During a foreclosure, understanding lien priority is critical, since it determines who gets paid first – and who might not get paid at all. Most unpaid construction parties have the right to file a mechanics lien claim on the property. But that doesn’t always guarantee payment. There are different types of liens, and some are more powerful than others. If you didn’t know, there’s a general order for handling liens, though each state has its own guidelines. Here’s a look at how tax liens and mechanics liens are typically paid in the event of a foreclosure.
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What is a tax lien?
A tax lien is a lien filed against your property by the government. The government will use a tax lien to secure the money owed to them from unpaid tax bills. These bills can include property, income, or other federal taxes.
When the IRS sends you a tax bill, and you neglect or refuse to pay it, they’ll start tax lien proceedings. They begin the process by creating a public notice to warn other creditors about the non-payment and to assert the role as the chief creditor. The notice states that the IRS has a legal claim on your property.
At that point, the IRS has the right to seize the property and sell it for back taxes.
What is a mechanics lien?
We credit Thomas Jefferson with creating our modern idea of mechanics lien laws during the construction of the capital. A mechanics lien is a claim filed against a property, by a construction contractor, when they’re trying to recover cash for work performed or materials supplied. These liens help to ensure that a contractor gets paid for the work they’ve completed.
They’re also incredibly helpful at reducing the amount of time that it takes a contractor to get paid.
When a contractor files a mechanics lien, it generally attaches to the property, not a person. When a prospective property buyer, financing company, or other party does a title search, the mechanics lien will show. Generally, if that buyer decides to purchase the property, they agree to assume the lien and address it.
This is why mechanics liens are so effective at helping contractors get paid.
Mechanics lien vs tax lien: Who has priority?
In most lien scenarios, there’s a “first in time, first in right” standard. Liens recorded first are generally addressed (i.e. paid) first.
During a seizure or foreclosure of the property, the proceeds of the sale are distributed to the creditors. Since a mortgage is technically a lien, the lending company would appear to stand first in line to get paid. The mortgage is typically created before construction would begin on the property.
If you think the government is going to wait politely in line, think again. The government’s tax lien has priority – Uncle Sam always get paid first.
After the government, typically, the original mortgage will get paid next. After that, mechanics liens and second mortgages are the next in line, but the order depends on the state’s rules.
Why lien priority matters in construction
In a foreclosure action, the property is sold and the proceeds are used to satisfy the outstanding debts. Depending on how much the liens add up to, there could be little to no money left after the government and mortgage companies take their share.
Before you enter into a contract on a project, it’s important to pre-qualify the project to be sure that there are no tax liens already. If there are, you’ll be starting off at a disadvantage. Should the time come when you need to file a mechanics lien, you’re not likely to recover much cash if the IRS seizes the property.
It’s also important to understand where mechanics liens generally fall in the order of payment if you’re considering filing one. If you’re having issues getting paid, you should file a mechanics lien as soon as possible.
In some states, all mechanics liens relate back to the start of the project, so it doesn’t matter whether you’re the first or last contractor to file. In others, construction liens have priority in the order in which they’re filed, so the early bird gets the payment worm.
But one thing is for certain: An unpaid contractor who files a mechanics lien will always be in a better position to get paid than a contractor who doesn’t.
If there’s a payment issue on a job, filing a mechanics lien can speed up the process. If filing the lien doesn’t get your company paid, you need to act upon the claim. Hopefully, you’ll be able to get in, get paid, and get out before any further issues arise.
Acting fast can make the difference between getting paid or waiting for the scraps after the government takes their piece of the pie, or more likely, the entire thing.