Understanding the Legal Effect of Federal Tax Liens When Selling, Refinancing, or Purchasing Real Property

By: Elizabeth Gonsalves, Esq.

Taxpayers owing balances to the IRS in excess of $10,000 for past tax years could have a Notice of Federal Tax Lien filed against their social security number or property. The legal effect of a Federal Tax Lien is to give the federal government legal claim to your property as security or payment for a tax liability. A Federal Tax Lien should not be confused with a Federal Levy on Wages or Bank Account. You can learn more about the difference between these two by clicking on our Federal Tax Lien link on our Free Advice page. A Notice of Federal Tax Lien may only be filed after a liability is assessed, a Notice and Demand for Payment is served on you and, you fail to fully pay the debt within 10 days of being notified of the liability.

Once these requirements are met, a Notice of Federal Tax Lien can issue in the amount of your tax liability. The Notice is a way of publicly notifying creditors that the federal government has a claim against all of your property, even property you acquire after the lien is filed. A federal tax lien establishes the federal government’s priority, in relationship to other creditors associated with your account, for use during such proceedings as bankruptcy, and the sale of real or personal property, among others.

Federal Tax Liens can often have an adverse effect on a taxpayer’s credit, as it tends to show a significant creditor (the federal government) has not received funds owed. Federal Tax Liens often create problems for taxpayers either trying to sell a property, refinance a property, or purchase a property. Such transactions implicate possible sale proceeds, loan proceeds, or sums intended for down payments which might be routed to the federal government instead of the delinquent taxpayer.

In each of these transaction situations, the IRS may be willing to cooperate with taxpayers in a way that assists such transactions to process successfully. Of course, the IRS requires a taxpayer’s cooperation in return, as well. You can read more about Notice of Federal Tax Lien here.

Taxpayer Selling a Property Having a Federal Lien on Record
When a taxpayer is attempting to sell real property having a Federal Tax Lien filed against it, the IRS will consider Discharging the Federal Tax Lien to allow the property to be sold free and clear of the cloud on title. A Discharge of Federal Tax Lien releases the effects of the lien against one piece of property. The IRS requires that Form 14135 be prepared and submitted to the Lien Unit with accompanying documentation relevant to the sale. A discharge request will be reviewed for important pieces of information such as, whether the proceeds of sale will provide for some or all satisfaction of the tax liability. In situations where the proceeds are not sufficient to provide for payment of the tax liability, such as a short sale, the IRS may require information about any other property owned by the taxpayer that may be used to secure the government’s interest. To learn more about requesting a Discharge of Federal Tax Lien you may refer to IRS Publication 783 for more information.

Taxpayer Refinancing a Property Having a Federal Lien on Record
In circumstances where a taxpayer is attempting to borrow funds by using collateral having a Federal Tax Lien on record, such as refinancing a property, the federal government may be willing to subordinate the lien in favor of the lender to assist the taxpayer in receiving the loan. A lien subordination involves making the federal lien secondary to another lien, such as that which would attach to property in circumstances where refinancing is approved. Similar to a Discharge request, the IRS would require information about the proceeds of such a loan and whether any sums could be used to pay all or a part of the tax delinquency on file. IRS Form 14134 is used to request a Lien Subordination and requires the inclusion of documents relevant to the transaction for approval. To learn more about Lien Subordination requests, you can read IRS Publication 784.

Taxpayer with a Federal Lien on Credit History Attempting to Purchase a Property
In situations where a taxpayer is attempting to purchase a property, having a Federal Tax Lien on a credit report often upsets the Purchase Money Mortgage loan approval process. Banks typically require a showing that any outstanding federal tax liability has already been accounted for in the form of a formal repayment agreement with the IRS. In other words, banks regularly require a showing that a tax resolution has already been established to account for debt to income ratios in evaluating a buyer for loan financing. While this may make sense from a lender point of view, we find this requirement counterproductive given the IRS Federal Tax Lien rules. Pursuant to Publication 785, and Revenue Ruling 68-57, where Purchase Money Mortgages or Purchase Money Security Interests are sought by a taxpayer having a Federal Tax Lien on file, the Federal Tax Lien is automatically subordinate and a request for Subordination of the Federal Tax lien is not required, nor will subordination be provided if applied for. This is true even in situations where the Federal Tax Lien was filed long before a Purchase Money Mortgage or Purchase Money Security Interest was approved and issued by a lender.

When a delinquent taxpayer attempts to purchase a home, has a Federal Tax Lien recorded against their social security number, and has not yet established a tax resolution with the IRS, a prospective lender that is not familiar with this rule will often require a showing that the liability is in a repayment plan, or has been satisfied in full. The problem here is that the IRS typically requires financial disclosure to approve a payment plan over time to account for back taxes owed. Financial disclosure involves a thorough review of your bank statements, including investment accounts, savings accounts, CD’s, etc. If the IRS is able to see that a taxpayer has sufficient funds to pay some or all of a tax liability owed (i.e., a significant sum of money sitting in a bank account intended to be used as a down payment for the purchase of a home) they will require immediate liquidation and payment on the tax balance, rather than a payment plan over time. Because the taxpayer intends to use that sum for a down payment, forfeiting such funds to the IRS will cause the purchase to fall through.

The fact is, a lender contemplating approval of a Purchase Money Mortgage for a taxpayer should simply approve the loan without requiring a payment plan with the IRS. First off, the Federal Tax Lien is secondary to the Purchase Money Mortgage by operation of law. Second, so long as the mortgage is reasonable, meaning the mortgage and utilities expenses do not exceed the national standard for Housing and Utilities as set forth by the IRS by county of residence, the housing and utilities expenses will be allowed. If the housing and utilities total an amount close to the national standard in your area, the IRS will accept a payment plan based on the taxpayer’s ability to pay, or disposable income, which is calculated after allowing the funds needed for the mortgage as a necessary living expense. You can check out the National Standard for Housing and Utilities in your county by number of people in your household here.

The concept behind Revenue Ruling 68-57 which renders a Federal Tax Lien automatically secondary to a Purchase Money Mortgage is that the taxpayer has acquired property or a right to property only to the extent that the value of the whole property or right exceeds the amount of the Purchase Money Mortgage.

Persons seeking to purchase a home are best advised to either resolve their outstanding tax liability owed to the IRS first, before significant sums are accumulating in a personal account, then take steps to purchase a home, or to provide a copy of Publication 785 to their lender for review by the lender’s underwriter. If you have an outstanding tax liability and plan to try to purchase a home soon, contact The Law Office of Elizabeth Gonsalves for assistance in negotiating the lowest possible payment plan first before you solicit lenders to purchase a home. We can assist you and help the transaction to run smoothly.