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Deed in Lieu in Commercial Real Estate

Deeds in Lieu as an Alternative to Commercial Property Foreclosure

In real estate, a deed in lieu, also known as a deed in lieu of foreclosure, is a potential alternative to a foreclosure or a short sale. It generally involves handing a lender the deed to a property in exchange or being released from all related debt obligations. For commercial real estate borrowers who have defaulted on their loans, a deed in lieu of foreclosure has several advantages over foreclosures and short sales, but they aren’t a good option in every situation.

In this article, we’ll review:

  • How a Deed in Lieu Actually Works

  • Benefits and Disadvantages of Deeds in Lieu

  • Deeds in Lieu vs. Foreclosures vs. Short Sales

  • Tax Implications of Deeds in Lieu

It’s important to realize that the exact regulations surrounding deeds in lieu vary from state to state, so, while we’ve included general information in this article, commercial borrowers should generally consult with an experienced real estate attorney to better understand the laws surrounding deeds in lieu in their particular area.

How a Deed in Lieu Actually Works

As we just mentioned, a deed in lieu typically occurs when a borrower gives their lender the deed to their property, and, in exchange, is released from their legal obligation to repay their mortgage. However, in practice, the process is somewhat more complex. First, borrowers should know that both the borrower and lender must agree to the deed in lieu in order for it to occur.

Lenders cannot legally force the borrower to give up their deed without court action, and, likewise, not all lenders will allow a borrower to go through with the transaction, especially if the borrower is ‘underwater’ on their property (i.e. they owe more than the property is worth). In this case, a lender may attempt to seek a deficiency judgement for the remaining amount, particularly if the loan is full recourse. In general, if the loan is non-recourse, lenders cannot seek a deficiency judgement, provided that the borrower has not violated any of the loan’s carve outs.

If a lender is open to a deed in lieu of foreclosure, the process usually begins with the borrower’s attorney providing a written offer to the lender. In response, the lender will generally reply with a counteroffer, which will include the exact conditions under which the lender will accept the transaction.

Lenders generally require the borrower to “make the first move,” so to speak, so that it does not appear as if the lender is coercing the borrower into accepting the deed of lieu, and giving up their right to fight a foreclosure in court. In addition, lenders typically will not allow deeds in lieu for properties that have any kind of secondary or subordinate financing, such as mezzanine debt. In many cases, the intercreditor agreement between a mezzanine lender and a first-position lender actually prohibits deeds in lieu in order to safeguard the mezzanine lender’s interest in the property. Plus, any liens, such as mechanic’s liens resulting from unpaid contractors, may also disqualify a borrower in the eyes of a lender.

Despite the risks for lenders, deeds in lieu do have some advantages, as the lender will not have to go to court and potentially wait months to gain possession of the property, if they do at all. With a deed in lieu, they can obtain the property instantly, and begin the sales process right away, meaning that they will generally recoup their losses significantly faster.

Benefits and Disadvantages of Deeds in Lieu

A deed in lieu of foreclosure has quite a few benefits (as well as certain disadvantages) when compared to a traditional foreclosure. In general, a deed in lieu is faster and less expensive for both the borrower and the lender. In addition, a deed in lieu is considerably ‘quieter’, as it will not involve a court hearing, which is highly beneficial for businesses and investors who want to want to avoid reputational risk while dealing with financial setbacks. Plus, a deed in lieu of foreclosure generally has much less impact on a borrower’s credit score than a foreclosure.

However, if a commercial borrower decides to sign over their deed to a lender, they have given up all hope of fighting their foreclosure or gaining any kind of emergency financing in order to remain in possession of their property. Since the foreclosure process can be lengthy, this can potentially give a borrower more time to seek out an investor or even a hard money lender to provide them funds to correct their default.

Deeds in Lieu vs. Foreclosures vs. Short Sales

Deeds in lieu are somewhat less common than the other major methods by which loan defaults are resolved; foreclosures and short sales. A foreclosure is the process that occurs when a lender attempts to recover the collateral for a loan (for the purposes of this article, commercial property). Some states allow foreclosure via power of sale, which permits a lender to sell a property after a borrower has defaulted on their loan. States that allow for power of sale require that the borrower be notified before the foreclosure (though waiting periods vary by state). In addition, power of sale states generally don’t allow a lender to seek a deficiency judgement when they use power of sale to foreclose on a property.

In contrast, other states only permit judicial foreclosures, which means that a lender must take the borrower to court in order to gain the right to foreclose on the property. This can be a more time-intensive and expensive process, especially due to the fact that borrowers can appeal a foreclosure judgement.

Unlike foreclosures, short sales occur when a borrower has been permitted by their lender to sell their property for an amount less than their total debt obligation. Just like a deed in lieu, the borrower will be released from any mortgage obligations after the sale is complete. Many states prohibit lenders from seeking deficiency judgements in the case of a short sale, and, even in states where it is permitted, lenders will often agree not to seek a deficiency judgement as part of the short sale agreement. Deeds in lieu are generally easier for commercial borrowers than short sales, as a borrower will not have to invest time and money marketing the property and securing a new buyer. However, just like deeds in lieu, lenders will not usually permit a borrowers to engage in a short sale if the property in question has any type of junior or subordinated debt. And, also like deeds in lieu, short sales usually have a less severe impact on borrower’s credit score than foreclosures.

Due to the fact that they can take a significant amount of time and cost a good deal of money, lenders often avoid foreclosures when possible. Despite that, if a lender wishes to seek a sizable deficiency judgement on a loan, they may opt for one. This is especially the case when state laws do not permit deficiency judgements alongside a short sale or a deed in lieu. Keep in mind that a lender can generally only seek a deficiency judgement on a recourse loan (or a loan that has become recourse due to the violation of non-recourse loan carve out).

Tax Implications of Deeds in Lieu

Technically, in the eyes of the IRS, forgiven debt must be counted as income. For commercial real estate borrowers who have had hundreds of thousands or millions of dollars of debt forgiven, this sounds like a potential financial nightmare. Fortunately, however, there is a way around this. The IRS allows taxpayers to elect to exclude canceled real estate debt, which it refers to as the “cancellation of qualified real property business indebtedness,” or QRPBI cancelation. This option is available to nearly all business types, with the notable exception of C corporations.

To learn more, speak with a commercial real estate loan specialist today.

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