Navigating Complex Real Estate Legal Issues: Foreclosure, Lien Priority, LLCs and More

Introduction

Real estate investing can be a lucrative endeavor, but it’s not without its legal complexities. From foreclosures and lien priority issues to LLC liability protection and bankruptcy considerations, investors must navigate a web of legal issues to successfully complete their projects. In this post, we’ll explore some of the most common legal challenges faced by real estate investors and provide practical guidance on how to address them.

Foreclosure and Lien Priority

One of the most critical issues investors face is dealing with properties that have multiple liens and are facing foreclosure. When a property owner defaults on a loan secured by a deed of trust, the lienholder can initiate foreclosure proceedings to recover their investment. However, the foreclosure process becomes more complex when there are multiple liens on the property.

Generally, liens have a “priority” that determines the order in which lienholders get paid from a foreclosure sale. The general rule is “first in time, first in right”, meaning that the oldest recorded liens have higher priority than more recently recorded liens. However, certain types of liens, like property tax liens and HOA assessment liens, can sometimes jump ahead in priority.

When an investor is considering purchasing a property at a foreclosure sale, it’s crucial to understand the priority of any existing liens. If there are senior liens that won’t be wiped out by the foreclosure, the investor will take title to the property subject to those liens. This means they’ll be responsible for paying off those senior liens to avoid a subsequent foreclosure.

Investors in junior lien position (like a second deed of trust) can also foreclose, but their foreclosure only wipes out liens that are even more junior. The foreclosing junior lienholder takes title subject to any senior liens. This is why it’s so important to thoroughly research the title and understand the amounts and priority of all liens before investing in a distressed property.

Equitable Subrogation

One way investors can protect their interest when providing new financing to pay off a senior foreclosing lienholder is through a legal principle called “equitable subrogation”. This allows a new lender who pays off a senior lien to essentially step into the shoes of that lienholder and assume their priority position.

For equitable subrogation to apply, the new lender must specifically structure the transaction to demonstrate their intent to be subrogated to the rights of the senior lienholder. This typically involves having a clear paper trail showing the source and application of the payoff funds. The loan documents should also expressly state the intent for the new lender to assume the paid-off lender’s priority.

Timing is also crucial. The sooner the senior lien is paid off and the new lender’s deed of trust is recorded, the stronger the argument for equitable subrogation. Any long gaps can provide opportunities for junior lienholders to challenge the new lender’s priority.

Even with all this, equitable subrogation is not automatic. Junior lienholders can object if they believe their interests are materially prejudiced. Having a skilled real estate attorney structure the transaction is the best way to ensure a successful equitable subrogation claim. Lenders will also typically require title insurance insuring their subrogated first lien position.

Quiet Title Actions

Sometimes, even after an investor has completed a foreclosure and taken title to a property, there can still be clouds or disputes regarding the property’s title. This is where a quiet title action comes in.

A quiet title lawsuit is a legal proceeding where a party asks the court to “quiet” any challenges or competing claims to a property’s title. The goal is to obtain a court order establishing clear title in the name of the rightful owner.

In the context of a foreclosure, an investor who purchases the property at the foreclosure sale may want to file a quiet title action if there are still disputed liens or encumbrances on the property’s title. For instance, if there are junior liens that the investor believes should have been wiped out by the foreclosure, a quiet title action can resolve that issue.

To prevail in a quiet title suit, the investor must demonstrate their valid claim to title. This typically involves presenting evidence of the properly conducted foreclosure sale, the trustee’s deed conveying title to the investor, and any other pertinent title documents.

Any other parties claiming an interest in the property, like junior lienholders asserting an improper foreclosure, will have the opportunity to argue their case. The court will then evaluate the competing claims and evidence to determine the rightful owner and the status of any disputed liens.

While a quiet title action can be a powerful tool to clear up title issues after a foreclosure, it’s not without costs. Legal fees, court costs, and the time involved can be substantial. Investors should carefully weigh the benefits of a quiet title action against the costs and effort required.

Strategic Bankruptcy

Another issue investors sometimes face after acquiring a foreclosure property is the threat of a subsequent foreclosure by a senior lienholder who was not paid off. One potential strategy to deal with this is a strategic bankruptcy filing.

