Foreclosures and Priority Issues
August 19, 2013

One of the unfortunate realities of the residential real estate market in the past several years has been foreclosures.  A foreclosure is the process by which a secured party recovers a balance due by exercising its interest in secured collateral.  Typically, this means that a bank forecloses on a home.  In Tennessee, we have deeds of trust.  A deed of trust is a three party agreement.  In a deed of trust, the borrower conveys legal title to the property to a third party, the trustee.  The trustee holds the legal title to the property in trust for the benefit of the lender.  This conveyance is made as security for a loan.  In the event there is a default on the loan, the trustee (or his successor) will foreclose the lien created by the deed of trust.  If there is no default, then once the loan is paid in full, the deed of trust will be released.  The foreclosure occurs because there has been a default in the payment of the loan.

Foreclosures are an issue for homeowners and condominium owners associations.   This is because foreclosures effect the collection of assessments.  Assessments are a lien on property.  The CCRs and master deed create a lien for assessments on the property they respectively encumber.  A foreclosure impacts this lien.  This has to do with issues of priority.  Priority is a complex subject.  Briefly stated, priority has to do with which secured lien takes precedence over another.  Usually, a lien must be recorded to have priority.  However, some liens, such as real estate taxes (because they are assessed by the sovereign, i.e., the county and city) do not have to be recorded.  Generally, the first recorded lien has priority over all other subsequently recorded liens.  The issue for associations is that the lien of their assessments is generally subordinated to the lien of a certain deeds of trust.  Subordination means that even though one lien is recorded first, it has lower priority to subsequently recorded liens.  This makes a deal of sense.  Why would a bank make a loan on property in an association if on-going assessments take priority over the loan?

In a foreclosure all junior liens not paid out of the proceeds realized at the foreclosure sale are wiped out as a lien on the property.  The amount due of the assessments is still an obligation of the former Unit Owner, but it is no longer a lien on the property.  The issue for the association is that generally there is no economic reason to collect from a homeowner who has been foreclosed upon.  A foreclosure thus likely means an economic loss for the association.  The assessments it may have realized from that property likely must be written off.  Unfortunately, many CCRs and master deeds in Tennessee do not necessarily address priority issues correctly.  We have seen many associations lose out on funds in foreclosure because the documents do not address priority issues correctly.  Boards should have a qualified attorney look into these matters.

While an association may lose its secured interest in a foreclosure, all is not negative news.  On the positive side there is a new homeowner.  This means that the association has replaced a non-paying homeowner with a new one.  Simply put, the income stream evidenced by the assessments from that property should restart (pro-rated from the date of foreclosure).  Further, recent changes in condominium law in Tennessee allow condominiums to recoup some losses (this will be more fully discussed at a later date).

Foreclosures are a complex subject.  Boards should be aware of the issues involved as foreclosures impact an association’s lien rights.  An informed Board will contact a qualified attorney to discuss these matters.

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