What Is a Trust Deed? Understanding Its Role in Real Estate

What Is a Trust Deed?

A trust deed —also known as a deed of trust—is a document sometimes used in real estate transactions in the U.S. It comes into play when one party has taken out a loan from another party to purchase a property. The trust deed represents an agreement between the borrower and a lender to have the property held in trust by a neutral and independent third party until the loan is paid off.

Although trust deeds are less common than they once were, some 20 states still mandate the use of one, rather than a mortgage, when financing is involved in the purchase of real estate. Trust deeds are common in Alaska, Arizona, California, Colorado, Idaho, Illinois, Mississippi, Missouri, Montana, North Carolina, Tennessee, Texas, Virginia, and West Virginia.

A few states—such as Kentucky, Maryland, and South Dakota—allow the use of both trust deeds and mortgages.

Trust deeds provide investment opportunities through a broker and can generate passive income from real estate without owning property directly.

How Trust Deeds Operate in Real Estate Transactions

A trust deed is a transaction between three parties:

• Lenders, officially known as beneficiaries. These are the interests a trust is supposed to protect.
• A borrower, otherwise known as a trustor. This is the person who establishes a trust.
• A trustee, a third party charged with holding the entrusted property until a loan or debt is paid for in full.

In a real estate transaction—the purchase of a home, say—a lender gives the borrower money in exchange for one or more promissory notes linked to a trust deed. This deed transfers legal title to the real property to an impartial trustee, typically a title company, escrow company, or bank, which holds it as collateral for the promissory notes. The equitable title—the right to obtain full ownership—remains with the borrower, as does full use of and responsibility for the property.

This state of affairs continues throughout the repayment period of the loan. The trustee holds the legal title until the borrower pays the debt in full, at which point the title to the property transfers to the borrower. If the borrower defaults on the loan, the trustee takes full control of the property.

Comparing Trust Deeds and Mortgages

Both trust deeds and mortgages are used to create liens on real estate and are recorded as debt in the county where the property is located. However, there are differences between them.

Number of Parties

A mortgage involves two parties: a borrower (or mortgagor) and a lender (or mortgagee). When a borrower signs a mortgage, they pledge the property as security to the lender to ensure repayment.

In contrast, a trust deed involves three parties: a borrower (or trustor), a lender (or beneficiary), and the trustee. The trustee holds title to the lien for the lender’s benefit; if the borrower defaults, the trustee will initiate and complete the foreclosure process at the lender’s request.

Type of Foreclosure

If a default occurs, a deed of trust and a mortgage follow different foreclosure processes. A defaulted mortgage will result in a judicial foreclosure, meaning that the lender will have to secure a court order. Trust deeds go through a non-judicial foreclosure, provided that they include a power-of-sale clause.

Judicial foreclosures are more expensive and time-consuming than non-judicial foreclosures. This means that in states that allow them, a deed of trust is preferable to a mortgage from the lender’s point of view.

Key Elements Found in a Trust Deed

A deed of trust contains similar information found in a mortgage document, such as:

• The identities of the borrower, lender, and trustee
• A full description of the property to be placed in trust
• Any restrictions or requirements on the use of the property while it is in trust
• The terms of the loan, including principal, monthly payments, and interest rate
• The terms of any late fees and penalties in the event of repayment

A trust deed also includes a power of sale clause, allowing the trustee to sell the property if the borrower defaults.

Foreclosure Processes Involving Trust Deeds

The foreclosure processes differ for mortgages and trust deeds. A judicial foreclosure is a court-supervised process enforced when the lender files a lawsuit against the borrower for defaulting on a mortgage. The process is time-consuming and expensive.

Also, if the foreclosed property auction doesn’t bring in enough money to pay off the promissory note, the lender may file a deficiency judgment against the borrower, suing for the balance. However, even after the property is sold, the borrower has the right of redemption: they may repay the lender within a set amount of time and acquire the property title.

A trust deed allows for a quicker and cheaper non-judicial foreclosure, avoiding court and following outlined procedures in the deed and state law. If the borrower does not make the loan current, the property is put up for auction through a trustee’s sale.

The title transfers from the trustee to the new owner through the trustee’s deed after the sale. When there are no bidders at the trustee sale, the property reverts to the lender through a trustee’s deed. Once the property is sold, the borrower has no right of redemption.

The trustee must pay the sale proceeds to the borrower and lender once the sale finalizes. The trustee will pay the lender the amount left over on the debt and pay the borrower anything that surpasses that amount, thereby allowing the lender to purchase the property.

Benefits and Risks of Investing in Trust Deeds

Investors who are searching for juicy yields sometimes turn to the real estate sector—in particular, trust deeds.

In trust deed investing, the investor loans money to a real estate developer. The investor’s name goes on the deed of trust as the lender. The investor collects interest on the loan; when the project is finished, the principal is returned to the investor in full. A trust deed broker usually facilitates the deal.

What sort of developer enters this arrangement? Banks are often reluctant to lend to certain types of developments, such as mid-size commercial projects—too small for the big lenders, too big for the small ones—or developers with poor track records or too many loans. Cautious lenders may also move too slowly for developers up against a tight deadline for commencing or completing a project.

Developers like these are often in a bit of a crunch. For these reasons, trust deed investors may often expect high interest rates on their money. They can reap the benefits of diversifying into a different asset class without having to be experts in real estate construction or management. This is a form of passive investment.

Trust deed investing has certain risks and disadvantages. Unlike stocks, real estate investments are not liquid, meaning investors cannot retrieve their money on demand. Also, investors can expect only the interest the loan generates; any additional capital appreciation is unlikely.

Invested parties may exploit any legal discrepancies in the trust deed, causing costly legal entanglements that may endanger the investment. The typical investor with little experience may have difficulty, as it takes specific expertise to find credible and trustworthy developers, projects, and brokers.

Practical Example: Trust Deed in Action

A short-form deed of trust document used in Austin County, Texas, covers the requirements for most lenders. The form begins with a definition of terms and spaces for the borrower, lender, and trustee to fill in their names. The amount being borrowed and the address of the property are also required.

After this section, the document goes on to specify the transfer of rights in the property and uniform covenants including:

• Details about payment of principal and interest
• Escrow funds
• Liens
• Property insurance and structure maintenance
• Structure occupancy—stipulating the borrower must take up residency within 60 days

The form also includes nonuniform covenants, which specify default or breach of any of the agreement terms. And it specifies that the loan the document deals with is not a home equity loan—that is, something the borrower will receive cash from—but one for purchasing the property.

The deed of trust ends with a space for the borrower’s signature, which must be done in the presence of a notary and two witnesses, who also sign.

The Bottom Line

Trust deeds are an alternative to mortgages in certain states. Instead of an agreement directly between a lender and a borrower, a trust deed places the title of a property in the hands of a third party, or trustee. Only after the borrower has satisfied the terms of their debt to the lender will the property be fully transferred to the borrower.

Trust deeds generally allow for a faster, non-judicial foreclosure process. Trustees have a duty to manage the sale proceeds properly during a foreclosure. Investing in trust deeds can offer a high-yield income stream, but it also carries the risk of illiquidity and the lack of capital appreciation. It is important to understand state-specific regulations and consult financial professionals when considering trust deeds.