You’ve run up a tax debt – either through filing a tax return with a balance due or if the IRS computes a balance due – through the Substitute For Return procedure. As mentioned in a previous discussion once this happens the IRS is automatically granted a lien on all of your property.
OK but what if you have other debts that may be secured by property – for example a home with an outstanding loan, a car with related unpaid debt, etc. Does the IRS automatically “jump ahead” of others with claims on your assets? They do not – the IRS is not granted any extraordinary rights relating to your property. They may acquire a lien against all your property but they are behind existing liens.
A lien represents a claim against an asset. Borrowing in connection with buying a home or a car usually involves a lien. A lender agrees to loan money for the purchase of an asset – in return they receive your promise to repay the money and a security interest in the purchased asset – a lien against the property.
In order for the lien to have effect there must be some public record of the lien. For real estate the lien is recorded along with title to the land, for vehicles the title itself usually includes lien information. This provides public notice that you have ownership of an asset but a third party has a claim against the asset.
The lien related to a tax debt is referred to as a “silent lien”. Once a tax obligation has been recorded by the IRS (the tax assessment) the IRS is required to provide the taxpayer a notice of the debt and a demand for payment. If payment is not made within ten days the lien arises (effective back to the date of the assessment). At this point there is no formal notification of the lien – thus the term “silent lien”.
In order for the lien to be valid against an asset there must be a public notification. For this notification the IRS uses what they refer to as a “Notice Of Federal Tax Lien” (NFTL). For real estate the IRS will actually record public notice of the lien with the property ownership records – as a lender would in connection with the purchase of the real estate. Notice will also be filed with the town hall where the taxpayer resides and with the secretary of state of the taxpayers state of residence.
The NFTL filings are done at locations where a borrower usually conducts their search for existing liens against a taxpayers assets. A prospective lender usually conducts what is referred to as a “UCC” search. UCC refers to the Uniform Commercial Code – a standardized set of rules that govern business transactions. A filing by a lender under the UCC provides public notice of the lenders interest in property – this is the equivalent of an NFTL filed by the IRS. UCC statements are filed with the secretary of states office. Filing of the NFTL with the secretary ensures that third parties will be given notice of the IRS lien when third parties conduct a UCC search.
Once the NFTL is filed what rights does the IRS obtain? Simply stated the IRS obtains any and all rights you have to all your assets. This concept is know as “step in shoes” – the IRS steps into your shoes when it comes to your assets. This concept applies to assets owned by the taxpayer as of the assessment date as well as any assets acquired after this date – until the debt is satisfied.
Here’s a typical scenario. You purchase a house in year 1 – for $400k. In connection with the purchase you borrow $300k from a bank. The bank obtains a lien against the property. The lien is recorded with the property land record. You own 100% of the asset. However the lender has a claim against the property. In year 2 you incur a tax debt of $500k. Since you own the property does the IRS have a lien that would entitle them to 100% of the home’s value? No – since notice of the IRS lien occurred after notice of the bank lien the IRS claim to the asset is behind the bank. So in this example if the IRS forced a sale of the home and it sold for $450k at a time where the bank was owed $250k the IRS would have a claim to $200k. This represents the taxpayers equity in the property.
Once the NFTL is filed does this mean you need to pay off the tax debt in order to sell any of your assets? No – the purpose of the NFTL is not to “punish” the taxpayer – it is a mechanism to protect the governments interest in your assets – so that the taxpayer cannot dispose of an asset without consideration of the tax debt.
Let’s return to our example. Could the taxpayer sell the home for $450k – remember there are two liens agains the property – the lenders claim is $250k and the IRS is owed $500k. A buyer of the property will want to obtain title to the property free of all claims. Does the taxpayer need to pay the IRS $500k in order for them to discharge their lien agains the property? No – the IRS will allow for the property to be sold – provided that they obtain the $200k equity that remains after the lenders obligation is paid.
The lien that is obtained by the IRS can be thought of as a “blanket” that is put on all of the assets held by the taxpayer. The IRS will allow for an asset to be taken out from beneath the “blanket” (i.e. release their claim agains the asset) provided that they obtain all equity that remains after satisfaction of liens that have priority over the IRS lien – i.e. the lender in our example. The IRS steps into the shoes of the taxpayer – if the IRS lien did not exist the taxpayer would have an interest in $200k upon a sale of the house. Provided that the IRS receives payment of $200k they will allow for the property to be sold from under the “blanket” – i.e the buyer will obtain the property without the IRS claim.
A formal request needs to be made by the taxpayer to remove the property from the lien. Documentation needs to be provided relating to the proposed sale transaction – sale price, selling costs, outstanding claims ahead of the IRS, etc. If the proposed transaction results in the IRS being paid any equity after these items it will most likely agree to allow for title to be transferred without the IRS lien. Note that if the net proceeds exceed what is owed to the IRS they will only be paid what is owed – the taxpayer / homeowner would receive any excess.
What if the taxpayer does not want to sell the property but wants to borrow money and use the property as security for the new loan? If a new lien was created in connection with the borrowing it would fall behind the IRS lien in terms of priority. In our example there would be claims against the asset of $750k ($250k existing lender and $700k IRS). Since the property is worth less than the claims there would be no remaining equity for the new lender – they most likely would not make the loan.
However all is not lost. If the taxpayer agreed to give the IRS all funds generated in the new loan transaction they would most likely agree to have their claim “subordinated” to the claim of the new lender. Again the taxpayer / debtor would need to provide the IRS with financial information related to the proposed loan and provide that the IRS would receive the loan proceeds (up the amount of the tax debt) in order to agree to this subordination.
The key concepts to remember in any lien situation – the lien is not meant as punishment; it’s intended to preserve the governments interest, the government has no interest in owning your assets; they want cash, and, if a transaction is proposed by the taxpayer the government will most likely allow it provided that their claim to the asset is satisfied.
In our next blog post we’ll discuss Payroll Tax Debt.
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Link to Outline Slides: Outline – Lien Priorities
Link to Video: Video – Lien Priorities