Why Landlords Should Avoid Prospective Tenants with Tax Liens

tenantby Thomas C. Lawson, CFE, CII

Of the literally millions of tenant screening credit reports handled by our office since 1980, none are so confusing as those where the tenant has excellent credit, but a great big nasty Federal or State tax lien filed against them. We have been asked the question a thousand times:

“Why didn’t you tell me not to lease my rental unit to that beautiful lady who your tenant screening report said: ‘has great credit but an outstanding tax lien’?”

What most landlords do not understand about a Federal or a State tax lien is that lien priority; meaning the person or entity that has the primary legal right to a person’s property, assets, cash, etc., defaults to a little known test called the “choateness test.”

This is a basic test to determine who has the right to seize or liquidate the assets of a tax payer in order to satisfy the lien. For legal and tax laypersons, you may consider the term choate or choateness in this context virtually the same as the term established and/or perfected.

As stated in the IRS’s Revenue Agent Training Manual, “…the choateness test follows the general rule for resolving lien priorities in that the lien that is “first in time” is “first in right.” A Federal tax lien for example is choate as of the assessment date, not the filing date.

You may be thinking that local statutes establish your lien rights as a landlord once tenancy is established; but where you are incorrect is in the context of competing tax liens.

It is pretty clear that if you learn of an existing Federal tax lien though a prospective tenant’s credit report, that lien is already choate. Thus, whatever local statutory landlord lien rights are established by virtue of the tenancy, are mooted by that lien because the lien came before the proposed tenancy.

That’s not to say that if a lien is filed after the date that the tenancy started, that your lien rights as a landlord are automatically perfected and you have nothing to worry about. You still have to perfect your lien rights if you expect to successfully compete with other holders such as the IRS.

Even though the term choate primarily relates to competing State tax liens versus Federal tax liens, the rule of thumb for any competing lien is that it becomes choate when the identity of the lien holder, the property subject to the lien, and the amount of the lien are established. That is easier said than done in the landlord/tenant context and here’s why:

In the case of United States v. Scovil, 348 U.S. 218 (1955), the Supreme Court held that the landlord did not have a choate lien until the landlord recovered a judgment. Prior to obtaining a judgment, the landlord’s lien was in choate [unperfected] because the amount of the secured debt was not certain, i.e., the secured debt could increase as time progressed and the secured debt could be reduced (potentially) by the landlord’s breach of contract [if so breached].

How does this affect you if the tenant is paying the rent on time and gives me no trouble?

Under the law, once a tax lien (specifically) is choate all title to the property of the taxpayer legally inures to the lien holder and the race is on to recover the assets in order to satisfy the lien.

That means technically that all of the assets of the tax payer become the property of the taxing authority until the lien is satisfied. So if the tenant is paying rent to you after the lien is choate, that tenant is essentially paying the rent with the lien holder’s money and they have the legal right to get it back. Guess who they are going to take it from — the landlord!

Because of this fact, savvy landlords periodically re-check the tenant’s credit report to see if any liens have popped up since the tenancy started because, to date, after 32 years serving thousands of landlords, we have yet to see properly perfected landlord lien rights.

What we do see is a damaged landlord who just gave the last “X” number of month’s rent to the IRS for a tenant who the landlord accepted with a tax lien identified in the credit report. The consistent fact in those cases has been the landlord’s attorney telling the landlord to, “just pay it” because you didn’t establish your lien rights.

If a Federal or State tax lien exists prior to the date of the establishment of the tenancy, that lien (or liens) takes priority and you could be required to pay all of the rent that the tenant will pay you to the tax authority that holds the lien.

Once a Federal or State tax lien is discovered on a prospective tenant’s credit report, run, don’t walk away from that prospect and find another tenant! If a tax lien pops up in a periodic review of a tenant’s credit report, immediately establish your lien rights, or the tax authority could moot local or state laws that establish your landlord lien rights and take from you at the very least, the rents paid to you from the date that the new lien became choate.

In summary, tax liens, are a very bad thing for landlords and those prospective tenants who have them need to be avoided like the plague!

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