Constitutional Questions about Tax Lien Foreclosures.

• Author: Alexander, Frank S.

As more and more local governments consider bulk sales and securitization of delinquent tax liens, constitutional questions remain about the enforceability of the liens. This article addresses some of those questions surrounding tax lien foreclosures and looks for a solution to the problem.

There are more than 150 different systems in use today for collecting property taxes in the U.S. Most states have at least two entirely different approaches for enforcing payment of the property tax. Other states leave the enforcement of the property tax to local governments, creating little consistency in procedures across a state.

There are no uniform laws on enforcement of property tax liens, and few title insurance companies will insure title derived from a tax sale. Federal courts have historically stayed away from issues involving the administration of property taxes, and state courts routinely have set aside tax sales, insisting on exact compliance with statutory procedures.

Background

After centuries of deference to state autonomy in the field of property tax collection, the U.S. Supreme Court in 1983 confronted the deceptively simple question of the application of due process notice requirements to the foreclosure of a property tax lien. In Mennonite Board of Missions v. Adams, Elkhart County, Indiana, conducted a routine tax foreclosure, publishing notice of the pending sale once a week for three weeks in accordance with state law. Following completion of the sale, the purchaser initiated an action to quiet title, necessitated in all likelihood by its inability to obtain title insurance based on a tax sale. In this subsequent proceeding, a lender which held a properly recorded mortgage on the property challenged the adequacy of notice to it by publication. The Supreme Court held that the Fourteenth Amendment guaranty of due process requires that a government conducting a tax foreclosure sale provide notice to a mortgagee of the pending foreclosure sale.

Confirming what most title insurance companies had suspected for decades, this decision of the Supreme Court cast into doubt the majority of property tax lien and tax sale procedures used throughout the country. Though the particular holding on the facts of the case was clear, the application of the holding has been subject to a wide range of interpretations. Reluctant to create bright lines of universally applicable rights and duties, the Court concluded that a party holding a "legally protected property interest" whose name and address are "reasonably ascertainable" based upon "reasonably diligent efforts" is entitled to notice "reasonably calculated" to inform it of the proceeding. This open textured rule of law has left for further debate four related questions: 1) What events, or stages, in a property tax enforcement proceeding give rise to the requirement of adequate notice? 2) What property interests are entitled to more than notice by publication? 3) How is the existence of the interests to be ascert ained? and 4) What efforts are required in order to identify accurate addresses of the interested parties?

This lack of clarity about the constitutional requirements applicable to property tax foreclosure procedures profoundly affects the social and financial stability of local governments. Ineffective and inefficient procedures encourage tax delinquency and the abandonment of inner city properties. Local governments are beginning to sell, or "securitize," in bulk transactions large volumes of delinquent tax liens. The dilemma is simply whether the financial markets, or bulk tax lien purchasers, appreciate the constitutional questions, which may taint the enforceability of the underlying tax liens.

Collection of Delinquent Taxes

Within the past few years, local governments have begun to view their delinquent tax digests as potential assets rather than administrative burdens. There are three reasons why a delinquent tax lien may be attractive to an investor in today's market. The first is that in all jurisdictions the property tax lien is accorded the status of being the first lien in priority of claims against the property. This permits the holder of the lien to enforce the lien and receive payment prior to payment of any and all other claims against the property, including all mortgages. The second is that delinquent taxes carry substantial penalties and rates of interest, all of which accrue to the benefit of the investor from the date of its purchase of the lien. This could provide rates of return from a minimum of 12 percent to in excess of 40 percent.

The third reason is that local governments are increasingly being granted authority to enter into negotiated bulk sale transactions, in which large volumes of a delinquent tax digest are transferred to an investor, frequently at a discount from the face value of the liens. Purchasing the liens at a discount further increases the effective yield received by the investor when the face amount of the accrued taxes, interest, penalties, and costs are paid upon redemption or foreclosure sale. A variation on a bulk sale of delinquent tax liens is the securitization of the delinquent tax digest which is accomplished by selling the liens to a special purpose trust which then issues bonds to investors.

The first large scale securitization of a delinquent property tax digest occurred in 1993, when Jersey City, New Jersey, transferred approximately $44 million in delinquent tax liens. Since that initial transaction, Jersey City completed a second transaction in 1994, and other jurisdictions have quickly followed. These include New Haven ($23 million, 1995), Fulton County/City of Atlanta ($30 million, 1995), New York City ($250 million, 1996), Washington, D.C. ($50 million, 1996), Philadelphia ($106 million, 1997), and Puerto Rico ($400 million, 1998). Hundreds of other local governments are actively considering such sales. By 1998, more than $1.5 billion in tax lien securitizations had been completed or were in process. This conversion of tax lien receivables into instant funds for local governments has not been limited to large cities; both Arlington, Virginia, and Marlborough, Massachusetts, also have undertaken such transactions.

One of the most critical determinants in the willingness of a private investor to purchase a property tax lien is the validity of the underlying security. While the super-priority status of a property tax lien may be relatively assured, and it is possible for a potential investor to make an informed judgment about the lien-to-value ratio of a particular lien on a specific piece of property, a potential investor in a large volume of property tax liens faces two fundamental challenges which remain unresolved. The first concern is simply the wide diversity...