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Lender And IRS Battle Over Rental Income

I previously wrote about the priority of federal and state income tax liens on title to mortgaged real estate.  Generally, an Indiana mortgage lien on title to real estate will trump a tax lien, assuming the lender recorded the mortgage before the taxing authority recorded its lien.  The recent decision in Bloomfield State Bank v. United States of America, 644 F.3d 521 (7th Cir. 2011) involved a priority dispute over rental income arising out of the mortgaged real estate. 

Rents.  In Bloomfield, the borrower, who defaulted, granted the lender a mortgage on the borrower’s real estate plus “all rents . . . derived or owned by the Mortgagor directly or indirectly from the Real Estate or the Improvements” on it.  The IRS filed its 26 U.S.C. § 6321 lien for taxes against the subject real estate several years after the lender recorded its mortgage but before the filing of the foreclosure suit.  The receiver, during the pendency of the foreclosure case, decided to rent some of the real estate and collected about $80,000 in rents. 

Contentions.  The IRS claimed that its tax lien took priority over the mortgage lien on the rentals because they were received after the filing of the tax lien.  The argument of the IRS focused on 26 U.S.C. § 6323(h)(1), which gives a mortgage interest in rentals priority over a tax lien only if the property secured by the mortgage was “in existence” when the federal tax lien was filed.  The IRS asserted that the relevant property was the rentals – which did not exist at the time the federal tax lien attached.  The lender, on the other hand, claimed that the relevant property was the real estate - which did exist 

What existed and when?  The Court sorted through the “existence” issue:

The “property” that must be in existence for a lender’s lien to take priority over a federal tax lien is the property that, by virtue of a perfected security interest in it, is a source of value for repaying a loan in the event of a default; it is not the money the lender realizes by enforcing his security interest.

The Court reasoned that there essentially is no difference between lien-enforcement proceeds taken the form of sale income versus rental income.  “To say that a parcel of land is ‘sold’ rather than ‘rented’ just means that the owner sells the use of the land forever rather than for a limited period.”  In Bloomfield, the real estate that generated the subject rental income existed when the borrower granted the mortgage (and thus before the tax lien attached).  The rental income was proceeds of the such property, which preexisted the tax lien.

Not like A/R.  The result would have been different had accounts receivables been the lender’s collateral.  The Court noted that a security interest in accounts receivables does not exist and thus does not trump a subsequently-filed federal tax lien “until a buyer of goods or services from the grantor of the security interest becomes indebted to the grantor.”  If the lender in Bloomfield did not have a mortgage on its borrower’s real estate, but just a lien on rentals, then until the rentals were received “the property on which the bank had a lien would not have come into existence.”  Instead, the lender had a lien on the real estate.  The rentals provision in the mortgage “created a perfected security interest in rentals received at any time.”  Ind. Code § 32-21-4-2(c).  The Court said:

By virtue of the rental-income provision in the mortgage, the bank had a separate lien on the rents, but that is not the lien on which it is relying to trump the tax lien.  The lien on which it is relying is a lien on the real estate.  If an asset that secures a loan is sold and a receivable generated, the receivables become the security, substituting for the original asset.  The sort of receivable to which the statute denies priority over a federal tax lien is one that does not match an existing asset; a month’s rent is a receivable that matches the value of the property for that month.

The lender thus prevailed in its priority dispute with the IRS.  Bloomfield reminds us that, generally, Indiana is a “first in time is first in right” state.  More specifically, the opinion points out that in Indiana a mortgage attaches, not only to the land and improvements, but also to any proceeds from the sale or rental of the real estate.