When an industrial mortgage lending institution sets out to impose a mortgage loan following a debtor default, an essential goal is to recognize the most expeditious manner in which the lender can acquire control and possession of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a quicker and more cost-effective alternative to the long and protracted foreclosure procedure. This article talks about steps and concerns loan providers should think about when making the decision to continue with a deed in lieu of foreclosure and how to avoid unexpected threats and obstacles throughout and following the deed-in-lieu procedure.

Consideration

An essential component of any contract is making sure there is appropriate factor to consider. In a basic deal, factor to consider can quickly be developed through the purchase price, however in a deed-in-lieu circumstance, confirming adequate consideration is not as simple.

In a deed-in-lieu circumstance, the quantity of the underlying financial obligation that is being forgiven by the lender typically is the basis for the factor to consider, and in order for such consideration to be considered "appropriate," the debt must at least equal or exceed the fair market value of the subject residential or commercial property. It is necessary that lenders get 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 advised the deed-in-lieu agreement consist of the customer's reveal acknowledgement of the fair market worth of the residential or commercial property in relation to the amount of the debt and a waiver of any potential claims connected to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

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

Deed-in-lieu deals preclude a customer's fair right of redemption, nevertheless, actions can be taken to structure them to limit or prevent the danger of a blocking difficulty. First and foremost, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure need to occur post-default and can not be considered by the underlying loan files. ought to likewise watch out for a deed-in-lieu plan where, following the transfer, there is an extension of a debtor/creditor relationship, or which consider that the borrower keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a renter or through repurchase options, as any of these arrangements can create a danger of the transaction being recharacterized as a fair mortgage.

Steps can be taken to reduce against recharacterization dangers. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions instead of substantive choice making, if a lease-back is short term and the payments are clearly structured as market-rate use and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the borrower is set up to be completely independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu contracts consist of the parties' clear and unequivocal recognition that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security purposes only.

Merger of Title

When a lending institution makes a loan protected by a mortgage on realty, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lending institution then gets the real estate from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the fee owner and getting the mortgagor's equity of redemption.

The general guideline on this problem provides that, where a mortgagee gets 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 proof of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the arrangement clearly shows the parties' intent to maintain the mortgage lien estate as unique from the fee so the loan provider maintains the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the loan provider's mortgage lien is extinguished and the lender loses the capability to handle intervening liens by foreclosure, which could leave the lender in a potentially even worse position than if the loan provider pursued a foreclosure from the beginning.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) ought to include express anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu circumstance for the lender to deliver a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, secures the debtor against exposure from the financial obligation and likewise retains the lien of the mortgage, thus enabling the lending institution to keep the ability to foreclose, should it become preferable to eliminate junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu deals can be a considerable sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a practical matter, the lender winds up taking in the cost since the customer is in a default scenario and usually does not have funds.

How transfer tax is computed on a deed-in-lieu deal is reliant on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a feasible alternative. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt as much as the quantity of the financial obligation. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited just to a transfer of the debtor's individual home.

For an industrial deal, the tax will be calculated based on the full purchase rate, which is expressly defined as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, but even more potentially extreme, New York bases the quantity of the transfer tax on "factor to consider," which is defined as the overdue balance of the financial obligation, plus the overall amount of any other surviving liens and any amounts paid by the grantee (although if the loan is fully option, the consideration is topped at the reasonable market price of the residential or commercial property plus other amounts paid). Keeping in mind the loan provider will, in the majority of jurisdictions, have to pay this tax once again when ultimately selling the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative factor in deciding whether a deed-in-lieu transaction is a practical choice.

Bankruptcy Issues

A major concern for lending institutions when identifying if a deed in lieu is a viable option is the issue that if the borrower ends up being a debtor in a personal bankruptcy case after the deed in lieu is complete, the bankruptcy court can trigger the transfer to be unwound or reserved. Because a deed-in-lieu transaction is a transfer made on, or account of, an antecedent debt, it falls squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period set forth in the Bankruptcy Code, the customer ends up being a debtor in an insolvency case, then the deed in lieu is at threat of being reserved.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be set aside if it is made within one year prior to a personal bankruptcy filing and the transfer was made for "less than a reasonably equivalent worth" and if the transferor was insolvent at the time of the transfer, became insolvent due to the fact that of the transfer, was taken part in a service that kept an unreasonably low level of capital or intended to incur financial obligations beyond its capability to pay. In order to alleviate versus these risks, a loan provider needs to thoroughly evaluate and evaluate the customer's monetary condition and liabilities and, ideally, require audited financial statements to confirm the solvency status of the debtor. Moreover, the deed-in-lieu contract must consist of representations as to solvency and a covenant from the customer not to submit for insolvency during the preference duration.

This is yet another factor why it is necessary for a lending institution to procure an appraisal to verify the worth 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 produced less than reasonably equivalent worth.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, the majority of owners and their lenders will acquire policies of title insurance to safeguard their particular interests. A lending institution thinking about taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can depend on its lending institution's policy when it ends up being the fee owner. Coverage under a lending institution's policy of title insurance can continue after the acquisition of title if title is taken by the very same entity that is the named guaranteed under the lender's policy.

Since lots of loan providers prefer to have actually title vested in a different affiliate entity, in order to guarantee ongoing coverage under the lender's policy, the named loan provider must appoint the mortgage to the intended affiliate title holder prior to, or all at once with, the transfer of the cost. In the option, the loan provider 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 business or an entirely owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the extension in protection, a lending institution's policy does not transform to an owner's policy. Once the lending institution becomes an owner, the nature and scope of the claims that would be made under a policy are such that the lender's policy would not provide the exact same or a sufficient level of security. Moreover, a lender's policy does not obtain any protection for matters which emerge after the date of the mortgage loan, leaving the lending institution exposed to any issues or claims originating from events which occur after the original closing.

Due to the reality deed-in-lieu deals are more vulnerable to challenge and risks as detailed above, any title insurance provider releasing an owner's policy is likely to carry out a more extensive review of the deal during the underwriting process than they would in a common third-party purchase and sale transaction. The title insurance company will inspect the parties and the deed-in-lieu documents in order to determine and mitigate threats provided by problems such as merger, clogging, recharacterization and insolvency, thus possibly increasing the time and expenses involved in closing the transaction, however eventually offering the lending institution with a greater level of defense than the lender would have missing the title business's participation.
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Ultimately, whether a deed-in-lieu deal is a practical option for a lender is driven by the particular facts and circumstances of not only the loan and the residential or commercial property, but the parties included too. Under the right set of circumstances, and so long as the appropriate due diligence and documentation is gotten, a deed in lieu can offer the lender with a more effective and cheaper means to recognize on its collateral when a loan goes into default.

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