Best Practices for Credit Bidding at Foreclosure

You currently hold the first mortgage on a rental property in California. The borrower is behind in payments to you and has disregarded all communications from you. You decide to file a notice of default to start the foreclosure process. Three months lapse, the sale has been set, the date of sale approaches, and you want to be strategic in deciding how best to proceed. You start asking yourself the following question: how much do I bid at the foreclosure sale?

As the foreclosing party, you are allowed to “credit bid”, meaning that you are able to bid as high as your note [including accrued interest, late fees, costs of foreclosure, etc.] without having to come up with actual cash at the sale. In California, other bidders, including non-foreclosing junior liens, must pay 100% of their bid in cashier’s checks or the equivalent. (As a side note, this is the reason most bidders will ask their banks for many cashier’s checks in varying increments, as the trustee handling the sale does not give back change at the sale. For example, if a bidder asks his bank for two $100,000 checks because he believes the bid will exceed the lender’s credit bid of $100,000, and he bids $140,000 at sale, the trustee will not immediately give back the overpaid amount [in this case, $60,000]; the trustee will return the overpayment in about seven to ten days after the sale. For this reason, the bidder should obtain multiple cashier’s checks in various denominations so as not to overpay in the biding process).

At first glance, the foreclosing party may think to fully credit bid what he is owed, especially if the property is worth considerably more than the amount owed to the lender; however, there are other factors to consider. What if the lender is way off in what he believes the property is worth? Sometimes, a property that is a bit esoteric is much harder to value than one thinks. Does the lender want to keep the property if she is the high bidder? Does she want to sell it right away upon owing it [should she be the high bidder]? Was there a personal guarantee on the note that is being foreclosed on? What is the current condition of the property? Is there a recent appraisal on the property? Are there any IRS liens attached to the property? These and many other questions must be considered when you are the foreclosing party.

Below are some general ideas/concepts to discuss with your real estate attorney (it is suggested that you hire an experienced attorney who is very familiar with the laws on foreclosure) when embarking down the foreclosure path.

IRS/Government Liens

First, we believe that the only time to open with a full credit bid is if a federal tax lien exists in a junior position (one needs to check with their attorney as to other government {or quasi government} liens, if the same rules apply). The reason for this is that, although the IRS lien may not have priority to the bidder’s lien due to the IRS lien typically being recorded after the foreclosing lien was in place, the IRS has a post-sale 120 day right of redemption; thus, if the end bid is less than what is owed, and the IRS exercises its right of redemption, the foreclosing party may experience a potential loss.

For example, let’s assume the following:

(a) On February 1, 2018, a first position deed of trust is recorded in the principal amount of $500,000.
(b) On March 29, 2018, a second position deed of trust is recorded in the principal amount of $75,000.
(c) On June 29, 2018, the IRS records a Notice of Federal Tax Lien in third position in the amount of $50,000.
(d) On December 1, 2018, the borrower misses the first interest payment and fails to make any subsequent payment to the lender.
(e) On January 30, 2019, the lender starts the foreclosure process.
(f) The foreclosure sale is set for May 29, 2019.
(g) The foreclosing lender is owed $560,000 (including principal, interest, late fee, and foreclosure fees)
(h) The foreclosing lender believes the property to be worth $700,000.

If the foreclosing lender opens the bidding at $400,000 (possibly to establish a low basis upon possession of the property if the property reverts), and no one else bids at the sale, the foreclosing lender now becomes the owner for $400,000. Typically, all junior liens are wiped out. However, with the post-sale right of redemption, the IRS has 120 days from the date of sale to redeem the property; that is, the IRS can pay the foreclosing lender only $400,000 and force the sale to the IRS. Now, where the foreclosing lender thought they were going to get a windfall, they will actually suffer a loss of $160,000 (the amount they were owed less the amount they received).

When a junior IRS lien appears on the public record and there is significant equity in the property, a full credit bid ($560,000 in the above example) should be made in order to protect the foreclosing lender’s interests.

What if there are no government liens on the property? There are some potential advantages to credit bidding less than the total amount owed. Below, we discuss a few. We will be using the same assumptions as above, with one caveat: no federal tax lien appears on the property.


Without a federal tax lien on the public record, it makes sense from an income tax standpoint to open the bidding lower than the amount owed to the foreclosing lender. With a full credit bid, the lender may be subject to paying income tax on the interest owed to the lender even though the lender did not receive any cash. By opening the bidding lower, the lender would not have to pay taxes on the unrealized interest and would have a valid argument that the property is worth less, resulting in a lower basis (remember, the property reverted to the foreclosing lender for the opening bid). If the lender were to then sell the property after holding it for at least one year, the lender may have a long-term capital gain which is usually taxed at a rate considerably lower than ordinary income.

Insurance Proceeds

The foreclosing lender typically is unaware of the condition of the property when the foreclosure begins. There may very well be damage to the property. Well, you say, that is why I am listed on the certificate of insurance in the mortgagee section. And you would be right. As the mortgagee, you have an insurable interest in the property. The insurance is to ensure that the lender is made whole. Well, if the foreclosing lender uses a full credit bid, then the foreclosing lender has, essentially, been paid in full. If damage is found on the property after the foreclosing lender becomes owner of the property, the lender may very well be out of luck. The insurance company can deny the claim on the basis that the lender’s full credit bid made the lender whole and that the lender’s insurable interest terminated when the property reverted. Unless the lender can prove that the damage was intentional, the lender may have no recourse. If the property reverted to the lender for less than what was owed, the lender maintains an insurable interest in the property and can make an insurance claim

Personal Guarantee

With entity borrowers (e.g, a corporation or limited liability company), lenders sometimes obtain a personal guaranty from the entity’s principals as a condition to making the loan. If the property reverts for the full credit bid, then nothing else is owed to the lender and they could not seek to collect additional monies from the guarantor. By underbidding, the lender may very well preserve its right to seek remuneration from the guarantor as the property was not worth what was owed. The lender may also be able to seek compensation from the guarantor for any damage done to the property, whether negligent or intentional.

Generalities and Summary

In general, keep in mind that a lower opening bid may entice others to begin bidding and create a true auction. The foreclosing lender is not prevented from bidding over and above the opening bid. In fact, the foreclosing lender is allowed to continue to credit bid up to the total amount it is owed; it does not have to accept anything less. Additionally, should the foreclosing lender desire to bid over what it is owed, the foreclosing lender can come to the sale with cashier’s checks in the same fashion as the third-party bidders.

In summary, it appears that best practices dictate that the only time the foreclosing lender should make a full credit bid is when an IRS lien appears on title in a junior position. Even then, the lender needs to investigate the value of the property, the IRS lien, and the likelihood that the IRS would exercise its right of redemption. Many times, the IRS will choose not to exercise its right, and may possibly negotiate its claim, but only a thorough and thoughtful analysis should come to the correct conclusion as to the correct course of action.

Other than potential government liens against the property, most foreclosing lenders would be prudent to start off credit bidding less than the entirety of what is owed. Remember, the credit bidder can always increase his bid….at least, up until the time the trustee says, “Sold!” Again, please consult with competent counsel prior to determining the correct amount to underbid in order to preserve as many rights as possible.

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