                                   United States Court of Appeals,

                                             Fifth Circuit.

                                             No. 92-1609.

                       DIETRICH INDUSTRIES, INC., Plaintiff-Appellant,

                                                   v.

                        UNITED STATES of America, Defendant-Appellee.

                                            April 16, 1993.

Appeal from the United States District Court for the Northern District of Texas.

Before REAVLEY, KING and WIENER, Circuit Judges.

        REAVLEY, Circuit Judge:

         Under Texas law of equitable subrogation, is the purchaser of encumbered property who

discharges a senior lien as part of the purchase price entitled to subrogate to the position of priority

over a junior recorded lien? We answer that the purchaser is subrogated to the senior position and

reverse the district court's summary judgment in favor of the junior lienholder.

                                         I. BACKGROUND

        Australian Acquisitions, Inc. (AAI) owned a tract of land in Hutchins, Texas. In 1988, AAI

executed a deed of trust on this property in favor of Broadlands Limited (Broadlands) to secure a

debt of $3,825,210.00 (Broadlands lien). Broadlands properly recorded the deed of trust on

September 28, 1988. In 1989, the Internal Revenue Service (IRS) filed two federal tax liens on the

property. IRS properly recorded the tax liens in Dallas County. The Broadlands lien was superior

to the tax liens.

        In March 1990, Dietrich Industries, Inc. (Dietrich) agreed to purchase the property from AAI

for $385,000.00. At the closing in May, AAI executed a special warranty deed conveying the

property to Dietrich. Sale proceeds in the amount of $319,892.01 were paid to Broadlands in

consideration for Broadlands's release of its lien.1 The parties applied the balance of the sale proceeds

   1
    The lien release is dated April 4, 1990. The release states that "in consideration for the partial
payment of the Indebtedness, [Broadlands] has agreed to deliver ... this Release of Lien...." The
partial payment was not made until May 1990, and we have no reason to doubt that this release
to pay closing costs; AAI received no money from the sale.

        As established by an uncontroverted affidavit, Dietrich had no actual knowledge of the junior

tax liens when it purchased the property. None of the documents pertaining to the Dietrich sale

mention the existence of tax liens.

        Dietrich asserts that it is entitled to equitably subrogate to Broadlands's position as the senior

lienholder. Dietrich claims priority only to the amount that it paid in discharging the Broadlands lien

($319,892.01). As an equitable lienholder, Dietrich claims the right to foreclose its own property.

Under Dietrich's theory, the foreclosure proceeds would first be used to satisfy Dietrich's equitable

lien of $319,892.01, and then be used to satisfy the junior tax liens. In this lawsuit against the United

States, Dietrich seeks a declaratory judgment that Dietrich holds an equitable lien which is superior

to the federal tax liens. Additionally, Dietrich seeks to judicially foreclose its superior, equitable lien.

        Dietrich and the government filed cross-motions for summary judgment. The district court

entered summary judgment in favor of the government, concluding that Dietrich is not entitled to

subrogation.

                                             II. ANALYSIS

A. FEDERAL TAX LAW

        The government does not dispute that, prior to AAI's sale to Dietrich, the Broadlands lien

was superior to the tax liens. The parties agree that AAI's sale to Dietrich did not extinguish the tax

liens. So the issue here is the priority of those tax liens, not their existence. In determining the

priority of federal tax liens, courts must consider the state law of subrogation. See I.R.C. §

6323(i)(2) ("Where, under local law, one person is subrogated to the rights of another with respect

to a lien or interest, such person shall be subrogated to such rights for purposes of any [federal tax

lien]."); see also Han v. United States, 944 F.2d 526, 529-31 (9th Cir.1991). Dietrich has priority

over the tax liens if, under Texas law, Dietrich is entitled to subrogate to Broadlands's position as

senior lienholder.

