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Mortgage Securing Residential Subdivision Development Primes Site Work Mechanic’s Liens

Today’s post follows up my July 3, 2007, July 7, 2007 and September 6, 2008 posts dealing with the priority of commercial construction mortgages over mechanic’s liens.  If you are struggling with lien priority questions related to the development of a residential subdivision, the Indiana Court of Appeals’ decision in Lincoln Bank v. Conwell Construction, 2009 Ind. App. LEXIS 1047 (Ind. Ct. App. 2009) (Lincoln.pdf) provides answers.

The interests.  Nichols Group owned real estate that it intended to develop into a residential subdivision.  Lincoln Bank gave a mortgage loan to Nichols Group to fund the development, and the bank recorded its mortgage in 2006.  General contractor, Conwell Construction, contracted with Nichols Group to develop the site (earth work, sewer, water, curbs and paving).  Conwell Construction, in turn, contracted with subcontractors Hedger (for curbs), Mitchell (for drains) and Grady (for paving).  The contractors only performed site development work.  They did not construct any houses, nor did they improve any specific lots.  Indeed no houses were ever built on the property.  Since the contractors didn’t get paid, they filed mechanic’s liens in 2007. 

The controversy.  The Court addressed the question of whether Lincoln Bank’s mortgage should have priority, as opposed to the bank and the four contractors sharing pro rata in any foreclosure proceeds.

Inventory of statutes.  Lincoln Bank, a thorough and logical opinion, addresses the applicable Indiana statutes:

 a. I.C. § 32-28-3-1 – Contractors may file mechanic’s liens for, among other
  things, the labor and materials at issue.

 b. I.C. § 32-28-3-5(c) – Mechanic’s liens are equal in priority to other
  mechanic’s liens.

 c. I.C. § 32-28-3-5(d) – Priority of construction mortgages (see also July 11, 2007
  and September 6, 2008 posts).

 d. I.C. § 32-28-3-5(d)(1-3) – Exceptions to general rule of construction mortgage
  priority for homes, improvements auxiliary to homes and utilities.

Section 5(d) and its three categories of exceptions.  The Court noted that a recorded mortgage has priority over a subsequently-recorded mechanic’s lien, per I.C. § 32-28-3-5(d), “to the extent of the funds actually owed to the lender for the specific project to which the lien rights relate.”  There was no dispute Lincoln Bank recorded its mortgage before the recordation of the mechanic’s liens, nor was there a dispute that Lincoln Bank’s mortgage “was for the specific project to which the lien rights relate.”  Therefore, if § 5(d) applied, Lincoln Bank’s mortgage would have priority over the mechanic’s liens.  The Lincoln Bank decision focused on the three stated carve outs in § 5(d) for construction (1) of houses, (2) of improvements auxiliary to houses and (3) on property controlled by a utility.  For those categories, Ward v. Yarnelle would control, meaning that there would be parity among the mortgage and the mechanic’s liens.

Exceptions not applicable.  Since the underlying site development work in Lincoln Bank related to the ultimate construction of houses, seemingly the door was open for the Court to apply one or more of the three exceptions to § 5(d)’s priority rule.  Instead, the Court viewed the work for what it was – construction, for a real estate investor, of a commercial project.  The work in question did not directly involve the building of an individual homeowner’s residence.  The closest call for the Court was § 5(d)(2), which governs the development or construction of “an improvement on the same real estate auxiliary to a Class 2 structure [house].”  Despite concluding that the contractors’ earth moving operations and asset installations were indeed “improvements,” the Court relied heavily on the fact that “no home had yet been constructed on the land” in concluding that § 5(d)(2) “does not apply to preparing land for the subsequent construction of houses.” 

Result.  The Court concluded, with regard to the foreclosure proceeds, that “the first priority is to satisfy Lincoln Bank’s mortgage.”  Thereafter, “the four mechanic’s liens are equal in priority.”  Lincoln Bank is particularly relevant today given recent failures of many residential subdivision development projects across Indiana.  These projects have, in certain instances, stalled before any houses were built or any specific lots were improved.  According to Lincoln Bank, where the general contractor or subcontractors have devoted resources only to subdivision site work, lenders holding a timely and perfected construction mortgage will not be forced to share equally with such contractors.