When a business mortgage lending institution sets out to impose a mortgage loan following a customer default, a crucial goal is to identify the most expeditious manner in which the loan provider can get control and possession of the underlying security. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more cost-effective alternative to the long and protracted foreclosure procedure. This short article goes over actions and concerns loan providers must consider when deciding to with a deed in lieu of foreclosure and how to avoid unexpected dangers and challenges throughout and following the deed-in-lieu process.

Consideration

A crucial element of any contract is guaranteeing there is appropriate factor to consider. In a basic deal, consideration can easily be developed through the purchase cost, but in a deed-in-lieu situation, confirming sufficient factor to consider is not as uncomplicated.

In a deed-in-lieu situation, the amount of the underlying debt that is being forgiven by the loan provider generally is the basis for the factor to consider, and in order for such factor to consider to be deemed "adequate," the debt ought to at least equivalent or go beyond the reasonable market worth of the subject residential or commercial property. It is crucial that loan providers acquire an independent third-party appraisal to corroborate the worth of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its recommended the deed-in-lieu agreement include the customer's express acknowledgement of the reasonable market worth of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any possible claims connected to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English common law that a borrower who protects a loan with a mortgage on genuine estate holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the debt up until the point when the right of redemption is legally extinguished through a correct foreclosure. Preserving the borrower's equitable right of redemption is the reason, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu transactions prevent a borrower's fair right of redemption, nevertheless, steps can be required to structure them to limit or prevent the threat of a clogging difficulty. First and foremost, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must take location post-default and can not be considered by the underlying loan files. Parties must also be cautious of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which ponder that the borrower retains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase choices, as any of these plans can create a risk of the transaction being recharacterized as a fair mortgage.

Steps can be taken to mitigate versus recharacterization threats. Some examples: if a debtor's residential or commercial property management functions are restricted to ministerial functions instead of substantive choice making, if a lease-back is brief term and the payments are clearly structured as market-rate usage and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is established to be entirely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu agreements include the parties' clear and indisputable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes only.

Merger of Title

When a lender makes a loan secured by a mortgage on real estate, it holds an interest in the genuine estate by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the loan provider then acquires the property from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the charge owner and acquiring the mortgagor's equity of redemption.

The basic guideline on this issue supplies that, where a mortgagee obtains the cost or equity of redemption in the mortgaged residential or commercial property, and there is no intermediate estate, merger of the mortgage interest into the charge occurs in the lack of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is crucial the agreement clearly shows the parties' intent to maintain the mortgage lien estate as unique from the charge so the lending institution retains the ability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the lender loses the capability to deal with stepping in liens by foreclosure, which might leave the lender in a potentially worse position than if the lender pursued a foreclosure from the beginning.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu agreement (and the deed itself) need to consist of reveal anti-merger language. Moreover, since there can be no mortgage without a debt, it is customary in a deed-in-lieu situation for the lending institution to provide a covenant not to take legal action against, instead of a straight-forward release of the debt. The covenant not to sue furnishes factor to consider for the deed in lieu, safeguards the customer against direct exposure from the financial obligation and likewise retains the lien of the mortgage, therefore enabling the loan provider to keep the capability to foreclose, should it become desirable to get rid of junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending on the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu deals can be a considerable sticking point. While most states make the payment of transfer tax a seller responsibility, as a practical matter, the loan provider ends up taking in the expense since the debtor is in a default scenario and usually lacks funds.

How transfer tax is calculated on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in identifying if a deed in lieu is a feasible alternative. In California, for example, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt up to the amount of the financial obligation. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is restricted only to a transfer of the borrower's personal home.

