Recent Developments
Chris Burti, Vice President and Legal Counsel

Proposed Ethics Opinion 99-5

This proposed ethics opinion would rule that an attorney, who makes an appropriate disclosure to the new lender and the borrower, would not be ethically required to cancel a deed of trust satisfied at the closing. The basis for the ruling is the right of the attorney to limit their representation of the client. The opinion seems correct as far as it goes. Arguably, the opinion does not go far enough. The opinion requires attorneys to advise clients and lenders if the attorney does not intend to cancel the existing instruments. The opinion does not address how much information the disclosure needs to include. A literal reading of the opinion may only require that the disclosure indicate that the representation is limited and does not include cancellation. The opinion only goes as far as stating that the attorney must "explain the limits of her representation sufficiently to allow the borrowers to make reasonably informed decisions about the representation" This statement gives us no guidance, whatsoever, as to what the explanation should cover to be deemed sufficient.

It should be clear that that uncanceled deeds of trust would make the title unmarketable if it can not be proved that they have been fully satisfied. As time passes and lenders are consolidated it becomes increasingly difficult to determine if uncanceled instruments are satisfied. This will also make it increasingly difficult for title insurers to insure over these matters. Of even greater concern would be uncanceled equity line deeds of trust. Raintree Realty and Construction, Inc. v. Kasey, 116 N.C App 340, 447 S.E.2d 823 (1994) is a classic horror story involving the difficulty of canceling this type of instrument and the disastrous result of failing to do so. If the client is purchasing property and the payoff is insufficient, the seller could continue to use the account, default and subject the property to foreclosure.

The opinion requires disclosure to the borrower and the lender. Under the exclusions from coverage set out in the 1992 ALTA policy forms, the insured can not recover for "Defects, liens, encumbrances, adverse claims or other matters . . . created, suffered, assumed or agreed to by the insured claimant." Arguably, accepting the limited representation contemplated by the opinion would preclude recovery from the Title Company for the problems discussed above. The inquiry and response seem to assume that a title policy will protect the borrower and lender but this may not be the case. The opinion does not address the attorney’s responsibility to the Title company. Most companies use a commitment requirement that calls for cancellation of outstanding deeds of trust. Many companies will issue the policy before cancellation based upon the attorney’s assurance that it will be canceled. This would clearly require further disclosure to the company. Because of the exposure created by the holding in Raintree, it would extremely risky for the Title companies to insure over uncanceled instruments.

If these and other similar issues are clearly explained to the client, it would not seem prudent for a borrower or lender to accept the limited representation. If this assumption is correct, it would not seem to be proper to recommend such action to a client.

The proposed opinion does provide that if the attorney charges for cancellation or charges a ‘payoff processing fee’ the attorney "may not close the file until the deed of trust is canceled of record." The opinion also requires the attorney to pursue the cancellation with reasonable diligence and promptness in such cases. There has been some discussion within the real property bar as to whether the closing attorney is responsible for cancellation. Most real property attorneys we have discussed the issue with strongly believe this to be the standard of practice. The proposed opinion clearly makes this assumption if there is no disclosure of "limited representation".

The obvious inference is that clients are not well served by cutting corners. As the difficulty in canceling instruments increases, attorneys should charge accordingly for this important service. In the end, the clients will save money and better protect their investment in their property.

Editorial Comment: Title companies are increasingly being asked by attorneys to insure over record defects that can be, and should be, corrected. In the past, many of these defects were automatically cured by the attorney as part of their clients’ representation. Due to competitive pressures, some companies comply with these requests when they formerly would have refused. If this process continues to expand, it begs the question of why search records at all if companies are going to insure all defects anyway.

The answer lies in the fact that North Carolina consumers enjoy one of the lowest claims rates and one of the lowest cost of title assurance (title premium plus attorney’s fees). The major difference in this state is the direct involvement of attorneys in the title examination process. In other states, where attorneys have abdicated title assurance responsibility to the Title companies, the cost to the consumer has increased dramatically. Unfortunately, with this increase in cost has come a corresponding increase in problems that have to be dealt with and title insurance does not compensate an insured for time, stress and aggravation.

As the complexity of closing real property transactions increases, the attorneys’ fees should increase in reasonable proportion. If closing attorneys are fairly compensated, they will not be tempted to limit representation and the client will benefit both economically and emotionally.

Proposed Ethics Opinion 99-6

This opinion if adopted would authorize attorneys to own title agencies providing that they did not render an opinion on title for policies issued by the agency on land in this state. The Ethics committee declined an opportunity to give specific guidance on the level of supervision required to ethically use independent abstracter. The Committee did say that a thorough screening including interviews with an evaluation of the abstracter’s education, experience and work history would not satisfy the attorney’s duty to properly supervise.

The consumer protection committee of the North Carolina Bar Association requested the Ethics Committee to adopt guidelines for attorneys concerning adequate supervision of non-attorneys in title examinations. This attempt to restrict the circumvention of consumer protection laws was not supported by the Ethics Committee.