B. TEXAS SUBROGATION LAW


was delivered upon payment of the money.
         Texas recognizes two types of subrogation:          "conventional subrogation" and "legal

subrogation." Fleetwood v. Med Center Bank, 786 S.W.2d 550, 554 (Tex.App.—Austin 1990, writ

denied). Conventional subrogation generally depends on an agreement between the parties, while

legal subrogation, which courts often call "equitable subrogation," is controlled by the principles of

equity. Dietrich claims equitable subrogation, which traditionally receives favorable treatment in

Texas. See id. There are several situations in which equitable subrogation might arise. See generally

Grant S. Nelson & Dale A. Whitman, REAL ESTATE FINANCE LAW §§ 10.1-10.7 (2d ed. 1985). We

are concerned with the application of the equitable subrogation doctrine to purchasers of encumbered

property.

1. Purchasers of Encumbered Property

        In Texas, any person who pays the debt of another to protect her own interest in property

is entitled to subrogate to the rights of the creditor whose claim was paid. Fears v. Albea, 69 Tex.

437, 6 S.W. 286, 289 (1887);             McDermott v. Steck Co., 138 S.W.2d 1106, 1109

(Tex.Civ.App.—Austin 1940, writ ref'd). This rule extends to purchasers who pay an existing

mortgage debt as a part of the purchase transaction. See First Nat'l Bank of Houston v. Ackerman,

70 Tex. 315, 8 S.W. 45, 47 (1888); Fears, 6 S.W. at 288-89. In these cases, courts consider the

purchaser/payor an equitable assignee of the lienholder (or mortgagee), and permit the

purchaser/payor to keep the lien alive and enforce the lien for her own benefit. See Fears, 6 S.W.

at 289. The equitable assignment is a legal fiction which does not depend on the parties' intent to

keep the lien alive. Nor is the equitable assignment affected by the doctrine of merger-of-title, which

in certain situations calls for the lien to merge into the title. Thus, equitable subrogation permits a

purchaser to hold an equitable lien on the purchaser's own property.

       Several Texas courts have stated a companion rule: a purchaser who assumes payment of a

mortgage as part of the purchase price, and thus becomes the principal and primary debtor, is not

entitled to subrogate to the rights of the lienholder. See, e.g., Harrison v. First Nat'l Bank of

Lewisville, 238 S.W. 209, 210 (Tex.Comm'n App.1922, judgm't adopted); Cheswick v. Weaver, 280

S.W.2d 942, 944 (Tex.Civ.App.—Beaumont 1955, writ ref'd n.r.e.); McDermott, 138 S.W.2d at
1109; see also 3 John Norton Pomeroy, EQUITY JURISPRUDENCE § 1213 (5th ed. 1941) (equitable

subrogation should not occur when a purchaser "has assumed payment of the mortgage debt and ...

rendered himself the principal and primary debtor therefor"). However, some Texas courts have

permitted subrogation in situations where the purchaser has assumed payment of a prior mortgage.

See, e.g., Murphy v. Smith, 50 S.W. 1040, 1042 (Tex.Civ.App.—1899, no writ); Davis v. John V.

Farwell Co., 49 S.W. 656, 658 (Tex.Civ.App.—1899, no writ); see also Nelson & Whitman, REAL

ESTATE FINANCE LAW § 10.7 (arguing that a purchaser who assumes payment of a lien and later pays

it should be subrogated to the position of the discharged lien). Because Dietrich did not assume

AAI's debt , we need not decide whether Texas law permits a purchaser who assumes a debt to

subrogate once that purchaser has paid the assumed mortgage. However, at least one Texas court

has applied the prior version of the rule concerning assumptions to purchasers who, instead of

assuming the mortgage, discharged the debt as part of the agreed purchase price. See McDowell v.

M.T. Jones Lumber Co., 42 Tex.Civ.App. 260, 93 S.W. 476, 476-77 (1906, no writ).

       The government argues that this case is controlled by McDowell. In McDowell, as here, the

seller and purchaser agreed that the purchase price would be used to pay t he seller's debt and

extinguish the accompanying lien, which was a superior lien. The purchaser, unaware of the existence

of a recorded junior lien, believed he was taking the land free of all encumbrances. Sometime after

the purchaser bought the property, the junior lienholder sought to foreclose its lien. Relying on the

rule that purchasers who assume mortgages may not subrogate, the court of appeals refused to allow

the purchaser to subrogate to the rights of the senior lienholder. If McDowell represents Texas law,

Dietrich is not entitled to subrogation.

