So is this how substitution of collateral (substitution of security) works?

[Evan C.]

Maybe someone can educate me on the actual uses and mechanics of using a substitution of collateral clause (aka substitution of security) in a loan when you are the borrower. I understand this is almost only used between an individual buyer and an individual seller who is seller financing the property, not banks. But I don't think I fully understand the law surrounding this and the actual ways it should be used.

As I understand it, this is what you could do with such a clause if you are buying a property and the seller is financing it to you:

As an example using easy numbers, you could buy a property through seller financing for a price of $100,000. You put 10% down and you borrow $90,000 from the seller and make those payments (at 5% amortized over 30 years). You then might renovate the property, so it's worth, let's say, $150,000 after 12 months.

At the end of the first year you have title to a property worth $150,000 which is serving as collateral on promissory note where you owe about $88,600. Your equity is $61,400 (you also paid something to renovate but I'm not sure we need to care too much about that for this example). If you sold after one year, you would net $46,400 (assuming closing costs/commissions are $15,000).  This is where the substitution clause comes in, as I understand it. Instead of paying off the old loan and netting the rest, you talk to the first seller who you've been paying for a year and get permission to substitute collateral. 

Instead of simply paying off the old seller, you identify a new seller financed property and you negotiate 10% down again. But in this case, all the proceeds of the sale of the first property go to you, and you are able to bring the entire proceeds of the sale as a down payment on the second property. So you have $150,000 as a down payment. Which is 10% of 1.5 million. So you buy a property, which is $1.5 million (or somewhat less maybe). You pay $150,000 down and borrow $1.35 million from the second seller in a first position lien. The note from the first seller is only $88,600 so you have more than enough equity remaining to place it in second position which leaves $61,400 in equity on the new property or about 4%.

The first seller continues to receive payments and has sufficient collateral to cover the note. 

The second seller gets payments on a new note worth $1.35 million.

You the buyer received the taxable income event from the sale of the first property. You get a new property worth $1.5 million and you go about fixing that up and raising its value for the next move.

Is this accurate? Not accurate? I understand there are some other factors I glossed over like gaining the approval of the first seller to switch collateral and the lien in second position, gaining approval of the second seller to put a second position lien below the big loan, and scheduling the sale of the first property to coincide with the purchase of the second property. Those would be tricky too, and the properties have to cash flow, but is this basically accurate?

[Chris Seveney]

Quote from @Evan C.:

Maybe someone can educate me on the actual uses and mechanics of using a substitution of collateral clause (aka substitution of security) in a loan when you are the borrower. I understand this is almost only used between an individual buyer and an individual seller who is seller financing the property, not banks. But I don't think I fully understand the law surrounding this and the actual ways it should be used.

As I understand it, this is what you could do with such a clause if you are buying a property and the seller is financing it to you:

As an example using easy numbers, you could buy a property through seller financing for a price of $100,000. You put 10% down and you borrow $90,000 from the seller and make those payments (at 5% amortized over 30 years). You then might renovate the property, so it's worth, let's say, $150,000 after 12 months.

At the end of the first year you have title to a property worth $150,000 which is serving as collateral on promissory note where you owe about $88,600. Your equity is $61,400 (you also paid something to renovate but I'm not sure we need to care too much about that for this example). If you sold after one year, you would net $46,400 (assuming closing costs/commissions are $15,000).  This is where the substitution clause comes in, as I understand it. Instead of paying off the old loan and netting the rest, you talk to the first seller who you've been paying for a year and get permission to substitute collateral. 

Instead of simply paying off the old seller, you identify a new seller financed property and you negotiate 10% down again. But in this case, all the proceeds of the sale of the first property go to you, and you are able to bring the entire proceeds of the sale as a down payment on the second property. So you have $150,000 as a down payment. Which is 10% of 1.5 million. So you buy a property, which is $1.5 million (or somewhat less maybe). You pay $150,000 down and borrow $1.35 million from the second seller in a first position lien. The note from the first seller is only $88,600 so you have more than enough equity remaining to place it in second position which leaves $61,400 in equity on the new property or about 4%.

The first seller continues to receive payments and has sufficient collateral to cover the note. 

The second seller gets payments on a new note worth $1.35 million.

You the buyer received the taxable income event from the sale of the first property. You get a new property worth $1.5 million and you go about fixing that up and raising its value for the next move.

Is this accurate? Not accurate? I understand there are some other factors I glossed over like gaining the approval of the first seller to switch collateral and the lien in second position, gaining approval of the second seller to put a second position lien below the big loan, and scheduling the sale of the first property to coincide with the purchase of the second property. Those would be tricky too, and the properties have to cash flow, but is this basically accurate?

 This is not accurate on how it would work. First trying to get this to work is near impossible. A seller is not going to substitute the collateral. Also in your situation the 2nd seller financing partner is NOT in first position the old lender who you still owe money to is in first position as you still owe them $88k. They would not want to take an equity stake as it is not in their interest and they would still want to be in first.