Editor’s note: If independent paralegals start entering pleas in District Courts all over the state under the "supervision" of an attorney hired by a Bail Bondsman in Charlotte, we can expect much more support from the committee. This is not a likely occurrence since the judges will not permit it but it is a fair analogy.

More on HB 979, Intestacy Revision

We have previously written on the pending rewrite of the intestacy statutes. One concern about the revision is the potential for inclusion in the elective share of gifts made prior to marriage. It could include gifts made prior to marriage if decedent passes within three years of the wedding. A typical situation would occur when a widower conveyed property to his children subject to a reserved life estate, subsequently married and died within three years of the gift. Under the revised statute, the elective share would include such real property counted in the total net assets and the children might have to provide recovery if they could not pay. This result was probably not intended but it could present real problems if the bill is passed without modification. At this time Representative Baddour is working to modify the bill to exclude gifts made prior to marriage. Hats off to Paul Welch for pointing out the problem.

Vacation Property: Is it Investment Property?
John F. Murphy

(Note: This article is the second of three reprinted with the permission of the American Federation of Exchange Accommodators. All three will address various issues pertaining to IRS Section 1031 tax deferred exchanges)

I asked the following question last October at our Las Vegas meeting: Does vacation property qualify as investment property?

Section 1031 provides for the non-recognition of gain upon the exchange of "property held for productive use in a trade or business, or for investment, if such property is exchanged solely property of like kind which is to be held either for productive use in a trade or business or for investment."

While you can find examples of what qualifies as trade or business or investment property, you won’t find a definition of these terms. What then is a "vacation" property for purpose of 1031? Is it an investment property?

Three requirements must be satisfied in order to qualify for tax deferral under Section 1031: (1) the transaction must be an exchange; (2) the exchange must involve like-kind properties; and (3) both the properties transferred and the properties received must be held either for productive use in a trade or business or for investment. Sec. 1031(a)-1(a) and (c), Income Tax Regs. Brauer v. Commissioner, 74 T.C. 1134, 1139-1140 (1980).

The answer to the question of whether "vacation property" might qualify as "investments property" or "like-kind" will most likely be found in Reg. 1.1031(a)-1(b) under definitions of "like kind", which states "(u)nproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale."

While my fifth grade English teacher might have criticized the grammatical context of this sentence, it seems to state that property held for appreciation in value by one who is not a dealer is investment property.

The language of this regulation, originally proposed on May 29, 1956, was adopted on November 6, 1956 by T.D. 6210, and has remained unchanged since that time. Written by the Internal Revenue Service, it amounts to substantial authority for purposes of penalty assessment as provided for under Reg. 1.6661-3(b)(2). It would help if one could find a clear meaning of the term "unproductive real estate," but a search reveals no authoritative interpretation of its meaning.

The rules of statutory construction point us in the direction of reviewing other code sections, regulations, legislative comments, court opinions, administrative comments, etc., to help determine the meaning of the term; and if that search provides no help in determining the meaning of the term, then the plain meaning as might be found in Webster’s or Black’s Law dictionaries may very well be the source of the answer to this question. Statutes, 73 Am Jur 2d.

A search of the Tax Analysts CD tax code, regulations, revenue rulings, and private letter rulings uncovers no definition of the term "unproductive real estate." A search of the tax case law does not reveal its meaning either.

In Private Letter Ruling 8103117, the service did allow for Section 1031 treatment where that taxpayer intended to acquire property for personal enjoyment and as an investment. As stated in this P.L.R., "(t) he house and lot you acquire in this trade will be held for the same purposes as the properties exchanged therefore: to provide for personal enjoyment of the community and to take a sound real estate investment."

A plain reading would seem to support the argument that "personal enjoyment" of a property does not prevent it from being able to benefit from the provisions of Section 1031.

Often times individual taxpayers, as well as their advisors, are fearful of taking a position that is not clearly delineated in the tax rules. They do not want to fight the giant.

However, it should be remembered that taxing statutes conferring authority to impose taxes are to be strictly construed. "When statutes are so drawn that their…intent is in doubt… then it is the duty of the courts when litigation arises, to construe such statutes or ambiguities liberally in favor of the taxpayer or citizen against the tax authority." 71 Am Jur 2d Supp., 8 tax Statutes. The same rules apply to ambiguous regulations.

It should also be remembered that the legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether to avoid them, by means which the law permits us well recognized, 71 Am Jur 2d, 7. Evasion or avoidance of tax.

The fact that a property does not produce current income does not preclude the property from being treated as "investment property" as stated by the United States Tax Court in Ray v. Commissioner, Docket Tax Court No. 36379-85 (Nov. 27, 1989). Such a finding would merely preclude the current deduction of expenses under Section 212, Expenses for production of income. Further limits of current deductions can also be found under section 183, commonly referred to as the hobby loss provisions; Section 280A, Disallowance of certain expenses in connection with business use of the home, rental of vacation homes, etc,; and Section 469, Passive activity losses and credits limited, to cite a few loss limiting provisions.