       But we believe that McDowell contravenes the Texas Supreme Court's decisions in Fears and

Ackerman. In Fears, the land in question was encumbered by a first and a second lien. The seller

and purchaser agreed that the sale proceeds would be used to pay the first mortgage, which was later

released. Unaware of the junior lien, the purchaser expected the land to be free of all liens. The

Texas Supreme Court concluded that the purchaser's payment of the senior lien entitled the purchaser

to subrogate to the superior rights of the senior lienholder. Fears, 6 S.W. at 289-90. In Ackerman,
the Texas Supreme Court similarly held that a purchaser who applies the agreed purchase price to

release a senior lien is entitled to subrogate to the position of the senior lienholder. Ackerman, 8

S.W. at 45, 47. The Texas Supreme Court's decisions in Fears and Ackerman control our decision

here.

        The McDowell court might have been correct in stating the rule that a purchaser who assumes

a mortgage is not thereafter entitled to subrogation. In fact, McDowell is often cited for such a rule.

See, e.g., Cheswick, 280 S.W.2d at 944; 68 TEX.JUR.3d Subrogation § 25, at 69 & n. 34 (1989).

Nevertheless, we believe that the McDowell court ignored the Fears and Ackerman decisions in

applying such a rule to a purchaser who, instead of assuming the senior debt, simply discharged the

debt as part of the agreed purchase price.

        Based on Fears and Ackerman, Dietrich is entitled to subrogate to Broadlands's position as

senior lienholder. The government proffers two additional arguments in support of its position that

equitable subrogation does not control this case.

2. Constructive Knowledge of the Tax Liens

        The government contends that Dietrich is not entitled to equitable subrogation because

Dietrich had constructive knowledge of the tax liens and was negligent in failing to discover the liens.

In some jurisdictions constructive knowledge bars a subrogation claim, see, e.g., Hieber v. Florida

Nat'l Bank, 522 So.2d 878 (Fla.App. 3d Dist.), pet. for review denied, 534 So.2d 399 (Fla.1988), but,

in Texas, a purchaser with constructive knowledge of the junior lien is not precluded from asserting

equitable subrogation. In Fears, the Texas Supreme Court applied the equitable subrogation doctrine

even though the purchaser had constructive knowledge of the junior lien. See Fears, 6 S.W. at 288,

292;    see also Sanger Bros. v. Ely & Walker Dry Goods Co., 207 S.W. 348, 349

(Tex.Civ.App.—Fort Worth 1918, writ ref'd); McDermott, 138 S.W.2d at 1107. The government

has cited no Texas authority for the proposition that a purchaser with constructive knowledge is

precluded from seeking equitable subrogation.2

   2
     The IRS relies on Providence Institution for Savings v. Sims, 441 S.W.2d 516 (Tex.1969), in
which the Texas Supreme Court noted that "[n]egligence on the part of one seeking subrogation
is of some importance when the right is wholly dependent upon equitable principles." Id. at 519.
3. Partial Payment of the Senior Debt

        As a general rule, a person is not entitled to subrogate to the rights of a creditor until the

creditor's claim against the debtor has been satisfied or paid in full. Sims, 441 S.W.2d at 519;

Ricketts v. Alliance Life Ins. Co., 135 S.W.2d 725, 735 (Tex.Civ.App.—Amarillo 1939, writ dism'd

judgmt cor.). Here, Dietrich did not pay the full amount of the debt which AAI owed Broadlands.

Broadlands, however, agreed to release its lien in consideration of the partial payment.

