Land Contracts: Mortgage Priority and Other Complications

Liebzeit v. Intercity State Bank (In re Blanchard), 520 B.R. 740 (Bankr. E.D. Wis. 2014) –

A Chapter 7 trustee sought to avoid a mortgage on the debtors’ property using the “strong arm” powers of a hypothetical bona fide purchaser of real estate.  The complication was that the debtors sold the real estate on land contract before they granted the mortgage.

The debtors sold the property under a land contract that was not recorded.  It contemplated that the debtors would obtain a mortgage “at the best interest rate possible and that the Debtors would ‘maintain loan.’”  Under the land contract the buyers made a $30,000 down payment and monthly “rent” payments of $500.  They also signed a separate rental agreement that provided for rent of $500 per month.  The balance of the purchase price was due in five years, but the buyers had an option for an “early buyout” at a price equal to the balance of the mortgage at that time.

In subsequently applying for a mortgage from a bank, the debtors provided copies of checks from the buyers, including one with a notation that it was for “rent,” and a copy of the rental agreement.  Although they did not provide a copy of the land contract, the rental agreement itself stated that it accompanied a contract to purchase.  An internal bank email noted that the property was sold on a land contract that would be paid off in five years.  The bank made the loan and the debtors executed a note, mortgage and an assignment of leases and rents.

After the debtors filed bankruptcy, the chapter 7 trustee sought to avoid the mortgage.  The trustee argued that even though the land contract was not recorded, the bank had actual notice so that it could not use the recording statute to defeat the prior claim under the land contract.  Further, since the debtors had already sold the real estate, they could not mortgage what they did not own.  So, the trustee argued that the bankruptcy estate was entitled to take the debtors’ interest in the property free and clear of the mortgage, and thus was entitled to all of the payments owed under the land contract.

Based on the bank’s actual notice, the court agreed with the trustee that the bank’s mortgage interest was junior to the land contract.  In addition, even though the land contract was unrecorded, the fact that the land contract buyers were in possession of the property served to give constructive notice.  Although occupancy would also be consistent with leasing the property from the debtors, courts have held that constructive notice goes beyond “mere observation” and includes facts that would have been disclosed through a reasonable inquiry of the party in possession.

However, in the court’s view it did not follow that the trustee could avoid the mortgage.  In considering the nature of land contract interests, a land contract creates an equitable interest in the purchaser while the seller retains bare legal title.  Any successors to legal title take subject to the purchaser’s equitable interest.  In this case the bank’s mortgage was subject to the land contract even though it wasn’t recorded because the bank had either actual or constructive notice of the land contract buyers’ interest.  However, that did not mean that the mortgage was invalid.

The issue is complicated because the vendor’s interests under a land contract are frequently considered to be personalty as opposed to realty.  The trustee argued that this meant that the bank could not perfect its interest using the mortgage.

The bankruptcy court noted that the argument that a vendor’s interest was personalty would logically mean that there would have to be an assignment of the vendor’s interest perfected by filing a UCC financing statement.  However, this argument had been rejected under applicable state law, and it was clear that an assignment of the vendor’s interest was properly recorded in the land records.

The court proceeded to discuss a variety of nuances about the status of a mortgage on an interest that was considered personalty.  The court’s conclusion remained that the mortgage was a valid lien on the debtors’ interest in the property.  Consequently the land contract payments were subject to the mortgage, although the mortgage would be extinguished if the land contract was paid off in full.

In response to the trustee’s argument that the debtors could not mortgage what they did not own, the court pointed out that the debtors did retain rights in the real property:  the right to enforce the land contract, to collect payments, and to foreclose if the land contract purchasers defaulted.  And since land contract vendors can mortgage their interest, and a bona fide purchaser would take subject to a recorded mortgage, the trustee could not avoid the mortgage.

In the end the efforts of the trustee to argue that the mortgage was invalid failed.  The land contract parties contemplated that the debtors would mortgage their interest.  The fact that the mortgage was junior to the land contract did not mean that the mortgage was void.  Rather the court “simply moved the mortgage to the back of the line, behind the land contract.”

Any time there is an ambiguity about the nature of interests, there will be uncertainty about the proper steps to perfect a lien on those interests.  Absent a statute establishing clear procedures, the safer approach would be to take steps to perfect as required for all potential types of interests.  In the case of a land contract, this means using both a real estate mortgage and a UCC security agreement and financing statement.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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