DEEDS IN LIEU OF FORECLOSURE

DEEDS IN LIEU OF FORECLOSURE
David Lawson, Underwriter
Fidelity National Title Group
ADVANTAGES TO LENDER AND BORROWER
Lender:
 Save time and money by avoiding the foreclosure process and expense
 As the owner, control operation and income of property
 Preserve valuable tenants who might otherwise leave during a foreclosure process
 Eliminate potential waste to the property during a lengthy foreclosure
 Obtain marketable title
 Arrange an early resale
 Avoid negative publicity while conducting a foreclosure
 Change governmental reporting – quicker removal of defaulted loan from books
Borrower:
 Obtain full or partial release from indebtedness
 Avoid deficiency judgments if the lender chooses to foreclose judicially
 Affiliated guarantors might obtain full or partial release from outstanding guarantees
 Avoid negative publicity and notoriety arising from being foreclosed
 Lender might agree to pay most or all of the costs of sale if the borrower has no funds
 Prior to finalizing a deed in lieu, a construction lender might fund any incomplete construction
to make the structure more marketable, giving the borrower income for construction
management services
 Borrower may obtain rights to continue possession and/or rights to re-acquire title later **
**BEWARE – If a lender grants rights of continuing possession, option to repurchase,
right of first refusal, etc., the deed in lieu may be interpreted in court as only a security
document.
 Any right of possession longer than two months should be at market rate, not
above or below, to avoid appearance that the lender is obtaining additional
repayment from above market rent or is providing a concession of below market
rents, particularly if there is any right to re-acquire title.
 Any option to purchase should be at market value based upon independent
appraisal and not tied to the unpaid balance of the loan.
TAX CONSEQUENCES
Tax consequences are very complex, depending on such details as the original purchase price of the
property, any depreciation taken in the past, and the solvency of the borrower, whether or not the
property is a qualified personal residence, and whether the loan is recourse or non-recourse.
A tax professional must be consulted. The grantor in the deed in lieu, even though not receiving any
cash, may very well have a sizeable tax obligation owing upon completion of the transaction.
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Lenders face tax consequences, too, since they are a party to a purchase and future resale.
A VOLUNTARY TRANSACTION?
Normally the borrower must initiate the offer of a deed in lieu of foreclosure. If not initiated by
borrower, the borrower may later challenge the deed based upon:
 Undue pressure, influence, duress.
 Lender using the borrower’s financial distress to drive a hard bargain.
 The lender may see equity or future potential value in the property that the borrower does not
recognize until later.
 Not all deeds in lieu are a simple handing over of the property. The lender may require other
assets, even cash, to be turned over as part of the deal if the debt far exceeds the property value.
TIMING OF DEED DELIVERY - WHEN IS A DEED A MORTGAGE?
“CLOGGING THE EQUITY OF REDEMPTION”
Courts have consistently ruled that a borrower cannot waive a statutory right to redeem property in a
foreclosure, whether a redemption period after a Sheriff’s Sale, or the minimum 190 day period
required to conduct a non-judicial Trustee’s Sale. This also applies to contract forfeiture time periods.
Any deed in lieu of foreclosure delivered to a lender in advance of a default or conditioned on being
used only if an existing default is not cured within a certain time frame would probably be
reinterpreted by a court as creating only an “equitable mortgage”. You cannot assume a deed in lieu of
foreclosure is a reliable deed conveying fee title unless, among other things, it is voluntarily executed
and delivered, and intended to be immediately recorded.
A bank manager told us he intended to obtain deeds in lieu from his builder customers at the time of a
workout that would allow the lender to keep funding the construction projects, but that he intended to
record the deeds later if the builder went into default. These deeds are clearly only security devises and
cannot ever be treated as fee title conveyances.
BEWARE of any request to hold a deed in lieu of foreclosure in escrow. Delivery into
escrow with instructions for the escrow agent to release the deed for later recording after
a future event of a default does not avoid the issue of the deed being an “equitable
mortgage”. You should expect to be drawn into future litigation over the issue.
PURCHASE CONTRACT – DEED IN LIEU OF FORECLOSURE SETTLEMENT
AGREEMENT
If there isn’t any existing written agreement between the borrower and lender, escrow will need either
some form of purchase and sale agreement, or a Deed in Lieu of Foreclosure Settlement Agreement,
setting out all provisions about the transfer of title and consideration passing. There needs to be clearly
stated consideration, even if it is only a covenant not to personally sue the grantor or a similar
provision. Sometimes the consideration will be the forgiveness of the debt evidenced by the
promissory note, but it will be a relatively rare circumstance in the current market.
