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Deed In Lieu Transaction in the Commercial Real Estate Setting

The Great Recession has resulted in an inevitable increase in commercial loan defaults (See my post of November 15, 2010, “Lender/Tenant Concerns When a Landlord Defaults on Its Mortgage“).  Any lender will tell you that it would rather avoid foreclosure for obvious reasons. Foreclosure is an expensive, lengthy, and sometimes risky process. A deed in lieu of foreclosure may be a viable alternative under the right circumstances, and its use in the commercial real estate market is on the rise.

In a deed in lieu of foreclosure transaction, the borrower voluntarily agrees to convey to the lender the property that secures the loan.  By utilizing this technique, a lender can significantly reduce the costs and delay inherent in the foreclosure process. At the same time, the commercial borrower can avoid the stigma of foreclosure, publicizing its financial difficulty, and reduce or eliminate any personal liability on the note.

It sounds simple. There are, however, plenty of issues to consider for both the lender and borrower before proceeding with a deed in lieu.

A key benefit the borrower seeks to get out of a deed in lieu transaction is a release of any personal or guarantor liability on the note. A borrower will also want to obtain a promise from the lender that it will not submit any negative reports to credit agencies.  A borrower should also check with its tax advisor as to the tax consequences of any contemplated deed in lieu transaction. A deed in lieu is generally treated as the sale of a property. A borrower could also have cancellation of debt income.

A lender should look at a deed in lieu transaction as it would a purchase transaction.  Due diligence by the lender should include a title search and review, an inspection of the property, a review of all leases and contracts relating to the property, and an environmental review. The lender will also want to assess the borrower’s solvency. This analysis is quite important, because the deed in lieu could be attacked as a fraudulent conveyance by a third party if the borrower is insolvent at the time of the transfer. In addition, on March 8, 2010, the American Land Title Association’s (ALTA) Board of Governors decertified ALTA form 21-06 Creditor’s Rights Endorsement, thereby shifting to owners and lenders the risk that the insured transaction constitutes a fraudulent or preferential transfer.  Another potential problem area is if there are junior lien-holders, mechanic’s liens, or judgments, then the lender may have no choice but to foreclose in order to clear the title to the property.

A deed in lieu of foreclosure can be a valuable tool for lenders and borrowers in the commercial real estate field. While there are many issues to consider before proceeding with a deed in lieu, considerable benefits can be realized if the deed in lieu is used properly.