Below is an article written by Michael Yellin for the New Jersey Law Journal. Yellin is a member in the Litigation Department and Real Estate Special Opportunities Group at Cole Schotz in Hackensack.
Issues Plaintiff Must Consider Before Resolving a Commercial Foreclosure Action
There are five financial issues that every plaintiff must consider before resolving a commercial foreclosure action. But a simple case law search makes clear that many clients are either uninformed of, or indifferent to, the consequences of ignoring these issues. Each issue is addressed in turn.
1. (Unnecessary) Sheriff’s Fees
By the time a foreclosure action is nearing completion, many commercial plaintiffs have grown impatient with the deliberate foreclosure process that is, for better or worse, designed for residential matters. As a result, when a foreclosure is nearing its end, many plaintiffs urge counsel to obtain a sheriff’s sale date as soon as possible. And while that may often be the best course of action, a patient plaintiff can avoid substantial and unnecessary sheriff’s fees in certain circumstances.
Pursuant to N.J.S.A. 22A:4-8, when property is sold at a sheriff’s sale, the sheriff is entitled to a fee of 6 percent of the sale price on all sums not exceeding $5,000 and 4 percent of the sale price on any excess amounts, with a $50 minimum fee to be charged. Because foreclosed properties frequently sell for a minimum bid of $100, the Sheriff’s fee is often insignificant.
Where a hurried plaintiff can run into trouble, however, is when a writ of execution is issued to the sheriff, but the matter is subsequently resolved without the need for a sheriff’s sale. In such circumstances, the sheriff is entitled to “1/2 of the amount of percentage allowed” had the sale taken place. N.J.S.A. 22A:4-8. For example, suppose a plaintiff obtained a foreclosure judgment for $3.8 million and had a writ of execution issued to the sheriff. Before the sheriff’s sale took place, the parties resolved the dispute, with the defendant paying $2.4 million in exchange for a discharge of the mortgage. The sheriff would be entitled to half of the fee it would have obtained if the property had sold at a sheriff’s sale for $2.4 million (the settlement amount), or $48,050. See, e.g., Regency Sav. Bank, F.S.B. v. Southgate Corp. Office Ctr., 388 N.J. Super. 420 (App. Div. 2006).
To avoid a post-settlement dispute over which party is liable for such a fee, a plaintiff should account for the payment of any sheriff’s fees in the settlement agreement or, at minimum, consider the possibility and implications of a settlement being reached before having a writ of execution issued.
2. Realty Transfer Fee
If the settlement of a foreclosure will result in the plaintiff taking title to the property, the plaintiff must be cognizant of potential liability for realty transfer fees. Upon the recording of a deed in New Jersey, a realty transfer fee must be remitted based on the amount of consideration paid for the property. See N.J.S.A. 46:15-7 et seq. A fee schedule setting forth the amount owed at various levels of consideration can be found on the Division of Taxation’s website.
Upon the recording of a sheriff’s deed, the “consideration” from which the realty transfer fee will be calculated is based on the sum of: (1) the amount bid for the property at the sheriff’s sale; plus (2) the remaining amount of any superior mortgages, as well as most remaining liens or encumbrances, to which the purchaser remains liable. Thus, if a plaintiff makes a winning $100 bid at the sheriff’s sale, but takes the property subject to a $1 million senior mortgage, the realty transfer fee will be calculated based on consideration of $1,000,100.
Parties to a potential deed-in-lieu of foreclosure (DIL) exchange should also be cognizant of statutory requirements and exclusions. If a lender discharges a mortgage in exchange for the DIL, and there is no other consideration for the exchange, there will be no realty transfer fee. See N.J.S.A. 46:15-10(c). If, on the other hand, the mortgage is not discharged (or other consideration is exchanged), a realty transfer fee must be paid at the time the DIL is recorded.