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Any agreement for the deed in lieu transaction should ideally address all of the usual issues of a
purchase and sale agreement, including the form of deed, possession, personal property being
transferred with the real estate, condition of title, preconditions to closing, date of closing, title
insurance and possibly disclosures of hazardous substance issues and warranties. Additional complex
provisions may be added by sophisticated lenders and their attorneys.
See below for additional “estoppel” provisions that are usually added to prevent future disputes over
the intent of the deed or challenges to its effectiveness.
MERGER vs. NON-MERGER OF THE DEED OF TRUST – TO RECONVEY OR NOT?
In most jurisdictions a deed in lieu of foreclosure will not automatically extinguish the lien of a
mortgage or deed of trust. Merger of the two interests held by one party (owner and lender) does not
occur unless it is intended. This is particularly true of a deed of trust in which there is a third party in
the document, the trustee. The debt must not be canceled if non-merger is intended
The lender may intentionally retain its deed of trust so that its deed of trust will:
 Still exist and retain its priority if a later bankruptcy or other court action sets aside the deed in
lieu as being a preference, or the deed is challenged and alleged to be only a security document.
 Be able to be foreclosed to eliminate junior encumbrances, including unanticipated mechanics’
liens.
 Retain coverage under an existing lender’s title insurance policy if an affiliate of the lender is
acquiring title.
FORECLOSING AGAINST YOURSELF
If properly documented, a lender can retain the right to foreclose its deed of trust and extinguish any
junior monetary liens or other junior interests. A lender may intentionally accept a deed in lieu even
knowing that there are junior liens, with the understanding that it can protect the property better by
becoming an owner immediately, but still proceeding with an anticipated foreclosure. Unanticipated
junior liens, such as mechanics’ liens, may be recorded after the deed in lieu, or judgments or junior
liens may be discovered to have been filed or recorded during the “recording gap”. If such liens are
junior in priority to the deed of trust they can be extinguished by foreclosure. The foreclosing lender
can still bid in the amount of their indebtedness at a Trustee’s Sale if they have carefully preserved the
debt. Without a valid debt a foreclosure cannot occur.
DOCUMENT PREPARATION
Deed:
The form of the deed, whether warranty or quit claim, is open to negotiation, but the contents require
special attention.
The grantee will normally be the lender, but some lenders will want an affiliate created as a single
asset entity to take title to avoid the lender having direct liability for environmental obligations or
warranties upon a resale (especially when acquiring property such as a condominium project).
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In most cases the deed should be prepared by an attorney, in part because of non-standard deed
provisions. The deed should:

Identify the deed of trust for which the deed is being given in lieu of foreclosure

State an appropriate consideration:
When there is a Settlement Agreement, consideration language can usually be copied from that
agreement for insertion into the deed.
The deed must not contain language contrary to any intent for non-merger and future
enforceability of the deed of trust, such as “satisfaction of indebtedness”, “an agreement not
to foreclose”, “assumption of the promissory note” or “reconveyance of the deed of trust”.

Contain non-merger language to preserve the lien of the deed of trust must be expressly
stated if that is the intent of the parties.

Include estoppel provisions:
Because a deed in lieu can sometimes be interpreted as a security document, it is best to add
estoppel provisions confirming that it is an absolute deed. An alternative is to attach an
“Estoppel Affidavit” to the deed. See below for normal contents of an Estoppel Affidavit.
Estoppel Affidavit:
Estoppel provisions are critical to prevent later disputes about whether or not a deed conveys fee title,
should be interpreted as a security instrument, or could be voidable.
Many deeds in lieu of foreclosure or Deed in Lieu of Foreclosure Settlement Agreements contain most
or all of the provisions commonly addressed in a title company Estoppel Affidavit, making a separate
Estoppel Affidavit superfluous.
Title companies have their own standard forms of Estoppel Affidavit. However, many of them were
drafted long ago with the assumption that the debt would be fully extinguished and a reconveyance
would occur simultaneously with the deed in lieu. Do not use any standard form of Estoppel Affidavit
without being sure all provisions fit the transaction. This is another reason an attorney should draft all
documents.
