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SELECTED ISSUES IN SINGLE MORTGAGE LOAN PURCHASES
FOR THE “LOAN TO OWN” BUYER
M. Andrew Kauss and Lynn E. Fowler
Kilpatrick Townsend & Stockton LLP
Before 1990, and the collapse of several commercial banks and the entire savings and
loan industry under the weight of bad real estate loans, it was extremely rare for commercial
real estate to be bought and sold without a significant level of representations and warranties
from the seller. It was then generally well accepted that a prudent buyer in an arms-length
transaction could not accept the risk of acquiring property on an “as-is” basis, nor would a seller
reasonably expect a buyer to do so.
In the aftermath of the financial debacle of that era, first the banks and savings and
loans disposing of REO, and then the Resolution Trust Corporation, began to test the appetite
of the market for the purchase of properties without any recourse of any kind against the seller.
It was during this period that the types of seller disclaimers that are commonplace today first
appeared. These provisions were often much more than mere “disclaimers”. Not only did they
provide for disclaimer of all seller warranties, but they also required the buyer to affirmatively
release all claims against the seller and all manner of persons and entities having any
relationship to the seller, and to affirmatively indemnify the seller and such persons and entities
against any claims whatsoever related to the property sold. These indemnities extended to all
matters, whenever arising, even during the period of the seller’s ownership of the property and
even if the result of the acts or omissions of the seller, and even if fully known to the seller and
whether or not disclosed. The rationale for the seller position was that the risk was reflected in
the price for the property, and justified the harsh terms of the disposition.
To the great surprise of many practitioners, the marketplace largely accepted the terms
of engagement proffered by these sellers. Whether the purported downward risk adjustment of
the price for the property was reality, or merely perceived because the prices represented so
much less than the selling lenders had invested in property being sold (not to mention what had
been invested in long lost equity), was lost in the fog of the transaction. Responsible buyers
(including institutional investors and those who managed their money) came to accept that it
could be prudent to buy real estate on this basis, if the due diligence process was sufficiently
thorough, and the third party assurances obtained in due diligence (i.e., tenant estoppels,
governmental assurances on zoning and entitlements) were sufficiently broad. Once the market
made this leap in the purchase and sale of distressed real estate, it was a much shorter leap to
the adoption of these transaction terms in non-distressed circumstances, between arms-length
buyers and sellers.
Of course, this approach to acquisitions of ownership interests in real estate could likely
never have evolved absent the ability to obtain title insurance to backstop the fundamental risk,
that of title to the real estate itself. A rational buyer could take the view that, if assurance (i.e.,
insurance) was available to guarantee that title had been obtained and was free of unknown
encumbrances, the balance of the risks in the transaction could be effectively evaluated on a
business level.
Not surprisingly, in the current environment, financial institutions disposing of distressed
debt generally seek to apply this same disposition philosophy to those sales as well. Because
this debt is being sold at a discount to its face value and/or a discount to the value of the
underlying collateral property, selling lenders often take the view that it is justifiable to shift to
the buyer all manner of risk existing at the time of sale, as to both the integrity and enforceability
of the debt, and the possibility of borrower claims and defenses based on prior actions of the
selling lender.
Loan purchases, however, involve additional layers of greater risk than those present in
the direct purchase of real estate. Certainly, all of the same risks related to the underlying
collateral real estate are present and must be assessed. However, overlaying this risk is the
risk of the integrity of the loan asset, including, most critically, the mortgage lien itself.
Separating the risks into title and priority of lien, on the one hand, and the enforceability of the
loan documents, on the other:

As to title and lien priority, it is relatively straightforward to obtain title insurance
covering the transfer of the mortgage itself. While on the face of it, it would also
appear to be relatively straightforward to obtain title insurance offering continuing
title insurance as to the priority of the mortgage lien, it is much less
straightforward to obtain this insurance without exposure for the acts or
omissions of the assigning lender/seller that may have impaired the lien of the
mortgage.

