The Seventh Circuit recently decided that a mortgage that assigns future rental income to the mortgagee creates a security interest that takes priority over a federal tax lien.  Bloomfield State Bank v. United States, No. 10-3939, 2011 WL 1773953 (May 11, 2011).  A bank made a loan secured by the borrower’s real estate, along with all rents derived or owned by the borrower directly or indirectly from the real estate.  After the borrower defaulted on the loan, a state court appointed a receiver to administer the borrower’s property.  The receiver rented some of the property and collected more than $80,000 in rent.

After the bank recorded its mortgage, but before the receiver collected any rents, the IRS filed a tax lien against the borrower’s real estate.  The IRS argued that its lien on the rental income took priority over the bank’s lien pursuant to the Federal Tax Lien Act, which provides that a security interest takes precedence over a federal tax lien only if, when the security interest is acquired, “the property is in existence and the interest has become protected under local law against a subsequent judgment lien arising out of an unsecured obligation.”  I.R.C. § 6323(h)(1) (emphasis added).  The IRS reasoned that because the receiver had not yet rented the property when the IRS filed its lien, the rental income did not exist at that time and, therefore, could not be property in which the bank had perfected a security interest.

The district court entered summary judgment in the IRS’s favor in a declaratory judgment action, but the Seventh Circuit reversed.  The Seventh Circuit concluded that the relevant property at issue was the real estate in which the bank had a security interest.  Because that property unquestionably existed when the IRS filed its lien, and because the bank had already perfected its security interest over that real estate, the bank had priority over the IRS.  In reaching that conclusion, the Seventh Circuit reasoned that the bank would undoubtedly have enjoyed priority over the IRS had the receiver sold the property, and “[s]ale income and rental income are just two forms of proceeds from land . . . .”

This is the first decision from a federal appellate court to interpret priority in future rental income.  United States district courts and bankruptcy courts have reached conflicting conclusions.  The Seventh Circuit’s opinion is a significant victory for secured lenders, but stay tuned for future developments.