Estoppel Affidavit - common provisions:
 Absolute conveyance of all interest of the grantor
 Not intended as a mortgage or for security purposes
 Free and voluntary
 Not made under coercion or duress
 Made by the grantor at their own request
 Possession has been surrendered (or identify length of possession remaining)
 There are no rights or options to purchase or to redeem title to the property
 (Consideration is usually identified)
 The consideration received by the grantor represents the fair value of the property
 The grantor is solvent, or the transfer will not render the grantor insolvent, if accurate
 (if applicable, a provision that the amount of indebtedness is greater than or equal to the fair
market value of the property)
 The grantor is not acting under any misapprehension as to the effect of the deed.
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Bill of sale:
Many deeds in lieu by builders, businesses and commercial landlords will involve inventory, building
permits, building plans, etc., which will require bills of sale to transfer ownership rights.
Reconveyance?
A request for reconveyance should not be executed if there is no intent to merge the deed of trust with
title. We have seen requests for reconveyance delivered in error undoing the intent of non-merger.
If a reconveyance is intended, the Request for Full Reconveyance, original Deed of Trust, and original
Promissory Note must be submitted into escrow for delivery to the Trustee for reconveyance. A deed
in lieu containing language that the deed of trust is merged and/or extinguished is usually not enough
to remove the deed of trust from title since a third party Trustee is involved.
WHO PAYS WHAT FEES?
This is entirely negotiable. Frequently the lender will agree to pay fees and costs that normally would
be paid by a seller because the seller may not have the funds available. Each sale may be different, so
read their Settlement Agreement or ask for instructions.
REAL EXCISE TAX – EXEMPT? NOT ALWAYS!
WAC 458-61A-208
(3) Foreclosure and contract forfeiture. The real estate excise tax does not apply to the following
transfers where no additional consideration passes:
(a) A transfer by deed in lieu of foreclosure to satisfy a mortgage or deed of trust.
(b) A transfer from a contract purchaser to the contract holder in lieu of forfeiture of a contract
of sale upon default of the underlying obligation.
(7) Documentation: A copy of the recorded original mortgage, deed of trust, contract of sale, or
lien document must be presented with the real estate excise tax affidavit.
What constitutes “additional consideration”?
 Assumption of indebtedness by the grantee if there is another monetary lien on the property
 Payment of cash or other valuable consideration to the grantor for any equity the grantor is
giving up
Examples:
(i) Meg sells to Julie on a real estate contract for a price of $65,000. Julie makes some payments, then
defaults. Julie feels that she has some equity in the property. Meg agrees to pay Julie $1,500 if Julie
will sign a deed in lieu of forfeiture. The current unpaid balance of the contract is $61,000. Even
though the transfer was by a deed in lieu of forfeiture, there is additional consideration passing (the
$1,500). The transfer is subject to tax. The taxable selling price is $62,500, which is the total of the
outstanding contract balance that was canceled plus the $1,500 paid to Julie. (taken from an actual
example in the WAC)
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(ii) George purchases property and obtains a $100,000 loan from Lender A secured with a 1st deed of
trust and a second loan of $25,000 from Lender B secured by a 2nd deed of trust. Later, George can't
make payments to either lender. At this time, George owes Lender A $95,000 and Lender B $23,000.
George transfers the real property to Lender B by deed in lieu of foreclosure. The debt to Lender A
remains unpaid on the property at the time of transfer. The transfer is partially exempt and partially
taxable. The deed in lieu of the junior position debt is exempt. The senior position debt to the Lender A
that remains outstanding on the property at the time of the transfer meets the definition of
consideration and is subject to tax. Tax would be due on $95,000.
If the seller pays Real Estate Excise Tax, the tax amount paid by the seller is additional
consideration and must be added to the sales price for re-computation of the tax payable.
ESCROW SETTLEMENT STATEMENTS
This type of transaction is a real “sale”. The “sales price” is usually the amount of the existing
indebtedness and the value of any additional consideration passing between the parties.
Many deeds in lieu involve personal property on the property or associated with it, including permits,
plans, etc., which might involve additional consideration and a potential obligation to pay use tax.
The HUD-1 Settlement Statement form is not required to be used with a deed in lieu of foreclosure.
FIRPTA
If the conveying party is a foreign person or entity and is subject to the Foreign Real Property Tax Act
(FIPTA) the parties have three choices:
 Bring into closing 10% of the outstanding debt or total consideration to be remitted to IRS.
