As a lender, it's your prerogative to learn as much as you can about a potential borrower's finances before you offer terms and finalize a loan. You get this information through due diligence, which involves searching for claims on the person or business's property.
Best practice for due diligence involves a four-part search of:
- UCC lien search
- Federal tax lien search
- State tax lien search
- Judgment lien search
Finding a recorded UCC-1 financing statement is relatively straightforward: you query the Secretary of State (SOS) where the property is located, or where the borrower is incorporated.
If there are liens on a borrower's real or personal property, including federal and state tax liens, you might not be the first party to get paid if the borrower defaults or files for bankruptcy.
Searching for tax liens comes with a few stumbling blocks. Creditors record state tax liens differently from one jurisdiction to the next, and if you’re not well-versed, you can make a costly lending mistake. Here are the tax lien search basics you need to know to ensure your interest is prioritized.
What is a tax lien?
A tax lien is an interest recorded by a federal or state government agency against a person or business's assets, including real estate, personal property, inventory, equipment, and financial assets. A government agency acquires a tax lien when it levies a tax against a party, which then fails to pay it on time. The Internal Revenue Service (IRS) or state records the lien against the debtor's property until they pay their tax liability in full.
What are the different types of tax liens?
- Federal tax liens filed by the IRS: This is the government's legal claim against a property when the debtor fails to pay a federal tax debt. A federal tax lien is recorded at the request of the IRS and cannot be discharged in bankruptcy.
- State tax liens: This is the state government’s legal right over a debtor's property to secure tax that is owed, typically state income or property taxes. The state's taxing authority files a lien against the debtor’s property when they fail to pay the amount owed. A state tax lien is recorded at the request of governmental agencies.
- County tax liens: This works similarly to state tax liens, and its application is subject to the state law. Each county has varying rules and regulations regarding the payment and lien certificates.
Why do tax liens matter?
An IRS tax lien usually takes priority over other creditors — even those who perfected their interests before the federal tax bill came due. State income and property tax liens also take precedence over other creditors in certain circumstances.
A tax lien differs from a UCC lien because a recorded UCC financing statement shows a borrower agreed to give a lender an interest in a particular property in exchange for a loan; it's a consensual lien. Tax liens, whether federal or state, are non-consensual. The borrower didn't agree to the government taking a security interest in their property.
In some cases, the debtor isn't even aware there's a tax lien against them. What does that mean for you? They wouldn't have disclosed it to you when applying for the loan. The likelihood of undisclosed tax liens is one reason why your due diligence must include state and local tax lien searches.
