and was recorded after the option.  The Borrower used the Refinance Loan to pay off the balance of the Construction Loan.

The Borrower then defaulted on the Refinance Loan.  Northern foreclosed and purchased the property at a trustee’s sale with a credit bid of $496,706.11.  Northern then filed a quite title action seeking judicial confirmation that the trustee’s sale extinguished the option.  While the lawsuit was pending, Northern sold the property to Brimet II, LLC (“Brimet”) and Brimet became the real party in interest to pursue the quite title action.  The trial court subsequently granted summary judgment in Brimet’s favor.  Destiny timely appealed.

On appeal, the Arizona Court of Appeals reversed the grant of summary judgment and remanded the case to the trial court with instructions to enter summary judgment in favor of Destiny.  Under the doctrine of replacement, if a senior mortgage is released of record and, as part of the same transaction, is replaced with a new mortgage, the latter mortgage retains the same priority as its predecessor.  The doctrine of equitable subrogation is similar in that a later lender can pay off the first and superior loan, allowing the later lender to be substituted into the priority position of the primary lienholder, regardless of the existence of a recorded intervening lien.  However, to avoid prejudice to junior lienholders, replacement and equitable subrogation only exist up to the amount paid to release the senior lien.  In this case, the Construction Loan that replaced the Acquisition Loan has priority over the option, in the amount of the balance owed on the senior loan, $442,296.12.  The Borrower’s payment of $652,500 on the Construction Loan to First Horizon extinguished the priority lien which was senior to the option.  After the lien was extinguished, the option had priority followed by the lien for the balance owed under the construction loan.  When Northern extended the refinance loan to the Borrower, Destiny’s option was already in first position.  Consequently, Destiny’s option was not extinguished when Northern foreclosed on its deed of trust and purchased the property at the trustee’s sale.  The Court therefore held that Brimet did not acquire title to the property fee and clear of the option.

Judge Orozco authored the opinion; Judges Portley and Howe concurred.