3. Mansion Tax
Although included in the realty transfer fee statutes, the “fee for the transfer of certain real property,” N.J.S.A. 46:15-7.2, is independently known as the “mansion tax.” The mansion tax is equal to 1 percent of the entire consideration for the purchase of certain types of real property, if the purchase price exceeds $1 million. Specifically, the mansion tax applies to the transfer of property classified as Class 2 (residential) and Class 4A (commercial), in addition to certain other types of property specified in the statute. Much of the discussion set forth above for the realty transfer fee is also pertinent to the analysis of the mansion tax. As with most things, however, the devil is in the details, and those details can have significant consequences. For example, if the consideration paid for an eligible property is exactly $1 million, there is no mansion tax. On the other hand, if the consideration is $1,000,001, a mansion tax of $10,000.01 will be owed.
Practitioners should also be aware of N.J.S.A. 54:15C-1, which imposes a 1 percent tax on the “sale or transfer for consideration in excess of $1,000,000 of a controlling interest in an entity which possesses, directly or indirectly, a controlling interest in classified real property ….” Thus, selling an interest in an entity owning applicable real property, rather than the property itself, will nonetheless trigger application of the mansion tax.
4. Bulk Sales
Under New Jersey law, if a business makes a “sale, transfer, or assignment in bulk of any part or the whole” of the business’s assets, the transaction will be subject to New Jersey’s Bulk Sale Law, N.J.S.A. 54:50-38. Specifically, the law requires the purchaser, assignee or transferee of the business’s assets to provide certain notice to the Division of Taxation at least 10 business days in advance of the transaction. If taxes are owed, the Division of Taxation will advise the purchaser of a required escrow that must be established with funds withheld from the purchase price, pending resolution of the tax deficiency. If the purchaser fails to provide the Division of Taxation with the proper notice of a bulk sale, or fails to establish an escrow account upon request, the purchaser will be jointly liable for the payment of all of the seller’s tax deficiency.
Although a sheriff’s sale is not subject to the Bulk Sale Law, a DIL exchange may be subject to aforementioned requirements. The Division of Taxation has specifically noted on its website that a DIL will be considered a bulk sale if the “property is or has been used for income producing purposes.” Thus, despite the fact that a foreclosing plaintiff can avoid the Bulk Sale Law by completing the foreclosure process, the plaintiff may still need to comply with the law’s requirements, prior to accepting a DIL.
5. Tax Implications of the Settlement of Recourse vs. Non-Recourse Loans
A plaintiff negotiating the settlement of a foreclosure action should be mindful of the tax implications for the borrower of settling recourse versus non-recourse loans. With non-recourse debt, a sheriff’s sale/DIL exchange is typically treated for tax purposes as a sale of the property to the lender, in exchange for the outstanding balance of the debt. The borrower may have a capital gain or loss based on the difference between the amount of the debt and the adjusted basis of the property. For example, the foreclosure of a $12 million debt, on a property with a fair market value of $11 million, with an adjusted basis of $8 million, would result in a capital gain for the borrower of $4 million (the difference between the $12 million debt and the property’s $8 million adjusted basis).
With a recourse loan, the sheriff’s sale/DIL exchange may result in a combination of capital gain/loss and cancellation of debt income. Typically, such a foreclosure/DIL exchange will be treated as a sale by the borrower to the lender for the property’s fair market value. Using the above example, the fair market value ($11 million) exceeds the tax basis ($8 million), which would result in a capital gain of $3 million. At the same time, if the lender agrees not to pursue the borrower for the balance of the loan, the borrower will be deemed to have cancellation of debt income equal to the difference between the debt discharged and the fair market value of the property. Using the above example, the borrower would have $1 million of cancellation of debt income ($12 million debt less the $11 million fair market value). There are a number of exceptions and exclusions to these general tax rules that are beyond the scope of this article.
In summary, before resolving a commercial foreclosure action, a plaintiff should be mindful of the potential fees and taxes that may result. Proper planning can avoid significant and oftentimes avoidable liabilities.