Liquidated damages not a “tax” for purposes of determining priority of lien in mortgage foreclosure

by Victoria Heldt

Baylake Bank v. Fairway Properties of Wisconsin, LLC
(Wisconsin Court of Appeals, September 15, 2011)

Fairway Properties of Wisconsin, LLC (Fairway) planned to develop a single-family housing complex on a piece of property located in the City of Waupaca.  The property was in a “tax increment district,” which is a mechanism used to allow municipalities to fund public improvement projects by diverting the property taxes to pay for those improvements.  The company entered into a mortgage agreement with Baylake Bank to procure financing for the development.

Fairway also signed a development agreement with the City, in which it agreed to meet certain goals each year for eleven years to ultimately build a housing complex with a minimum value of $4,500,000.  In exchange, the City agreed to provide improvements to the property such as sidewalks, wells, and driveway approaches.  The contract contained a clause that required Fairway to pay a “liquidated damages penalty” if it did not meet the specified goal each year.  The fine amounted to the difference between the actual property tax levied for the year and the property tax that would have been levied had the project goal been met (increasing the value of the property.)  This clause ensured that the City would be reimbursed for the funds it used in making the improvements.

Fairway eventually defaulted on its mortgage, prompting the Bank to bring a foreclosure action into district court naming Fairway and the City in the case.  The City answered, alleging Fairway owed over $150,000 in delinquent property taxes and over $80,000 in fines resulting from the violation of the liquidated damages clause.  The Bank agreed that the delinquent taxes took priority over the Bank’s mortgage interests, however claimed the charges under the development agreement’s liquidated damages provision were subordinate to the Bank’s interests.

The issue hinges on whether or not the liquidated damages penalty is considered a tax which, therefore, takes priority over the Bank’s position as mortgagee in a foreclosure action.  In a summary judgment, the district court concluded the damages were “real estate taxes,” relying on the language of the contract which read:  “the payment due is a special charge which may be entered in the tax roll as a charge against the real property identified in Exhibit A then owned by the developer and collected in the same manner as real estate taxes.  The amount due is a lien upon the property superior to all other liens.”  Since the court classified the damages as a tax, they ruled that the Bank’s interests as mortgagee were subordinated to the City’s interests.  The bank appealed.

The Court of Appeals noted that cities have no inherent power to tax and that it may only tax in such cases where statutory or constitutional language authorizes a tax for that specific purpose.  In this case, the court relied solely on language in a contract for the authority to tax.  This is insufficient to give the City the right to classify fines from the liquidated damages clause as a tax.

Next the Court addressed whether the City provided any alternative basis for authority to classify the damages as a tax.  The City relied on the tax increment law (Wis. Stat. §66.1105) for authority to levy the tax.  The language of the law grants the power to create tax incremental districts, prepare projects in the districts, and enter into contracts necessary to proceed with the plan.  The statute is silent, however, regarding a city’s authority to impose taxes on the entities in the district.

The Court concluded that the development agreement’s liquidated damages do not have priority as a property tax.  The district court decision was reversed.

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