Best Practices: Understanding Homestead Exemptions and their Effect on Collateral

The Small Business Administration’s (“SBA”) Standard Operating Procedures (“SOP”) require lenders collateralize 7(a) loans greater than $350,000 to the maximum extent possible up to the loan amount.
See SOP 50 10 5(I) at pg. 156. Accordingly, lenders “must take available equity in the personal real estate (residential and investment) of the principals as collateral.” Id.

A number of states have enacted homestead laws that protect an individual’s primary residence from foreclosure or forced sale. Homestead laws are enacted with the intent that debtors should not become homeless following a forced sale. While most homestead laws do not protect debtors from creditors foreclosing on a consensual liens – i.e. liens that secure specific indebtedness – a number of jurisdictions have homestead laws that can (i) inhibit a lender’s ability to foreclose on a personal residence and/or (ii) limit the recoverable value of a foreclosed lien upon primary residence. Accordingly, it is important that lenders understand the impact homestead laws may have on collateral.

For purposes of this article, a “homestead” is an individual’s primary residence and includes the associated land and dwelling. An individual can establish a homestead by residing at the subject property and demonstrating an intent to remain at the property. In some jurisdictions, a homestead may be established by filing the appropriate notice. Homestead protection is generally not afforded to assets owned by a corporation or LLC, and individuals can only have one homestead. Because homestead laws are state specific and nuanced, legal counsel should be engaged with any questions or concerns.

Homestead laws are relevant when evaluating who should execute a mortgage. Homestead rights are determined not according to the parties listed on the deed, but rather pursuant to who has established homestead rights in a property. For example, both spouses could have homestead rights in their primary residence despite only one spouse appearing on the deed. A lender could have difficulty foreclosing on a mortgage that was not acknowledged or executed by the spouse not appearing on the deed but who has valid homestead rights in the property. Such an inability to foreclose on a residential mortgage could jeopardize the SBA’s guaranty.

Texas grants individuals the greatest homestead protection in the union. Under Texas law, and with the exception of first position purchase money liens, a consensual deed of trust recorded against a homestead may not be foreclosed upon. Texas law is unclear whether a deed of trust recorded against a homestead would become operable should the property lose its homestead status in the future. Creditors often make a business decision and elect not to record a deed of trust on a Texas homestead property because of the inability to foreclose.

California law allows foreclosing on homesteads, but protects varying amounts of equity depending on the number and characteristics of the parties who have established the property as their homestead. For example, California homestead law protects $75,000 in a homestead if only one individual resides at the property and that person is under the age of 65. A lender would only be able to foreclose on a homestead if the proceeds from the sale would exceed $75,000.00. In such a foreclosure, the first $75,000.00 would be earmarked to the debtor and all excess funds would be available to creditors.

Lenders should consider taking the following precautions when addressing homestead laws:

• Confirm the Mortgagor’s Homestead: Principals pledging multiple residential properties should confirm which property is and is not their homestead. This may be accomplished via an affidavit stating which address is the principals homestead.

• Confirm the Homestead has been Established Pursuant to State Law: The veracity of a homestead affidavit should be confirmed against state law. Some questions to explore include: Does the principal reside at the stated homestead? Has a homestead been established pursuant to state requirements? Is the principal a residents of the state where the property is located?

• On a Mortgage, Obtain the Signature of each Individual Claiming the Collateral Residence as a Homestead: Lenders should consider having both spouses execute and/or acknowledge the mortgage to best ensure the ability to foreclose on a property has been preserved.

For more information on homestead exemptions and related issues, please contact us at 215-542-7070 or at info@starfieldsmith.com.