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“Arizona Tax Liens Wreaking Havoc On Lenders, Borrowers”

Law360 By David E. Funkhouser

Law360, New York (May 09, 2014, 6:45 PM ET) -- The Arizona Legislature has provided the state's 15 counties with powerful means to ensure the payment of delinquent real property taxes: the sale of, and potential of foreclosure on, real property tax liens.

When a real property owner fails to pay real property taxes, and after a certain amount of time has passed, the county treasurer advertises and sells a tax lien on that piece of property for the aggregate amount of all unpaid taxes that are delinquent on the property, together with all penalties, interest and charges respectively due for the current or preceding years.

The county treasurers sell the tax liens to any person who pays the expenses outlined above and who also offers to accept the lowest rate of interest on the amounts paid. The statutes cap the potential interest rate at 16 percent, but given that the sales occasionally go uncontested, it is not uncommon for tax lien purchasers to get the full 16 percent interest rate on their investment.

After the tax lien purchaser has purchased the tax lien, any person or entity that has a legal or equitable claim in the property — such as the owner, lienholder, etc. — may then redeem that tax lien. In other words, the interested party may pay to the county treasurer the amount for which the tax lien was sold, plus the interest accrued at the rate stated in the certificate of purchase. Assuming someone timely redeems the lien, that essentially ends the matter — the lender’s liens encumbering the property remain intact, and the owner of the property remains the fee title owner of the property.

If, three years after the sale of the tax lien, it has still not been redeemed, the purchaser of the tax lien can bring a civil action to forever foreclose the rights of interested parties to redeem the tax lien. That lawsuit should not be (but often is) taken lightly by anyone with a legal or equitable interest in the property. Why? Because if the court finds that the sale of the lien was valid, and that the tax lien has still not been redeemed, the court must enter a judgment that forecloses the rights of all interested parties to redeem the tax lien.

In addition, that judgment directs the county treasurer to expeditiously execute and deliver to the tax lien purchaser a treasurer’s deed to the property. That judgment and deed have the combined legal effect of: (1) prohibiting interested parties from ever being able to redeem the tax lien, and (2) extinguishing all legal or equitable rights or interests that anyone else has in the property (subject to a few exceptions dealing with easements, etc.).

Otherwise stated, if no one redeems the lien, and judgment is entered in favor of the tax lien holder, the holder becomes the owner of the property in fee simple — all liens are extinguished immediately, and the prior owner loses the property.

Once an action to foreclose redemption rights has been brought, interested parties can still redeem the lien, but they must do so prior to judgment being entered. Furthermore, if redemption does not occur until after the action is brought, the redeeming party must also pay the purchaser the amounts it incurred in bringing the lawsuit (including reasonable attorneys’ fees and costs).

With shocking frequency across the counties of Arizona, homeowners and lenders are failing to redeem delinquent tax liens, and are thereby losing their pecuniary and fee simple interests. On the other hand, tax lien purchasers — most commonly limited liability companies set up for the express purpose of taking advantage of this statutory scheme — buy tax liens for a mere few thousand dollars, and often end up with a six-figure windfall.

For them, it is a win-win situation. If someone redeems the lien, the tax lien holder still gets (1) a return of their original principal investment, and (2) interest, often at a handsome rate of return. If no one redeems, the tax lien holder wins the proverbial lottery — they end up with a piece of real property for essentially pennies on the dollar. For lenders and homeowners, the results are devastating — lenders are losing millions of dollars, and homeowners are losing their homes.

The question becomes, why are financial institutions letting it happen? It makes sense, perhaps, that an insolvent borrower does not have the capacity to pay the back taxes. But why, when a financial institution is named as a defendant in a tax lien foreclosure action, does it not immediately redeem the tax lien? After all, most deeds of trust permit the lender to pay delinquent taxes and then add those amounts to the balance of the loan, thereby charging them through to the borrower.

There appear to be a number of reasons:

First, financial institutions — particularly large financial institutions that operate nationally — may simply be unaware of the tax lien process in Arizona. Some financial institutions assume that the tax lien will, as in other states, simply end up as a subordinate judgment lien on the property. They may not understand that Arizona tax liens are a unique breed of “superlien” that will, if unredeemed, wipe out all other liens.

Second, there are situations, as with any lawsuit, where the complaint does not timely reach the hands of the appropriate person within a financial institution and/or their outside counsel. Thus, no one responds and judgment is entered. This may be more likely to happen if the lawsuit is assigned to a lawyer or law firm unfamiliar with Arizona tax lien foreclosures. After all, on the face of the lawsuit, it may appear that the amount in controversy is only a few thousand dollars. This could not be further from the truth.

Third, some financial institutions may be hesitant to redeem tax liens on properties with upside-down loans. However, this conclusion should undergo additional consideration. The failure to pay taxes is almost always an event of default under the loan documents between borrower and lender. Thus, it is almost always prudent for a financial institution to redeem the tax lien on behalf of the borrower (typically only a few thousand dollars), add those amounts to the balance of the loan (if allowable), and charge them through to the borrower.

If the borrower remains delinquent, then the financial institution can immediately foreclose on and sell the property (either judicially or nonjudicially). Even if a property encumbered by a $100,000 loan is only worth, for example, $80,000, redemption still makes sense; by paying a few thousand dollars, the financial institution preserves $80,000 in value. After all, this is essentially an all-or-nothing scenario.

In sum, companies and individuals are purchasing and foreclosing on tax liens in Arizona at an unprecedented rate. It is critically important for lenders, borrowers and lawyers that specialize in this field to be aware of, and familiar with, Arizona’s tax lien statutes. Falling asleep at the wheel can cost lenders their security interests and borrowers their homes — all while the tax lien holder, who purchased the tax lien for a few thousand dollars, enjoys a windfall.