As in the case of a sale of real estate, if the seller is unwilling to provide
assurances as to the title issue described above, or the continuing integrity of the
loan documents generally, the alternative is to obtain third party assurances. In
this case, the only third party’s assurances that are at all useful are those that
come directly from the borrower.
In many circumstances, the mortgage loans offered for sale in recent years by
commercial banks and similar lenders have appeared on their face to be relatively low risk.
They are not loans secured by properties worth significantly less than the amount of the debt.
Rather, they are often 
matured construction loans or construction/mini-permanent loans,

secured by successful projects (often, multi-family rental residential),

with sufficient cash flow to service the debt and perhaps more (particularly in this
low-interest rate environment), and

with appraised values equal to or exceeding the outstanding debt;
BUT, refinancing is not available because 
the appraised value will not sufficiently exceed the outstanding debt to satisfy
loan-to-value criteria; and

the borrower has no sources of additional capital in order pay down the debt in
connection with a refinancing.
The relationship of the amount of the debt to the internal economics of the collateral
property creates a perception of high quality and low risk in these loans. Certainly, their sellers
believe they are high quality and low risk, because they are regularly offered for sale in auction
environments under harsh proposed sale terms and under expectations of a purchase price at a
minimal discount from the face amount of the debt (which is often the case).
However, in light of the nature of the loan as an asset, the economically more sound
loan is often the more risky loan in terms of the likelihood of encountering borrower
intransigence and opposition. A borrower who is far “under water” has little or no incentive to
oppose a lender’s efforts to foreclose the property, particularly if the loan is non-recourse and
there is no threat of “carve-out” liability. However, the borrower who has developed a
successful project that is servicing its debt but cannot be refinanced is much more likely to view
the loss of its equity as a temporary aberration of the market cycle, and much more likely to be
incentivized to fight for the time that might allow the market cycle to resurrect that equity.
The “loan to own” buyer’s strategic approach to these perceptibly “high quality/low risk”
loans will vary. The ultimate goal in purchasing the loan and, hopefully, acquiring the property,
is to recapture not only the borrower’s lost equity but also any upside beyond that. At one
extreme, the “loan to own” buyer could be the identified source of the new equity that is required
to allow the asset to be recapitalized and refinanced, under an arrangement with the borrower
that allows the borrower to retain an opportunity to salvage some of its equity once the new
equity has been retired with an agreed-upon return. At the other extreme, the borrower could
be girded for battle, in which the “loan to own” buyer confronts a variety of possibilities. It may
be paid off at face value, which means the quality of the investment return will be determined by
the depth of the purchase discount, the interest rate on the loan (and whether any default
interest can be collected) and the length of time that the loan is held. On the other hand, the
buyer may face a protracted battle with the borrower either inside or outside of bankruptcy,
including all manner of claims by the borrower as to why the loan is not enforceable as written,
usually due to the alleged actions of the selling lender. It is in this context that the “loan to own”
buyer must assess, and attempt to ensure, the quality of the asset it is purchasing.
TITLE INSURANCE FOR THE MORTGAGE ASSIGNMENT
Under the 2006 ALTA title insurance forms, the assignee of an insured mortgage is
entitled, without more, to the rights and benefits of the original lender under the policy. Under
Section 1(e) of the Conditions of the policy, successor owners of the loan are “insureds”, but
with caveats:
(e)
“Insured”: The Insured named in Schedule A.
(i)
The term “Insured” also includes
(A)
the owner of the Indebtedness and each successor in
ownership of the Indebtedness, whether the owner or
successor owns the Indebtedness for its own account or as
a trustee or other fiduciary….
*
*
*
(ii)
... reserving, however, all rights and defenses as to any successor
that the Company would have had against any predecessor
Insured, unless the successor acquired the Indebtedness as a
purchaser for value without Knowledge of the asserted defect,
lien, encumbrance, or other matter insured against by this policy.
*
*
*
There are two forms of endorsement to the original lender’s policy available to insure the
assignment:

ALTA Endorsement 10-06 (Attachment 1) does not “date down” the policy or
bring forward any coverages of the policy or any endorsements that are a part of
the policy. It merely insures the effectiveness of the assignment and that no
release or reconveyance has been placed of record. It does not cover matters
recorded after the effective date of the original policy, except to insure that no
release or reconveyance has been recorded. The coverage provided by this
endorsement is generally conditioned upon the proper endorsement and delivery
of the underlying notes.

