Secured lenders scored a major victory in priority disputes with the Internal Revenue Service when the United States Court of Appeals for the Seventh Circuit issued its opinion in Bloomfield State Bank v. United States, 10-3939 (slip opinion available here). In the case, the Seventh Circuit considered the competing priority of a Bank’s mortgage and an IRS tax lien in real estate rent collected by a state-court receiver while the Bank’s foreclosure action was pending.
Historically, a secured lender’s prior recorded mortgage has priority over a subsequent federal tax lien. This first-in-time presumption is modified by the federal statutory requirement that the property subject to the competing state lien is “in existence” prior to, or within 45 days after, the recording of a Notice of Federal Tax Lien. Over several decades the IRS has successfully asserted this requirement, frequently referred to as the choateness doctrine, to reach property ahead of claims by prior secured creditors in various classes of collateral. In its decision in Bloomfield State Bank, the Seventh Circuit defined an important boundary to the IRS’s argument.
The IRS successfully argued before the U.S. District Court that, because the receiver did not enter into the leases or collect rent until after both the mortgage and the tax lien were recorded, the rents were not “in existence,” and therefore the tax lien had priority over the prior mortgage.
Represented by R. Brock Jordan and Reynold T. Berry of Rubin & Levin, the Bank appealed the District Court’s decision. In an opinion authored by Hon. Richard A. Posner, the Seventh Circuit observed that the specific issue was one of first impression for federal appellate courts and recognized conflicting case law among various lower courts. Judge Posner went on to identify problems with the choateness doctrine, particularly as applied to proceeds of an existing asset. In the ruling, the Seventh Circuit concluded, as the bank had argued, that the real estate itself was the subject of the competing liens:
The “property” that must be in existence for a lender’s lien to take priority over a federal tax lien is the property that, by virtue of a perfected security interest in it, is a source of value for repaying a loan in the event of a default; it is not the money the lender realizes by enforcing his security interest. . . The real estate that generated the rental income at issue in this case existed when the mortgage was issued and thus before the tax lien attached; the rental income was proceeds of that property, which pre-existed the tax lien.
The impact of this decision beyond the Seventh Circuit remains to be seen. However, after a long line of decisions extending the choateness doctrine to permit federal tax liens to usurp prior perfected liens and security interests, secured creditors should welcome the ruling. If you have any questions related to enforcing the rights of creditors, please do not hesitate to contact the lawyers of Rubin & Levin, P.C.