When an entity files for bankruptcy, an “automatic stay” immediately goes into effect. This stay halts all collection activities against the debtor, including foreclosures. The idea behind a strategic bankruptcy is to file just before a senior lienholder forecloses, with the goal of using the breathing room provided by the stay to sell the property or refinance the senior debt.

For real estate investors, a Chapter 11 bankruptcy (reorganization) is often the appropriate choice. Chapter 11 allows the debtor to propose a plan to restructure their debts and pay creditors over time, all while continuing to operate their business. In the foreclosure context, the goal would be to use the Chapter 11 process to sell the property and pay off the foreclosing senior lienholder before they can complete their foreclosure.

There are a few key considerations for investors contemplating a strategic bankruptcy:

1. Timing is critical. The bankruptcy must be filed before the foreclosure sale occurs. Once the sale happens, it’s too late.
2. There must be sufficient equity in the property to justify the costs of the bankruptcy. The filing fees, attorney’s fees, and other professional costs can be significant.
3. The investor must be prepared to follow through with the bankruptcy process. This includes proposing a viable reorganization plan and making required payments to creditors. Simply filing to buy time with no real plan is considered bad faith and can have serious consequences.
4. If the goal is to sell the property during the bankruptcy, the investor must be confident they can do so quickly. The longer the bankruptcy drags on, the more likely the senior lienholder will seek permission from the court to proceed with foreclosure.

One potential exit strategy is to request a dismissal of the bankruptcy case if the property is sold and the senior debt is paid off. This gets the debtor out of bankruptcy once the immediate threat has passed. However, dismissal is not automatic – creditors can object if they believe dismissal would prejudice their interests.

Repeatedly filing bankruptcy just to stave off foreclosure with no real intent to reorganize is also problematic. If the court finds the investor is engaging in “bad faith” repeat filings, they can impose restrictions on future filings.

So while a strategic Chapter 11 can be a tool in the toolbox for dealing with foreclosing senior lienholders, it’s not a silver bullet. Investors need to understand the process, the costs, and the potential risks before heading down this path.

LLC Liability Protection

For investors dealing with distressed properties and potential liabilities, holding title in the name of a limited liability company (LLC) can provide an important layer of protection. LLCs are designed to shield their owners’ personal assets from the debts and liabilities of the company. This is known as the “corporate veil”.

If an investor holds a foreclosure property in an LLC and someone is injured at the property, the plaintiff would typically only be able to go after the assets of the LLC (like the property itself), not the investor’s personal bank accounts or home. The same applies for mortgage loans or other debts incurred by the LLC – only the LLC’s assets are on the hook.

However, the liability protection of an LLC is not absolute. There are several ways the corporate veil can be “pierced”, allowing creditors or plaintiffs to reach the owners’ personal assets:

1. Commingling funds: If the LLC owners mix their personal funds with LLC funds or use the LLC accounts for personal expenses, a court may find that the LLC is just an “alter ego” of the owner.
2. Undercapitalization: If the LLC does not have enough capital to reasonably cover its anticipated business needs and liabilities, a court may disregard the LLC form.
3. Failure to follow corporate formalities: LLCs must follow certain formalities like holding annual meetings, maintaining separate books, and documenting major decisions. Neglecting these formalities can lead to veil piercing.
4. Fraud or wrongdoing: If the LLC is used to perpetrate fraud or other wrongdoing, the veil can be pierced to hold the owners personally liable.

To maximize the liability protection of an LLC, investors should:

• Keep LLC funds and personal funds strictly separated. Have dedicated LLC bank accounts and credit cards.
• Ensure the LLC is adequately capitalized to cover reasonably anticipated liabilities and expenses.
• Follow all required LLC formalities and keep good records.
• Never use the LLC to engage in fraud or misrepresentation.

It’s also important to note that LLC owners are still personally liable for their own wrongdoing. The LLC provides protection from the actions of co-owners or employees, but if an owner personally commits a tort or signs a personal guarantee, they’re on the hook regardless of the LLC.

LLC Bankruptcy

Just like individuals, LLCs can also file for bankruptcy protection. The two most common types of bankruptcy for LLCs are Chapter 7 (liquidation) and Chapter 11 (reorganization).