ALTA Endorsement 10.1-06 (Attachment 2), as is the case with ALTA 10, the
ALTA 10.1 insures the effectiveness of the assignment and insures that no
release or reconveyance has been placed of record (other than as may be noted
in the endorsement). Like ALTA Endorsement 10-06, the coverage provided by
this endorsement is conditioned upon the proper endorsement and delivery of the
underlying notes. However, unlike ALTA Endorsement 10-06, in addition, this
endorsement does “date down” the policy and provide coverage over certain
enumerated matters occurring after the effective date of the policy and before the
date of endorsement. By its express terms, this endorsement does not “date
down” the policy for purposes other than as stated, that is, the endorsement does
not bring forward coverages of any other endorsements that are a part of the
policy.
In most circumstances involving commercial properties, the underwriting guidelines for
the title company to issue an ALTA 10.1 endorsement will require an estoppel statement from
the owner of the collateral property as a condition to the issuance of either of the above
endorsements. The title company’s requirement would generally provide:

A written sworn statement by the record owner of the land, stating that the lien of
the mortgage(s) is (are) still good and valid and, in all respects, free from all
defenses, both in law and in equity, should be furnished to the Company.
Attachment 3 is a sample of such an estoppel. In some circumstances, the title company will
accept an indemnity from the assignor if the borrower estoppel is not available. If neither a
borrower estoppel or assignor indemnity is available, any endorsement would be subject to an
exception such as the following:

Consequences, if any, arising out of any inability to foreclose or delay in
foreclosing the Insured Mortgage(s) based upon the expiration of any statute of
limitations, or challenges raised to the priority or enforceability of the Insured
Mortgage based upon the acts or conduct of the original or subsequent lender.
Even if an estoppel or indemnity has been obtained, for insurance of assignments of a loan
known to be non-performing, the title company will include the element of the above exception
related to statutes of limitation to address the possibility that the loan is so far past due as to be
unenforceable.
While the underwriting procedures followed by the title companies (i.e. borrower
estoppel and/or assignor indemnity) suggest their belief that the issuance of an ALTA 10.1
endorsement insures the assignee against the most fundamental risk in the transaction – the
risk of a borrower claim of invalidity or unenforceability of the mortgage based on the actions of
the prior lender since the date of the policy – a close reading of these endorsements and the
ALTA 2006 Loan Policy form leaves some significant doubt about this. The ALTA 10.1 extends
the date of the policy as to the specific enumerated matters that it insures; by its express terms,
it does not otherwise extend the date of the policy or any of its coverages. Most notably, it does
not extend the date of policy for the purpose of insuring clause 9 of the ALTA 2006 Loan Policy
form:
9. The invalidity or unenforceability of the lien of the Insured Mortgage upon the
Title. …
Without an extension of the date of policy for the coverage of clause 9, it is difficult conclude
that the ALTA 10.1 provides the desired coverage. While clause 2.c. of the ALTA 10.1 does
provide insurance of priority over “defects, liens, or encumbrances” arising since the date of the
policy, it is hard, in light of the failure to extend the coverage of clause 9 of the ALTA 2006 Loan
Policy form, to read this as including coverage for the types of borrower claims that are of the
greatest concern. Since the substance of the estoppel in Attachment 3 would appear to go
directly to the issue of “validity or enforceability of the lien”, it is puzzling that the ALTA 10.1
does not expressly include that coverage.
Moreover, there remains some question as to whether the ALTA 10.1 leaves open
issues of the imputation of the acts of the assigning lender to undermine or invalidate even the
limited scope of coverage provided. Is the endorsement’s merely changing the “Insured” under
the policy from the assignor to the assignee as of the date of endorsement sufficient? The
assignor was the “Insured” under the same policy prior to the date of endorsement. Better
practice would suggest the inclusion of some affirmative statement of non-imputation. Even
better practice, were the title insurer willing, would be the issuance of a completely new policy in
favor of the assignee.
THE “LOAN TO OWN” BUYER AND BANKRUPTCY
On the face of it, the buyer of a loan should fare no better or worse in a borrower
bankruptcy than the original holder of the loan. However, in light of the uncertain, and
sometimes seemingly capricious, nature of results in bankruptcy court, depending on whether a
particular court or judge is pro-lender or pro-debtor, are there particular risks for the “loan to
own” buyer in this environment? The “loan to own” buyer has purchased a loan with no intent of
being a lender. This reality may be evidenced by the very fact that the buyer has purchased a
distressed loan; and, it is very likely to be strongly evidenced by the buyer’s dealings with the
borrower, or lack thereof, after the purchase. Will the “loan to own” buyer’s behavior as the
holder of the loan impact its treatment in bankruptcy?
In Radlax Gateway Hotel, LLV v. Amalgamated Bank, 132 S.Ct. 2065 (2012), the
Supreme Court recently ruled on the ability of a debtor to confirm, over the objection of a
secured lender, a “cramdown” plan that called for the auction of a secured lender’s collateral
property under auction rules that prohibited the secured lender from credit bidding in the
auction. At issue was the secured lender’s right to credit bid, under Section 363(k) of the
Bankruptcy Code, which provides:
Unless the court for cause orders otherwise the holder of such claim may bid at
such sale, and, if the holder of such claim purchases such property, such holder
may offset such claim against the purchase price of such property.
(Emphasis added) The Bankruptcy Court had found that there was no “cause” to deny credit
bidding, and the debtor did not appeal this finding. The debtor sought to confirm that plan under
the “cramdown” provisions of Section 1129(b)(2)(A), on the basis that the plan provided the
secured lender the “indubitable equivalent” of its secured claim.
Referring to the matter before it as an “easy case”, the Court had little difficulty rejecting
the debtor’s arguments (which, as described by the Supreme Court, appeared to be little more
than sophistry) rather summarily. However, there are two interesting things about the case that
are relevant to this discussion. First, the very fact that a matter such as this reached the
Supreme Court demonstrates just how dangerous an environment bankruptcy court can be for
lenders. Second, and more substantively, because the debtor had not appealed on this basis,
the opinion in Radlax does not address at all the issue of what would constitute “cause” to deny
a lender the right to credit bid.
There are, of course, more general risks, such as seemingly innocuous discrepancies in
loan documents in the hands of a bankruptcy judge. In In re Head Grading, Co., the United
States Bankruptcy Court for the Eastern District of North Carolina held a deed of trust invalid
and declared an $180,000 debt unsecured where the promissory note was misdated by a single
day and thus, the court ruled that there was no “note of even date” as described in the trust. In
re Head Grading, Co., 353 B.R. 122 (Bankr. E.D.N.C. 2006). The court found that “North
Carolina law requires deeds of trust to specifically identify the debt referenced therein,” Id. at