         The government argues that Dietrich's failure to pay the entire debt prevents it from

subrogating to the rights of Broadlands. We disagree. This general rule requiring payment of the

entire debt protects the senior lienholder whose rights are being subrogated (i.e., Broadlands). Sims,

441 S.W.2d at 519. The rationale behind the rule is that equitable subrogation should not prejudice

the senior lienholder's attempt to collect the entire indebtedness secured by the senior lien. See id.;

Ricketts, 135 S.W.2d at 735. The fact that Dietrich has not paid the entire indebt edness is not a

matter about which the government, as a junior lienholder, can complain. See Hurt v. Read, 108 F.2d

282, 283 (5th Cir.1939). Moreover, Broadlands's rights will not be prejudiced by Dietrich's

subrogation because Broadlands agreed to release its entire lien in exchange for partial payment of

the debt.

C. EQUITY

        In applying the Texas rules of equitable subrogation, we do not lose sight of the equities.

Dietrich purchased the property with the expectation that the property would be free of

encumbrances. Had Dietrich been aware of the federal tax liens, it could have structured the purchase

in a manner that would have protected its interest. For example, Dietrich might have taken a formal

assignment of the Broadlands lien or purchased the property at foreclosure sale which met the notice


The Sims court explained that jurisdictions are split as to the effects of constructive knowledge in
equitable subrogation cases. The court found no Texas cases holding that constructive
knowledge bars an equitable subrogation claim, but found one Texas court of appeals case which
adopted the view that constructive knowledge did not preclude equitable subrogation. Id. (citing
Sanger, 207 S.W. at 349.)

              The Sims court concluded that its case did not entirely depend upon equitable
       subrogation, so the court did not decide the effect of constructive knowledge in cases
       involving purely equitable subrogation.
requirements of I.R.C. § 7425. Equitable subrogation in this case treats Dietrich as if it took a formal

assignment of a portion of the Broadlands lien.

        Denying subrogation in this case would give the government an unearned windfall in that it

would elevate the government's liens for no good reason. See generally Nelson & Whitman, REAL

ESTATE FINANCE LAW, § 10.7; Note, Subrogation of Purchaser to Rights of Senior Mortgagee

Against Junior Encumbrances, 48 YALE L.J. 683, 689 (1939). Before AAI's sale to Dietrich, the

government's tax liens were subordinate to the Broadlands lien. Dietrich's subrogation does not place

the government in a worse position than it occupied before AAI's sale to Dietrich. See Sanger Bros.,

207 S.W. at 350 (recognizing that subrogation would not place junior lienholder in a worse position);

see also Han, 944 F.2d at 530 & n. 3; Burgoon v. Lavezzo, 92 F.2d 726, 732-33 (D.C.Cir.1937)

(same).3

        Dietrich is entitled to subrogate only to the extent of its payment to Broadlands

($319,892.01).4 Permitting Dietrich to subrogate to the rights of Broadlands does not extinguish the

tax liens. At foreclosure, proceeds shall be used to satisfy Dietrich's equitable lien before being used

to satisfy the federal tax liens.5

                                         III. CONCLUSION

        Dietrich holds a superior, equitable lien in the amount of the proceeds paid to Broadlands.

Dietrich is now entitled to seek judicial foreclosure of its senior lien. Accordingly, we reverse the

district court's judgment in favor of the government and remand for further proceedings consistent

with this opinion.

   3
    According to Dietrich, the tax liens were practically worthless before the sale to Dietrich
because the property had no value in excess of Broadlands's security interest.
   4
    Some Texas cases suggest that subrogation extends to the amount paid to discharge the
senior debt plus interest on that amount. See Ricketts, 135 S.W.2d at 735; Ross v. Brown, 396
F.Supp. 192, 196 (E.D.Tex.1975). We do not address whether a purchaser's subrogation right
extends to interest because Dietrich only seeks to subrogate to the extent of its payment to
Broadlands ($319,892.01).
   5
    The government is in a better position than it was before the sale to Dietrich. The
government is not entitled to proceeds after satisfaction of the $319,892.01 senior lien. Before
the sale to Dietrich, the tax liens were subordinate to Broadlands's deed of trust, which secured a
debt of $3,825,210.95.
REVERSED AND REMANDED.
