Commercial Real Estate, Capital, Insurance, Leasing & Management

Deed-in-Lieu of Foreclosure Has Issues

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Larry Kahn discusses the risks and tax consequences involved with deed-in-lieu real estate transactions.

A deed-in-lieu of foreclosure offers benefits for both parties. For lenders, it makes everything go faster, expense and possible uncertainty of going through the foreclosure process. For debtors, reduce the embarrassment of a public foreclosure sale and provide a solution of personal liability. On the other hand, deed-in-lieu transactions pose risks to the lender and will have tax consequences for both parties.

The issue is other liens on the property may not be apparent. These other liens would not be addressed without foreclosure. Foreclosure is a cleansing process.  An example of this comes to mind. A seller sold a piece of vacant land. At a point in time a year or so later they took it back in a Deed-in-Lieu of Foreclosure transaction. They sold it again. The new buyer put a building on the property. A lien-holder presented a valid claim which had previously gone unidentified by the title company. Title insurances’ liability only covered the claim value of the vacant land. The seller ultimately had to resolve matters and make his second buyer whole.  Being nice may leave you open to unidentified liability.

Debtor Issues
The debtor want to negotiate for release of any personal or guarantor liability, for no negative reports by the lender to credit reporting agencies and an agreement not to sue the debtor and guarantors.  The tax consequence of a deed-in-lieu is generally treatment as a sale of the property, with gain or loss determined by the difference between the amount of the debt and the adjusted tax basis of the property. Unless insolvent, the debtor might also have cancellation of debt (COD) income in certain circumstances. Often a deed-in-lieu is attacked as a fraudulent conveyance, something the title insurance would not protect against. However, if the lender foreclosed, the foreclosure sale would be a barrier to such an attack.

Lender Issues
Environmental issues need to be addressed since most likely the lender is not named on the environmental report. Consideration must be given to potential problems and liabilities relating to leases, especially for tenants with whom the lender does not have a subordination agreement.  One needs to address rents due from tenants, security deposits and operating expenses as well. Title insurance is critical for a new prospective buyer and his lender. One needs to make sure the deed-in-lieu transaction is acceptable with your title insurance vendor. 

Deed-in-lieu transactions are complex and we suggest you use an attorney. 

Contact Franklin Street with your real estate questions. Laurence Kahn is available at 407.458.5419 or [email protected].

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