For a business deal, the tax will be calculated based on the full purchase rate, which is specifically defined as including the amount of liability which is presumed or to which the real estate is subject. Similarly, however even more potentially draconian, New york city bases the quantity of the transfer tax on "consideration," which is specified as the unsettled balance of the financial obligation, plus the total quantity of any other surviving liens and any amounts paid by the grantee (although if the loan is fully option, the factor to consider is capped at the fair market worth of the residential or commercial property plus other amounts paid). Bearing in mind the loan provider will, in many jurisdictions, need to pay this tax once again when eventually offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative consider choosing whether a deed-in-lieu transaction is a feasible choice.
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Bankruptcy Issues
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A significant concern for lenders when figuring out if a deed in lieu is a practical alternative is the concern that if the borrower ends up being a debtor in an insolvency case after the deed in lieu is complete, the bankruptcy court can cause the transfer to be unwound or set aside. Because a deed-in-lieu deal is a transfer made on, or account of, an antecedent financial obligation, it falls directly within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with preferential transfers. Accordingly, if the transfer was made when the customer was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period set forth in the Bankruptcy Code, the customer becomes a debtor in a bankruptcy case, then the deed in lieu is at threat of being set aside.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be reserved if it is made within one year prior to a bankruptcy filing and the transfer was produced "less than a reasonably equivalent value" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was engaged in a business that preserved an unreasonably low level of capital or planned to incur financial obligations beyond its ability to pay. In order to reduce versus these risks, a loan provider must carefully examine and evaluate the debtor's monetary condition and liabilities and, preferably, need audited monetary declarations to validate the solvency status of the debtor. Moreover, the deed-in-lieu arrangement must consist of representations as to solvency and a covenant from the customer not to declare personal bankruptcy during the preference period.

This is yet another reason that it is essential for a loan provider to acquire an appraisal to confirm the value of the residential or commercial property in relation to the debt. A present appraisal will help the lending institution refute any allegations that the transfer was made for less than reasonably comparable value.

Title Insurance

As part of the preliminary acquisition of a genuine residential or commercial property, the majority of owners and their loan providers will acquire policies of title insurance coverage to protect their particular interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can depend on its lender's policy when it ends up being the cost owner. Coverage under a loan provider's policy of title insurance coverage can continue after the acquisition of title if title is taken by the same entity that is the named guaranteed under the lending institution's policy.

Since lots of loan providers choose to have actually title vested in a separate affiliate entity, in order to guarantee continued coverage under the lending institution's policy, the named loan provider needs to assign the mortgage to the intended affiliate victor prior to, or concurrently with, the transfer of the cost. In the alternative, the lender can take title and after that communicate the residential or commercial property by deed for no factor to consider to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the continuation in coverage, a lending institution's policy does not convert to an owner's policy. Once the lending institution ends up being an owner, the nature and scope of the claims that would be made under a policy are such that the lending institution's policy would not offer the same or an appropriate level of protection. Moreover, a lender's policy does not get any security for matters which arise after the date of the mortgage loan, leaving the lending institution exposed to any concerns or claims coming from events which occur after the initial closing.

Due to the truth deed-in-lieu transactions are more prone to challenge and dangers as outlined above, any title insurance company providing an owner's policy is most likely to undertake a more rigorous review of the deal during the underwriting process than they would in a typical third-party purchase and sale deal. The title insurance provider will scrutinize the parties and the deed-in-lieu documents in order to identify and mitigate dangers provided by concerns such as merger, obstructing, recharacterization and insolvency, thus potentially increasing the time and expenses involved in closing the deal, but eventually supplying the loan provider with a greater level of protection than the loan provider would have missing the title company's participation.

Ultimately, whether a deed-in-lieu deal is a feasible alternative for a lender is driven by the specific facts and scenarios of not just the loan and the residential or commercial property, however the parties included as well. Under the right set of circumstances, and so long as the proper due diligence and paperwork is obtained, a deed in lieu can provide the lender with a more effective and more economical ways to realize on its collateral when a loan goes into default.

Harris Beach Murtha's Commercial Property Practice Group is experienced with deed in lieu of foreclosures. If you need support with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most often work.