While these cited sections limit the annual losses that might be taken in any one year, they do not prevent a property from being classified as "investment property."

While Section 1221 defines "capital assets," it does not explicitly define "investment property." Rather, it defines capital assets in terms of what is not a capital asset. Since a vacation property is not excluded, one could reasonably conclude that a vacation home must be a capital asset.

Perhaps Black’s Law Dictionary, 6^th Edition, will provide an answer to the question of "unproductive real estate."

The nearest term that can be found was "produce" in the form of a verb, meaning "to yield, as revenue." From an accounting or tax sense I would think in terms of producing income, or in the negative, not producing income, as a reasonable meaning of the term "nonproductive real estate." Since a vacation property, used personally, would not produce income but could be an appreciating asset, it would seem to fit within the term as defined under the regulation.

For the less adventuresome, a private letter ruling request might be considered. Under Rev. Proc. 98-1, the user fees for such an application could range as little as $500 up to about $3,650, depending upon the gross income of the applicant. The application process would take about three to four months before an answer is given.

What’s the Big Hurry?
NC Bar Association

(Printed with permission from the North Carolina Bar Association Real Property Section Annual Meeting)

Scope: Discuss residential mortgage lending process-application, processing, underwriting, and closing, plus why some closing packages arrive day of closing and future trends in the mortgage industry over the next 12-18 months.

Application: REALTORS and lenders prefer for prospective homebuyers to contact their lender and pre-qualify over the phone or in person before starting the house hunting process.

The actual loan application may take place in person, either at the lenders office, by mail, by FAX or by telephone. Most lenders will use their PC or laptop computer so the application may be transmitted electronically to their home office.

The applicant should bring the following to application: Offer to Purchase, pay stubs,

W-2 forms, tax returns if self employed, and bank statements.

Credit reports are pulled up during the application meeting so any problems may be discussed on a timely basis.

Many lenders, using Freddie Mac "Loan Prospector", will be able to, electronically, obtain loan approval within 15-30 minutes after the loan application is complete.

Processing: Loan documents are sent, via UPS, to a specific Loan Counselor. The Appraisal is ordered within 24 hours after receipt of the package. It is presently ordered by FAX to the appraiser chosen by the loan officer. We require it to be returned via UPS "next day delivery". Review and underwriting of the appraisal will take 2-3 days.

The counselor will make an introduction telephone call to the buyer, reviewing any documents needed for final loan approval and discussing closing arrangements.

The counselor will maintain communications with the buyer and loan officer during the time up to when the closing package is sent to the Closing Attorney. Any documents needed at closing (HUD-1 on present house, 1^st pay stub, etc.) are discussed with the buyer in order to eliminate problems at closings.

Underwriting: All FHA and VA loans and some conventional loans will need to go to the lenders underwriting department for final loan approval. Turnaround time is usually only 2-3 business days.

The results are communicated to the buyer, loan officer, and Realtor on a timely basis.

Closing: Several weeks prior to closing we will fax the title order to the Closing Attorney. The final closing package is sent, via UPS, to arrive at the Attorney’s office 2-3 days prior to closing. We do our best to keep the package from arriving on the date of closing, but there are rare instances where this is the best we can do.

Why:

Loan Officer did not set a realistic closing date

Appraisal came in late or value was less than sales price. Therefor, the price may need to be renegotiated.

Loan was slow going to Underwriting or Underwriting has questions or concerns that must be satisfied prior to releasing the package.

Homebuyer changes loan amount or closing date without consulting the lender.

Homebuyer is late submitting required documents that were requested early in the Application/Processing process.

After closing, the attorney is expected to return the closed loan to the lender within 2 days. The lender will review the package, and if necessary, send specific papers to FHA and PMI companies for mortgage insurance or VA for guaranty.

The Next 12-18 Months: Appraisal-The lender will E-Mail the appraisal request to the appraiser and the appraisal will be returned via e-mail. Lender will use Automatic Underwriting to reduce the review down to 1 day. Also, if the LTV is 65% or less, an appraisal may not even be required.

Underwriting-More lenders will use Freddie Mac "Loan Prospector". Homebuyers then will be able to learn of loan approval much quicker than in the past.

Closing-Lenders will become clients of attorneys with all closings from a specific lender being handled by 1 or 2 attorney firms. Note the growth of financial service companies such as GE, GMAC, and Cendant who will start to control large chunks of business. The growth of E-Commerce will see major lenders moving towards using the Internet to order & confirm title work. This may be done through Title Companies or direct to the attorney. Lenders will look for attorneys who are able to receive a closing package electronically, possibly through the Title Companies.