An Indiana Federal Court Discusses Strict Foreclosure

If you’re wondering what “strict foreclosure” means in Indiana, look no further than Judge Barker’s opinion in the CIT Group v. United States of America, 2007 U.S.Dist. LEXIS 96180 (S.D. Ind. 2007) (CITOpinion.pdf) case. The opinion provides a straightforward discussion of strict foreclosure, with a federal tax lien twist.

What happened. Lender entered into a purchase money mortgage transaction with borrower. Borrower defaulted, and lender foreclosed. The real estate was sold at a sheriff’s sale, and the lender was the successful bidder. Unbeknownst to the lender, a federal tax lien had been filed against the borrower and had been recorded before the filing of the foreclosure action, albeit after the recording of the lender’s mortgage. Presumably due to inadvertence, the lender failed to name the United States in its foreclosure action, so the tax lien survived the foreclosure case. The lender brought an action for strict foreclosure against the federal government with the goal of cutting off the federal tax lien.

Strict foreclosure, generally. In Indiana, strict foreclosure is defined as “the means by which a party, who acquires title through or after a foreclosure sale (or by deed in lieu of foreclosure), may cut off the interests of any junior lienholders who, for some reason, were not parties to the foreclosure action.” Strict foreclosure is a remedy that operates to cut off the right of junior lienholders to redeem. In CIT, seemingly the lender (senior lien holder) should have been entitled to strict foreclosure because it purchased the property at the sheriff’s sale after foreclosure of the borrower’s/owner’s/mortgagor’s interests.

The rub. Only later did the lender discover that the United States had recorded a tax lien on the property. Even though the lien undoubtedly was junior to the lender’s mortgage lien, the United States argued that its lien should not be extinguished in the strict foreclosure action given its unique, statutorily-protected nature. The statue at issue was 26 U.S.C. § 7425(a) entitled “Discharge of Liens.” The United States argued, based on the statute, that because the government was not joined as a party to the action, the judicial sale should be subject to the federal tax lien. Judge Barker adopted this “defense” and concluded that the federal tax lien should survive and continue to encumber title to the property, no matter who holds title, until it is satisfied. Judge Barker stated “but for the fact that, by federal statute, primacy is given to the federal tax lien, we believe strict foreclosure likely would be available to a mortgagee so as to extinguish any other junior lienholders’ interests.”

Survival. As explained in CIT, strict foreclosure normally provides a remedy to senior lienholders, after the sale of the property at a foreclosure sale, to bring an action for the purposes of clearing title and extinguishing any subordinate liens or interests. But the CIT case illustrates a unique scenario involving the treatment of a federal tax lien. Here is Judge Barker’s explanation of, in essence, the upshot of her decision:

Provided [lender] continues to hold title to the real estate it acquired by Sheriff’s Deed at the foreclosure sale, equity allows it to assert its mortgage lien position as against the United States even though the United States was not named in the foreclosure action. If title to the property is thereafter conveyed to a third-party purchaser, however, that purchaser would no longer be able to assert [lender’s] mortgage lien priority so as to extinguish the federal tax lien. So long as [lender] continues to hold legal title to the real estate, the United States’s lien remains in effect, but inchoate – dormant, as it were – because it is uncollectible against [lender]. Should the property be sold by [lender] to a third party, the government is entitled to execute on its lien and be paid, presumably from the proceeds of the sale.

Do due diligence. This was a bad result for the lender because it acquired the property at the sheriff’s sale subject to a $10,200 lien, which will have to be satisfied when the lender liquidates the property. It is my understanding the result could have been avoided had the United States been made a party to the foreclosure action, although rules and exceptions surrounding federal tax liens could be (and someday will be) the subject of their own blog post. The failure to name the United States in CIT probably stemmed from a defective title insurance policy commitment (title search) or possibly the lender’s failure to order a title search to begin with. Lenders and Indiana counsel should remain mindful to purchase a title insurance policy commitment before filing a complaint, with a “date down” thereafter, which commitment will help identify all parties, with interests in the property, that should be named in the suit. If that was in fact done by the lender in CIT, and if the title company missed the federal tax lien, then the lender may have been indemnified by the title insurance company for the loss associated with the $10,200 tax lien.

NOTE: Legislation in 2012 impacted strict foreclosures in Indiana.