123 (citing In re Foreclosure of Deed of Trust of Enderle, 431 S.E.2d 549 (N.C. Ct. App. 1993),
and Putnam v. Ferguson, 502 S.E.2d 385 (N.C. Ct. App. 1998)), and reasoned that because the
date in the deed of trust and the note differed, “it did not properly and specifically identify the
obligation secured.” Id. at 124. The court stated that the “clarity and certainty in lien perfection
requirements would be lost” if the rule were not strictly adhered to. Id. A prospective buyer of
this loan could reasonably conclude that, under state law, this would be a scrivener’s error that
is resolved by reference to the other evidence on the face of the documents themselves, or, if a
defect, one that is readily subject to reformation of the instrument. Thus, a prospective buyer of
this loan could reasonably conclude that there was no material risk.
It is worth noting that the decision in Head Grading was contrary to an earlier state court
decision apparently precisely on point. In In re Foreclosure of Hooper, the North Carolina Court
of Appeals affirmed a trial court ruling that upheld the validity of the foreclosure of a deed of
trust that was dated November 10, 1995, and purported to secure a $150,000 debt obligation
“as evidenced by Promissory Note of even date herewith, the terms of which are incorporated
by reference”, even though there was no promissory note dated November 10, 1995. It did so
based on extrinsic evidence offered by the lender and the lack of any contrary evidence offered
by the buyer. See, John C. Murray, Defective Real Estate Documents: What are the
Consequences?, 42 Real Prop. Prob. & Tr. J. 367, 404 (2007). (Summarizing In re Foreclosure
of Hooper, 541 S.E.2d 524 (2000) (unpublished decision)).
Herein lies a potential serious risk for the “loan to own” buyer. Assume that the debtor in
bankruptcy can demonstrate from discovered evidence the lender’s acquisition of the loan with
a clear intent to acquire the property through foreclosure, and a post-acquisition course of
conduct by a loan buyer which, while clearly within the lender’s rights, is perceived to be
unreasonable and contrary to customary practice of lenders desiring only to be paid in full.
Could the debtor successfully argue that such a course of conduct constitutes “cause” to deny
the right to credit bid under Section 363(k)? As noted above, the Supreme Court provides no
insight on this issue in the Radlax case; and there is little other case authority on the issue,
certainly none that is particularly helpful to this analysis. See, John T. Gregg, A Review of
Credit Bidding Under 11 U.S.C.A. §363(k), Norton Annual Survey of Bankruptcy Law (August
2008). Would such a course of conduct move a bankruptcy judge to reach an absurdly harsh
result on other issues, as in Head Grading? In any event, a “loan to own” buyer, in its dealings
with the borrower, would be prudent to balance its desire to acquire the property against the risk
of behaving overly aggressively in its efforts to do so.
TAX TRAPS
There are a variety of potential tax risks to a buyer of a note at a discount that must be
borne in mind in any “loan to own” strategy. These are risks that, generally speaking, are not
present for the original holder of the note. These risks emanate from the fact that the buyer of a
note at a discount has a tax basis in the note equal to the purchase price for the note, rather
than the fact amount of the debt. As long as the buyer holds the note without triggering a
taxable event, this fact does not present any particular challenges. However, there are a
number of circumstances where the tactical steps that are integral to a “loan to own” strategy
could constitute a taxable event, thereby triggering “phantom” income to the note buyer. (For a
complete treatment of the tax implications of the acquisition of distressed real estate loans, see
Chester W. Grudzinski, Jr., The Consequences Of Acquiring Distressed Real Estate Loans, 37
WGL-RETAX 14 (2009)).
1.
Significant Modification of Note – Exchange Triggering Tax
If the buyer of a note at a discount subsequently engages in a “significant modification”
of the note, the buyer is treated as having exchanged the purchased note for a “new” modified
note. This exchange is a taxable event, which triggers a “phantom” gain (or loss) in the amount
of the difference between the buyer’s basis in the note (initially, its purchase price) and the
value of the “new” modified note (generally, its face amount). This gain (or loss) will either be
short term or long term capital gain, depending on whether the modification is deemed to have
occurred within one year after acquisition of the note, or thereafter.
Under IRC Regulations §1.1001-1(a), the gain or loss realized from the conversion of
property into cash, or from the exchange of property for other property “differing materially either
in kind or in extent”, is treated as income or as loss sustained. The amount realized from a sale
or other disposition of property is the sum of any money received plus the fair market value of
any property (other than money) received. Under Regulations §1.1001-3(b), a significant
modification of a note, results in an exchange of the original note for a modified note that “differs
materially either in kind or in extent” for the purposes of Regulations §1.1001-1(a), resulting in
the possibility of a taxable event. A modification that is not a “significant modification” is not an
exchange for purposes of §1.1001-1(a).
Under Regulations §1.1001-3(c)(1), a modification can occur either by agreement of the
parties, or by operation of the terms of the note. The former includes
“any alteration, including any deletion or addition, in whole or in part, of a legal
right or obligation of the issuer or a holder of a debt instrument, whether the
alteration is evidenced by an express agreement (oral or written), conduct of the
parties, or otherwise”. Regulations §1.1001-3(c)(1)(i).
Additionally, while, generally, an alteration of a legal right or obligation that occurs by operation
of the terms of a note is not a modification, there are certain alterations which will constitute
modifications, even if they occur by operation of the terms of the note: Specifically:

An alteration that results in the substitution of a new obligor, the addition or
deletion of a co-obligor, or a change (in whole or in part) in the recourse nature of
the instrument (from recourse to nonrecourse or from nonrecourse to recourse) is
a modification.

An alteration that results in the conversion of a note to an instrument or property
right that is not debt for Federal income tax purposes is a modification unless the
alteration occurs pursuant to a holder's option under the terms of the instrument
to convert the instrument into equity.

An alteration that results from the exercise of an option provided to an issuer or a
holder to change a term of a note is a modification unless:
o
the option is “unilateral”; and
o
in the case of an option exercisable by a holder, the exercise of the option
does not result in (or, in the case of a variable or contingent payment, is
not reasonably expected to result in) a deferral of, or a reduction in, any
scheduled payment of interest or principal.
An option is “unilateral” only if, under the terms of an instrument or under
applicable law: (i) there does not exist at the time the option is exercised, or as a
result of the exercise, a right of the other party to alter or terminate the instrument
or put the instrument to a person who is related to the issuer; (ii) the exercise of
the option does not require the consent or approval of (a) the other party, (b) a
person who is related to that party, or (c) a court or arbitrator; and (iii) the
exercise of the option does not require consideration (other than incidental costs
and expenses relating to the exercise of the option), unless, on the issue date of
the instrument, the consideration is a de minimis amount, a specified amount, or
an amount that is based on a formula that uses objective financial information.
Regulations §1.1001-3(c)(3). The failure of a party to exercise an option to
change the terms of the note is not a modification. Regulations §1.1001-3(c)(5).
Generally, the failure of the borrower to perform its obligations under the note is not itself
viewed as an alteration of a legal right or obligation and, therefore, is not a modification.
Regulations §1.1001-3(c)(4)(i), Similarly, a mere forbearance by the note buyer is not a
modification. However, if the forbearance is accompanied by a written or oral agreement to
modify other terms of the note, it will constitute a modification, as will a forbearance that extends
for a period more than two years, plus any additional period that the parties are engaged in
good faith negotiations, plus any period that the borrower is in bankruptcy. Regulations
§1.1001-3(c)(4)(ii).
As to the time at which a modification is deemed to have occurred:

A modification occurs at the time of execution of an unconditional operative
agreement, even if not effective until a later date. However, if the agreement is
subject to conditions, then the modification occurs upon the satisfaction of the
conditions and the agreement’s becoming effective.
3(c)(6)(i) and (ii).

Regulations §1.1001-
A modification that results from a bankruptcy plan of reorganization occurs at
such time as the plan becomes effective.
Whether the modification of a debt instrument is a significant modification is determined
under Regulations §1.1001-3(e). The general rule is set out in Regulations §1.1001-3(e)(1):
“General rule. Except as otherwise provided in paragraphs (e)(2) through (e)(6)
of this section, a modification is a significant modification only if, based on all
facts and circumstances, the legal rights or obligations that are altered and the
degree to which they are altered are economically significant. In making a
determination under this paragraph (e)(1), all modifications to the debt instrument
(other than modifications subject to paragraphs (e)(2) through (6) of this section)
are considered collectively, so that a series of such modifications may be
significant when considered together although each modification, if considered
alone, would not be significant.”
To supplement this less than helpful general rule, Regulations §1.1001-3(e) specifies the
following objective tests and “safe harbors”:
1.
Change in Yield: A change in yield that is more than the greater of 25 basis
points (0.25%) and 5% of the existing annual yield is deemed significant.
Regulations §1.1001-3(e)(2)(ii).
2.
Change in Timing of Payments: In general, a modification that changes the
timing of payments (including any resulting change in the amount of payments)
due is a significant modification if it results in the material deferral of scheduled
payments. The deferral may occur either through an extension of the final
maturity date or through a deferral of payments due prior to maturity. The
materiality of the deferral depends on all the facts and circumstances, including
the length of the deferral, the original term of the instrument, the amounts of the
payments that are deferred, and the time period between the modification and
the actual deferral of payments. Regulations §1.1001-3(e)(3)(i). While this
general statement is not very useful, there is a “safe harbor” period which begins
on the original due date of the first scheduled payment that is deferred and
extends thereafter for a period equal to the lesser of five years and 50% of the
original term of the instrument (without reference to borrower options to extend).
The deferral of one or more scheduled payments within the safe-harbor period is
not a material deferral if the deferred payments are unconditionally payable no
later than at the end of the safe-harbor period. If the period during which
payments are deferred is less than the full safe-harbor period, the unused portion
of the period remains a safe-harbor period for any subsequent deferral of
payments on the instrument. Regulations §1.1001-3(e)(3)(ii).
3.
Change in Obligor: If the note is a recourse debt instrument, then the
substitution of a new obligor is a significant modification. Regulations §1.10013(e)(4)(i). Conversely, if the note is a nonrecourse debt instrument, then the
substitution of a new obligor is not a significant modification. Regulations
§1.1001-3(e)(4)(ii). The Regulations do not provide any guidance on how “carve
out” guaranties or “springing” guaranties bear on the question of whether the
note is a “recourse debt instrument”.
4.
Addition or Deletion of Co-obligor: The addition or deletion of a co-obligor is a
significant modification if the addition or deletion of the co-obligor results in a
change in payment expectations. Regulations §1.1001-3(e)(4)(iii).
5.
Change in Security or Credit Enhancement: A modification that releases,
substitutes, adds or otherwise alters the collateral for, a guarantee on, or other
form of credit enhancement for, a recourse debt instrument is a significant
modification if the modification results in a change in payment expectations.
Regulations §1.1001-3(e)(4)(iv)(A). As to “nonrecourse debt instruments” this
issue is addressed in a temporary regulation effective July 6, 2011, which
provides that a modification that releases, substitutes, adds or otherwise alters a
substantial amount of the collateral for, a guarantee on, or other form of credit
enhancement for a nonrecourse debt instrument is a significant modification.
The substitution of a similar commercially available credit enhancement contract
is not a significant modification; and, an improvement to the property securing a
nonrecourse debt instrument does not result in a significant modification.
Regulations §1.1001-3T(e)(4)(iv)(B).
6.
Change in Priority of Debt: A change in the priority of a note relative to other
debt of the borrower is a significant modification if it results in a change in
payment expectations.
7.
Change in Nature of Instrument as Debt: A modification that results in an
instrument or property right that is not debt for Federal income tax purposes is a
significant modification.
8.
Change in Recourse Nature of Instrument: A change in the nature of a note from
recourse (or substantially all recourse) to nonrecourse (or substantially all
nonrecourse) is a significant modification. Similarly, a change in the nature of a
note from nonrecourse (or substantially all nonrecourse) to recourse (or
substantially all recourse) is a significant modification.
9.
Accounting or Financial Covenants. A modification that adds, deletes, or alters
customary accounting or financial covenants is not a significant modification.
The Regulations provide that a “change in payment expectations” can be either a
positive or negative change, and occurs if, as a result of a transaction:
a.
there is a substantial enhancement of the obligor’s capacity to meet the payment
obligations and that capacity was primarily speculative prior to the modification
and is adequate after the modification; or
b.
there is a substantial impairment of the obligor’s capacity to meet the payment
obligations and that capacity was adequate prior to the modification and is
primarily speculative after the modification.
2
Tax Triggered by Foreclosure
If the buyer of a note at a discount subsequently acquires the collateral property through
foreclosure or deed in lieu of foreclosure, the buyer will be deemed to have disposed of the note
in return for its acquisition of the collateral property. If the value of the collateral property
exceeds the buyer’s then basis in the note, the foreclosure or deed in lieu of foreclosure will
trigger a “phantom” gain in the amount of the excess. Again, this gain will either be short term
or long term capital gain, depending on whether the foreclosure or deed in lieu of foreclosure
occurs within one year after acquisition of the note, or thereafter.
While the value of the property at the time of foreclosure will always be subjective and
open to debate, it goes without saying that the essential goal of the “loan to own” note buyer is
to purchase the note for a price substantially below the value of the collateral property.
One question that always comes up is whether the amount bid in at a foreclosure sale
represents the fair market value of the property. While the results of the foreclosure sale will be