In a Chapter 7 bankruptcy, the LLC ceases operations and a trustee is appointed to sell off the company’s assets to pay creditors. Any remaining debts are typically discharged (with some exceptions like fraud liabilities or certain taxes).

A Chapter 11 bankruptcy allows the LLC to continue operating while it proposes a plan to restructure and pay off its debts over time. This can involve downsizing, selling off assets, negotiating with creditors, and other measures to restore the company to financial viability.

For real estate investors, an LLC bankruptcy can be a double-edged sword. On one hand, it can provide a way to deal with overwhelming debts and liabilities, giving the LLC a fresh start. It can also halt pending foreclosures or other collection actions against LLC properties.

On the other hand, an LLC bankruptcy also comes with significant downsides:

• Loss of control: In a Chapter 7, the trustee takes over and makes decisions about selling assets. In Chapter 11, the LLC owners remain in control but must get court approval for major decisions outside the ordinary course of business.
• Cost: Bankruptcy can be expensive. Filing fees, attorney’s fees, and other professional fees can quickly add up.
• Public record: Bankruptcy filings are public record and can damage the reputation of the LLC and its owners, making it harder to get financing or do business in the future.
• Potential veil piercing: If the bankruptcy court finds that the LLC owners misused the LLC form or engaged in fraud, they could be held personally liable.

Investors should also understand that while an LLC bankruptcy typically does not directly impact the personal credit and assets of the owners (thanks to the LLC liability shield), there are some exceptions. If an owner has personally guaranteed LLC debts, commingled personal and business funds, or engaged in fraud, they could face personal liability despite the bankruptcy.

Ultimately, the decision to file for LLC bankruptcy should not be taken lightly. It’s a complex process with significant costs and consequences. Investors should consult with an experienced bankruptcy attorney to weigh their options and understand the potential risks and benefits.

Fraudulent Conveyances

Another issue that can come up in the context of distressed real estate investing is fraudulent conveyances. A fraudulent conveyance is a transfer of assets made with the intent to hinder, delay, or defraud creditors.

In the real estate context, this could take the form of an investor transferring a property to a family member or related entity for little or no consideration when the property is at risk of foreclosure. The goal is to put the property beyond the reach of creditors.

Fraudulent conveyance laws, which vary by state, allow creditors to challenge such transfers and potentially void them. If a court finds that a transfer was indeed fraudulent, they can order the property returned to the debtor’s ownership, making it available to satisfy creditor claims.

There are two main types of fraudulent conveyances:

1. Actual fraud: This is where the debtor makes the transfer with the actual intent to defraud creditors. Proving actual intent can be difficult, but courts will look at “badges of fraud” like insider transfers, secret transactions, or transfers of substantially all the debtor’s assets.
2. Constructive fraud: Even if there’s no actual fraudulent intent, a transfer can be considered fraudulent if the debtor doesn’t receive reasonably equivalent value in exchange and is insolvent at the time of the transfer or becomes insolvent because of it.

For investors, it’s important to steer clear of any transactions that could be construed as fraudulent conveyances. This means ensuring that any property transfers are for legitimate business purposes and for fair market value. Keeping good records of the business justification and valuation for all transactions is also critical.

If an investor suspects a fraudulent conveyance has occurred, they may be able to file a lawsuit to have the transfer voided and the property brought back into the debtor’s name. However, these lawsuits can be complex and expensive, so it’s important to weigh the costs and benefits before proceeding.

Conclusion

Navigating the legal landscape of real estate investing can be tricky, particularly when dealing with distressed properties and foreclosures. Understanding issues like lien priority, equitable subrogation, LLC protection and bankruptcy, and fraudulent conveyances is crucial for investors looking to protect their interests and maximize their returns.

While this article provides an overview of some key legal concepts, it’s no substitute for personalized legal advice. Every investor’s situation is unique, and the laws can vary significantly from state to state. Consulting with an experienced real estate attorney is the best way to ensure you’re making informed decisions and protecting yourself legally.

With proper legal guidance and a solid understanding of the issues at play, investors can navigate even the most complex real estate legal challenges and come out ahead. The key is to be proactive, diligent, and always prioritize legal compliance and risk management.