To Deed in Lieu or Not by Jeffrey W. Harrison

The Deed in Lieu of Foreclosure can be a useful tool to be employed when a real estate mortgage is in default.  In a Deed in Lieu of Foreclosure, the Lender accepts a conveyance of the Property in lieu of foreclosing its lien, and agrees that the conveyance satisfies some or all of the outstanding debt.  The consensual transfer of the mortgaged property, if properly carried out, can certainly be preferable to a potentially adversarial judicial foreclosure or non-judicial foreclosure.  The typical Deed in Lieu transaction provides several benefits which may be considered advantageous to the Lender and the Borrower.  Some of these benefits include the following: (a) the quick transfer of control of the Property to Lender, (b) a less expensive and more efficient transfer of the Property, (c) a more confidential transfer of the Property that reduces the stigma typically associated with a foreclosure, (d) with the increased cooperation of the Borrower, the Lender is often able to obtain more current information on the status and condition of the Property, (e) a reduction in the likelihood of a challenge to the transfer of the Property to the Lender, and (f) the avoidance of the possibility of competitive bidding that could be encountered at a foreclosure sale.

While the benefits of a Deed in Lieu transaction are many, the Lender and Borrower should carefully consider certain factors before entering into a Deed in Lieu of Foreclosure.  First of all, the Lender must consider and address the issue of any junior liens affecting the Property.  The Lender should first obtain a comprehensive title report (and possibly a title policy or endorsement) to confirm that there are no junior liens.  If there are any junior liens, the Lender will acquire title under the Deed in Lieu subject to such liens and the equitable right of redemption held by such lienholders to purchase the Property after the conveyance by paying the amount of the debt.  For this reason, it is important that the Lender clearly state in the Deed in Lieu documents that the lien will be retained by the Lender and will not be merged with the fee title in the Property conveyed to the Lender in the Deed, So, if a junior lien is later discovered, the Lender could foreclose its lien and extinguish the junior lien.

Section 51.006 of the Texas Property Code was passed by the legislature in 1995 in an attempt to protect lenders acquiring title pursuant to a Deed in Lieu from claims of junior lienholders.  The statute provides that the Lender can void a Deed in Lieu to the extent that the Borrower fails to disclose a junior lien to the Lender and the Lender has "no personal knowledge" of the undisclosed lien.  However, the value of this statute has been questioned, because Texas courts have held that a recorded lien held by a junior lender constituted "personal knowledge" to the senior lender even though such lender had no "actual knowledge" of the lien.  Another portion of Section 51.006 does provide some protection for a Lender accepting a Deed in Lieu as it expressly provides that such Lender may later foreclose its lien.

Another matter for consideration when completing a Deed in Lieu transaction is whether the indebtedness will be completely extinguished or a deficiency will be retained.  To the extent that the Borrower intends that the debt be completely extinguished this should be clearly stated.  A deficiency may be retained by the Lender accepting a Deed in Lieu, but the documents will need to be carefully drafted to avoid a future claim that the transaction creates an equitable mortgage, which is an equitable concept that actually allows the Borrower to repurchase the Property for the amount of the debt. 

 Some potential disadvantages to a Deed in Lieu transaction are: (a) the Lender will not extinguish any liability for security deposits paid by tenants of the Property as would occur if there were a foreclosure (in accordance with Section 92.105(c) of the Texas Property Code), (b) the Lender will take title subject to any Federal Tax Liens that were filed against the Borrower at least 30 days prior to the conveyance, and (c) the transfer remains subject to potential bankruptcy claims for fraudulent transfer or voidable preference.  In order to attempt to protect the Lender from a bankruptcy claim, the Lender would certainly be advised to obtain an appraisal on the Property, establishing the value of the Property to be less than the outstanding debt.

It is important to understand that a properly completed Deed in Lieu transaction is not accomplished with a simple deed.  The Deed in Lieu documents should include a deed, releases and various agreements containing representations and covenants that precede and survive the actual delivery of the deed and possession of the Property.  Please feel free to contact us if you are considering a Deed in Lieu transaction, as we can assist you with these important provisions and documents whether you are a Lender or a Borrower.