relevant evidence of the fair market value, courts have routinely held that the foreclosure sale
bid by the lender is not determinative of fair market value and can be rebutted by other
evidence.
3.
Market Discount Generating Ordinary Income
The purchase of a note at a discount creates a “market discount” for tax purposes in an
amount equal to the amount of the discount. This “market discount” then accrues over the
remaining term of the note and is required to be recognized as ordinary income (rather than
capital gain) at the time of payment or disposition of the note.
The policy behind the market discount rules reflects Congress’s belief that differences
between the purchase price of a note and the remaining principal amount reflect changes in
interest rates, and the corresponding gain should be taxed similarly to interest. However, in the
case of a mortgage in default, the value of the mortgage is more tied to the value of the
collateral than the prevailing interest rates. Accordingly, there may be arguments that these
market discount rules do not apply to notes that are in default and accelerated at the time of
purchase.
For example, legislative history indicates Congress’s intent to exclude from the
application of the market discount rules the purchase of a demand loan, under the theory that it
is short term by nature and relatively immune from fluctuations in value caused by interest rate
swings. A mortgage note in default is arguably analogous to a demand loan and should be
similarly excluded from the application of the market discount rules.
If the market discount rules do apply to mortgage notes in default, a number of issues
remain. Generally, the difference between the principal amount and the purchase price of the
note would be the amount of the market discount. However, in a “loan to own” situation, the
buyer would rarely expect to get the full principal amount, so it would be nonsensical to treat the
remaining principal balance as the appropriate measure of market discount.
Similarly, the market discount accrues over the remaining term of the note. Again, in a
“loan to own” transaction, the buyer of the note does not expect to hold the note to maturity, so
the typical market discount accrual period arguably should not apply.
These issues make analyzing the impact of the market discount rules problematic at
best. Even though these rules have been enacted in 1984, Treasury has not taken steps to
address the applicability of the market discount rules to purchases of notes in default.
ATTACHMENT 1 - ALTA 10 Endorsement - 2006 (Assignment)
ENDORSEMENT
Attached to Policy No. _________
Issued By
Title Insurance Company
1.
The name of the Insured is amended to read: _________________.
2.
The company insures against loss or damage sustained by the Insured by reason of:
a.
The failure of the following assignment to vest title to the Insured Mortgage in the
Insured:
________________________________________________________________;
b.
Any modification, partial or full reconveyance, release, or discharge of the lien of
the Insured Mortgage recorded on or prior to Date of Endorsement in the Public
Records other than those shown in the policy or a prior endorsement, except:
________________________________________________________________;
This endorsement shall be effective provided that the note or notes secured by the lien of the
Insured Mortgage have been properly endorsed and delivered to the Insured at Date of
Endorsement.
This endorsement is issued as part of the policy. Except as it expressly states, it does not (i)
modify any of the terms and provisions of the policy, (ii) modify any prior endorsements, (iii)
extend the Date of Policy, or (iv) increase the Amount of Insurance. To the extent a provision of
the policy or a previous endorsement is inconsistent with an express provision of this
endorsement, this endorsement controls. Otherwise, this endorsement is subject to all of the
terms and provisions of the policy and of any prior endorsements
USADMIN 9792793 3
ATTACHMENT 2 - ALTA 10.1 Endorsement - 2006 (Assignment and Date Down)
ENDORSEMENT
Attached to Policy No. _________
Issued By
Title Insurance Company
1.
The name of the Insured is amended to read: _________________.
2.
The company insures against loss or damage sustained by the Insured by reason of:
a.
The failure of the following assignment to vest title to the Insured Mortgage in the
Insured: __________________;
b.
Any liens for taxes or assessments that are due and payable on Date of
Endorsement, except: _________;
c.
Lack of priority of the lien of the Insured Mortgage over defects, liens, or
encumbrances other than those shown in the policy or a prior endorsement,
except: __________;
d.
Notices of federal tax liens or notices of pending bankruptcy proceeding affecting
the Title and recorded subsequent to Date of Policy in the Public Records and or
prior to Date of Endorsement, except: ______________________________ ;
e.
Any modification, partial or full reconveyance, release, or discharge of the lien of
the Insured Mortgage recorded on or prior to Date of Endorsement in the Public
Records other than those shown in the policy or a prior endorsement, except:
__________________________.
This endorsement shall be effective provided that the note or notes secured by the lien of the
Insured Mortgage have been properly endorsed and delivered to the Insured at Date of
Endorsement.
This endorsement is issued as part of the policy. Except as it expressly states, it does not (i)
modify any of the terms and provisions of the policy, (ii) modify any prior endorsements, (iii)
extend the Date of Policy, or (iv) increase the Amount of Insurance. To the extent a provision of
the policy or a previous endorsement is inconsistent with an express provision of this
endorsement, this endorsement controls. Otherwise, this endorsement is subject to all of the
terms and provisions of the policy and of any prior endorsements
USADMIN 9792793 3
AFFIDAVIT AND ESTOPPEL CERTIFICATION
State of
, County of
:
The undersigned, being first duly sworn, deposes and says the following:
(1)
I am:
(i)
the [title or office:] _________________of [company name:]
, OR
(ii)
[name] _____________, an individual,
the Borrower that made, executed, and delivered that certain deed of trust or mortgage
(“Mortgage”) in favor of
, as the original beneficiary or
mortgagee, dated
, recorded in __________, in the land
records of
County, ________.
(2)
This Affidavit and Estoppel Certification (Certification) is made to the best knowledge of
the undersigned Borrower.
(3)
Based on information and belief, the Mortgage is a good and valid lien upon the property
described therein (Property), and the Mortgage and the note or notes, indebtedness and
other obligations secured by the Mortgage (Obligations) are in all respects free from all
defenses, in law and in equity.
(4)
This Certification is made for the protection and benefit of the current owner and holder
of the Obligations secured by the Mortgage, and all other parties that may acquire an
interest in the Property, and particularly for the benefit of any title insurer that insures the
title to the Property directly or indirectly in reliance on the facts and representations
contained in this Certification
(Borrower) By:
OR
_________________________________
(Borrower, individually)
SUBSCRIBED AND SWORN TO before me this ____ day of
20___.
Notary Public for
My commission expires:
USADMIN 9792793 3
,