September 9, 2020

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Arizona Supreme Court Establishes Factors to Distinguish Home Improvement Loans from Construction Loans When Considering Anti-Deficiency Protection

By Michael Ripp, Kevin Heaphy and Daniel Herder, Attorneys for Ryley Carlock & Applewhite

In the fifth appeal of Helvetica Servicing Inc. v. Michael S. Pasquan, the Arizona Supreme Court was asked to determine whether a loan used to pay off a purchase money loan and “renovate/expand the Property” qualifies as a purchase money obligation. Generally under Arizona’s anti-deficiency statutes (A.R.S. § 33-814; §33-729(A)), a creditor cannot recover a judgment for the deficiency balance of purchase money loans (i.e. loans used to purchase a home), which include loans for the construction of new homes. By contrast, “home improvement loans” are not entitled to anti-deficiency protection if the creditor commences a judicial foreclosure (as opposed to a trustee’s sale). Although simple on the surface, what distinguishes a construction loan from a home improvement loan is an unanswered question in Arizona, and poses particular problems where a loan is used to substantially remodel or expand an existing residence.

In Helvetica, the borrowers “demolished most, but not all, of the residence,” including replacing “the existing building with a larger single-family residence and related improvements.” The loan documents and deeds of trust also called the loan a “construction loan.” The Court rejected a bright-line rule that only a loan used to build a house from scratch could qualify as a construction loan, commenting that “there is substantial grey area between a loan used to finance a newly constructed, built from scratch home and a loan used to remodel the kitchen.” The Court further reasoned that “construction” includes “building or rebuilding qualified properties,” even if the project did not begin from scratch and “home improvement” includes elective enhancements such as expanding the property, but not rebuilding a damaged structure. 

The Court held that to determine whether a loan is a construction loan or a home improvement loan, a court should examine the totality of the circumstances based on the following factors, which the Arizona Supreme Court adopted from a 1979 California Court of Appeals case:

(1) whether there was a complete or substantially complete demolition of an existing structure and a new building constructed in its place; (2) the intent of the parties when executing the loan documents; (3) whether the structure was inhabitable or inhabited during construction; (4) whether the structure was largely preserved and improved or substantially expanded; and (5) whether the project is characterized as “home improvement” or “construction” in the loan documents and in the permits or other official documents.

The Court declined to determine whether the loan at issue was a construction loan or a home improvement loan, but noted that the record before it presented a “close call.” The Court then remanded the case back to the trial court for the appropriate factual findings and, in all likelihood, a sixth appeal. 

The factors set forth by the Arizona Supreme Court in Helvetica provide helpful considerations when documenting the loan. Many lenders have been conditioned to characterize any mortgage or deed of trust that secures a loan that will be used in part to demolish or improve property to any degree as a “construction mortgage” to take advantage of the favorable priority the Uniform Commercial Code gives to construction mortgages. Helvetica suggests that such a practice should be more carefully examined in a residential construction context. Instead, lenders should consider requiring borrowers to make affirmative representations that a given loan is intended for home improvement and not construction. Likewise, lenders should ask whether the home will be inhabited during the renovations and whether the structure will be completely “gutted,” or merely remodeled. While “papering over” a loan is unlikely to persuade a court to find that a substantial construction project is not a construction project, keeping the Helvetica factors in mind in the documentation process may avoid needlessly characterizing a “close call” loan as one that will preclude the lender from seeking a deficiency. Lenders must also consider the Helvetica factors when deciding how to foreclose on a residential property. If the loan was clearly a construction/purchase money loan, it would ordinarily make little sense for the lender to foreclose judicially instead of by trustee’s sale. On the other hand, if the loan was arguably a home improvement loan and the likely deficiency is significant, (and at least partially collectible), the lender should consider judicial foreclosure, which would allow the lender to request and prove a deficiency claim.

Ryley Carlock & Applewhite has proudly represented lenders and financial institutions for its entire 71-year history. For more information, please contact the authors by email at mripp@rcalaw.com, kheaphy@rcalaw.com, or dherder@rcalaw.com.

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