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Irwin Law
Irwin Law, Lawyer
Category: Real Estate Law
Satisfied Customers: 7081
Experience:  Lawyer- Broker 30+years - foreclosure, short sale, liens, title attorney.
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Quot;Clogged Equity" Lender lends developer 100%

Customer Question

quot;Clogged Equity"
Lender lends developer 100% construction finance. Contractor builds 4 houses, at a cost of $200k each. Anticipated selling price is $240k (for a budgeted profit of $40k per house). Lender gets to buy one house at $80k, for a budgeted profit (to Lender) of $160k ( = $240k selling price, less purchase prive of $80k). That is the only return to Lender.
Non NY lawyer warned "beware of clogged equity".
First American Title advises in article: "Clogging issues should not NORMALLY arise in connection with contingent interest and shared appreciation loans because the mortgagor may redeem the mortgaged property from a subsequent foreclosure and pay off the loan."This is my requirement: please provide reference advising that the proposed profit share to Lender does / does not work in CO. No rush. Reference (i.e., court case authority) required for credit.
Submitted: 9 months ago.
Category: Real Estate Law
Expert:  Irwin Law replied 9 months ago.

You are saying that the builder is building four homes for a budgeted profit of $40,000 per house. That would be a total of $160,000 profit. However, one of the homes is to be sold to the lender for only $80,000 which means that on that one home the builder will lose $120,000. The remaining three homes, selling at $40,000 profit each returns $120,000 total. The builder's net profit/loss is zero. I don't know why any sane lender or contractor would do a deal like that; however, if you wish I'll do a few minutes worth of research on the topic if that's what you want.

Customer: replied 9 months ago.
Sorry. Lender gets to buy one house at $120k. Appologies for the error in math. Just in case I still got the math wrong, the idea is the lender and developer split the profit 50-50. Yes, please find a case which says that profit sharing loan CAN be done, because the Clogged Equity rule does not apply, or a case which says that this profit sharing loan SHOULD NOT be done, because borrower can repay principal back at any time thereby satisfying loan in full, leaving lender with potentially zero return.
Customer: replied 9 months ago.
Still got the maths wrong. Lender gets to buy one house for $160k.
Expert:  Irwin Law replied 9 months ago.

Okay. Lender buys the house for $160 K, sells it for $240 K. Net Profit $80,000. Contractor makes $140,000 on three homes, but loses $40,000 on the one sold to lender. Contractor' s net profit $100,000. So the prophet does not quite come out equal. Equity clogging is not a legal doctrine or rule. Equity of redemption simply refers to the right to repurchase a property that has been foreclosed on. The contractor's ability to pay off the mortgage at any time will not affect the bank's equity position in the one house. The law is very clear everywhere that provisions in mortgages that attempt to negate the borrower's statutory right of redemption (called equity clogging) are void. But in your fact situation, equity clogging is not an issue to begin with.

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Customer: replied 9 months ago.
Dear Irwin
You write the following: "But in your fact situation, equity clogging is not an issue to begin with."
Please provide a reference backing that up. The First American Title Insurance publication "Clogging Revisited" states that an normally IS CLOGGING:"Clogging issues commonly arise in connection with convertible mortgages. These are mortgages in which the mortgagee has an option to purchase the mortgaged property at some future time ...Several courts have held that the option feature of a convertible mortgage is unenforceable as a clog on the equity of redemption. In Barr v. Granahan, the Wisconsin Supreme Court held that specific performance of an option to purchase real estate would be inequitable and UNENFORCEABLE if the option were given without consideration other than making the loan and if the value of the property had greatly increased."When the lender lends the expectation is that the property's value will greatly increase, on account of the development carried out by the developer.Now that we know that in some states (e.g., Wisconsin) an option is unenforceable, what is the position in CO? The lender's right to buy one house at $160k is, I presume, an option (lender can't be forced to buy, so it must be an option).If your assersion is that the right to purchase a house at undervalue is not Clogged Equity, I ask that you back that up with authority from a CO court.Re math: contractor makes a profit on 3 homes of $120k ( = 3 x 40), then loses $40k on one home, for a net profit of $80k, which is the same profit made by lender.
Expert:  Irwin Law replied 9 months ago.

I must respectfully ***** ***** spend any more time on this issue, especially since you are asking for extremely detailed case law documentation which would require hours of research time. I look wish you best of luck in finding an answer that suits you, and I will opt out of this thread.

Customer: replied 9 months ago.
Thanks. I appreciate it is a lot of work. I am a good tipper!
Expert:  Irwin Law replied 9 months ago.

Perhaps this may shed some light on the subject; however, I am not going to read it yet, and I notice that it stops on p 5, and there is more to it, including a conclusion. http://files.ali-cle.org/thumbs/datastorage/skoobesruoc/source/CR047_12--Murray,%20J--Deeds%20in%20Escrow%20-%20March%2003_thumb.pdf

Expert:  Irwin Law replied 9 months ago.

Hello again. Do you have a follow-up question? I am not an employee of Just Answer and I receive credit for assisting you based on your rating. Please enter a positive rating for my assistance here by clicking on 3, 4, or 5, for which there is no additional cost to you. Thanks again for using JUST ANSWER.

Customer: replied 9 months ago.
Apologies. I had not realised you provided an answer. The question is this: A mortgagee gets an option to purchase part of the mortgaged property. Does the option amount to "clogged equity"? In some states, the option would not be enforceable, e.g., Wisconsin:"In Barr v. Granahan, the Wisconsin Supreme Court held that specific performance of an option to purchase real estate would be inequitable and UNENFORCEABLE if the option were given without consideration other than making the loan and if the value of the property had greatly increased."What is the situation in CO? Please support your answer with reference to CO case law. The value of the property is expected to increase, because the loan is a development loan.
Expert:  Irwin Law replied 9 months ago.

Please support your answer with reference to CO case law.

That requires a CO lawyer with CO case law data base. It also requires, the

exact loan document. Otherwise you can't tell an option agreement from an fee. One word in the right/wrong place change everything. It would be quite expensive and can't be done from here. Thanks for coming back. I'll take what's offered at this point.