We are doing a junior lien for construction overruns from the initial construction of the home. The borrowers are now living in the home and we will soon be rolling this all into the permanent financing. Our loan software is giving us a warning that this junior lien is subject to rescission because the borrowers are now living in it. I believe this junior lien is still a residential mortgage transaction for the initial construction of the dwelling and exempt from rescission...right?

4. Special rule for principal dwelling. Notwithstanding the general rule that consumers may have only one principal dwelling, when the consumer is acquiring or constructing a new principal dwelling, any loan subject to Regulation Z and secured by the equity in the consumer's current principal dwelling (for example, a bridge loan) is subject to the right of rescission regardless of the purpose of that loan. For example, if a consumer whose principal dwelling is currently A builds B, to be occupied by the consumer upon completion of construction, a construction loan to finance B and secured by A is subject to the right of rescission. A loan secured by both A and B is, likewise, rescindable.

Not sure that is the correct quote. If you want to be conservative and give them a right of rescission because they are living in the property - well, you are free to do that. If the second lien transaction is actually to complete the acquisition/construction of the dwelling however, lien status is not a determining factor. Neither is occupancy.

2. Lien status. The definition is not limited to first lien transactions. For example, a consumer might assume a paid-down first mortgage (or borrow part of the purchase price) and borrow the balance of the purchase price from a creditor who takes a second mortgage. The second mortgage transaction is a residential mortgage transaction if the dwelling purchased is the consumer's principal residence.

IF the house is not done, how are they living in the house? You would not think they could get an occupancy permit and all of this might jeopardize your title insurance.