 Bring 10% of the outstanding debt or total consideration to be held in escrow while the grantor
applies for a waiver or reduction.
 Sign a waiver of escrow liability.
1099 REPORTING
Pursuant to 1099-S regulations a transaction is exempt if it is a transfer in full or partial satisfaction of
a debt secured by the property.
However, if there is any additional consideration passing other than satisfaction of debt secured by the
property, such as payment for any equity being given up by the borrower, 1099 reporting is required.
AUTHORITY ISSUES FOR LLC’S, PARTNERSHIPS, CORPORATIONS
A deed in lieu of foreclosure is outside of the scope of ordinary course of business. It is not a routine
transaction that falls within the normal powers of corporate officers, managing partners, managers of
LLC’s or general partners of limited partnerships.
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Great care must be taken to obtain the unanimous consent of any board of directors, managing and
non-managing members, partners, or limited partners. Any executed document that exceeds the
authority of the signing party is void or voidable.
Whitney v. Citibank, 782 F2d 1106 (2d Cir. 1986)
The lender induced a breach of fiduciary duty by two of three general partners where the lender
induced two partners to consent to a deed in lieu without knowledge of the third partner and in breach
of the partnership agreement, resulting in compensatory and punitive damages against the lender.
ISSUES OF FRAUD
Historically not all deeds in lieu of foreclosure involved institutional lenders or over-encumbered
property. Unscrupulous sellers on a real estate contract or carrying back a purchase money deed of
trust have been known to require the execution of a deed in lieu at the time of the initial sale, for the
purpose of bypassing the foreclosure process. Such a deed in lieu should not be held in escrow since it
will undoubtedly be construed by a court as a security instrument. Escrow should anticipate
depositions and active involvement in any court action challenging such a deed in lieu.
We have seen deeds in lieu used to fraudulently avoid paying real estate excise tax, structuring a sale
to make it appear that there was initially a loan followed almost immediately by a deed in lieu,
claiming an exemption from excise tax. The Department of Revenue will normally re-interpret such a
transaction as a simple sale and impose tax, interest and penalties.
Foreclosure Rescue scams may involve lending money and taking an advance deed in lieu.
NEED FOR TITLE INSURANCE
A lender insured under a loan policy does not lose its loan policy coverage once a deed in lieu is
recorded as long as
(a) the deed of trust is not reconveyed and is still enforceable, or
(b) title is acquired by the lender and the deed of trust is reconveyed.
But if an affiliate of the lender who is not an assignee of the loan takes title, it has no coverage under
the original loan policy. In that instance, if the deed of trust remains of record but is no longer
enforceable based upon provisions of the deed or settlement agreement which extinguish the debt (no
debt, no ability to foreclose) loan policy coverage will lapse.
The loan policy only provides coverage as of the date of recording of the deed of trust and does not
provide updated coverage through the date of the deed in lieu.
 New mortgages, deeds of trust, contracts, judgments, liens, easements, restrictions, etc., may
have attached after the recording of the deed of trust.
 The grantor may have conveyed title to someone else.
 The grantor may have lost and/or gained land through a boundary line adjustment or quiet title
action that did not properly include the lender.
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Extended coverage:
Some lenders will automatically request extended coverage title insurance for an owner’s policy out of
habit, thinking of themselves as a lender, or ask for it intentionally because they are concerned with off
record matters such as mechanics’ lien rights. Do not assume that a title company will agree to
provide extended coverage. Get in touch with them as soon as you become aware of such a request.
The request may be buried in the body of the Deed in Lieu Settlement Agreement.
Title companies will usually want a new survey before agreeing to delete the general exceptions that
relate to survey matters.
More importantly, the borrower is in financial trouble and the title company is unlikely to rely on
indemnification from the borrower for unrecorded mechanics’ lien rights.
Non-Merger Endorsement:
A lender can request a Non-Merger Endorsement to confirm that its original loan policy coverage
remains in effect following a deed in lieu of foreclosure. It is most appropriately issued as an
endorsement to the original loan policy. The title insurer will need to review in advance drafts of the
proposed deed in lieu and any settlement between the borrower and lender. The title company’s
primary concerns will be:
 does the debt remain intact,
 are the deed and settlement agreement consistent with each other,
 does the deed clearly identify the deed of trust and expressly state there is no intent to merge
the deed of trust with fee ownership?
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