Homeowner Options Where a Deficiency Balance Exists after Foreclosure

Some states have anti-deficiency laws to protect the homeowner facing a foreclosure of his property. If the home purchaser used his home as collateral to get a "money purchase mortgage" loan, he, in fact, pledges the property to the seller for the unpaid balance of the sale price. If the homeowner is later subject to a foreclosure sale, a deficiency occurs if the amount owed on the mortgage is greater than the value of the property. The deficiency is the amount of the loan not repaid through the foreclosure sale of the property.

Anti-Deficiency Laws and Protections

Under anti-deficiency laws, if a buyer takes out a purchase money mortgage for the purchase of a house he occupies, this homeowner will not be held responsible for any deficiency. The lender can only recover the property and the proceeds of a subsequent sale. The purchaser does not pay any deficit between the sale proceeds and the outstanding loan balance. Anti-deficiency laws typically provide no protection for non-purchase money mortgages, such as a second mortgage obtained after the original acquisition. In addition, no protection exists when the property is not used as the primary residence of the purchaser.

Most states have these types of anti-deficiency laws to protect the purchaser from a deficiency on a loan used to acquire the house intended for personal residence. These laws protect the purchaser from any deficiency on the loan if the home is later foreclosed upon by the lending institution where the lending institution takes title to the property at a foreclosure (trustee's sale). These laws also protect the purchaser if the property is sold at auction for an amount less than what is owed on the loan, including all associated costs and unpaid accrued interest at a foreclosure sale.

Purchase Money Loan

For any anti-deficiency statute to apply under state law, the residence must be purchased as the property owner's principal residence and not as an investment rental. However, if the loan that is being foreclosed upon is not "purchase money", and/or there are no anti-deficiency laws in that state concerning "purchase money" loans, and the auction sale proceeds of a foreclosed property is less than what is owed on the loan, the property owner could be subject to a deficiency judgment for the lender's balance. This is unlike the case when the initial loan on the primary residence was a purchase money mortgage, and when the loan was never refinanced. Any deficiency on this foreclosed upon loan would not typically result in a deficiency judgment later on. The rationale for such statutes is that the bank making the loan takes the risk that its appraiser will accurately appraise the fair market value of the property and not make an inflated valuation of the home's fair market value. If there are junior secured loans subject to the foreclosure that are not "purchase money", these junior loans, as a matter of law, will be wiped out at a foreclosure sale by the senior lien. Potentially, the lenders of these junior "wiped out" loans might claim a deficiency owed by the property owner.

Types of Foreclosure Proceedings

Real property can be subject to judicial and non-judicial foreclosures. A judicial foreclosure occurs when a borrower defaults on his property mortgage, and the lender files a lawsuit against the borrower in state court to foreclose upon the property. The homeowner must file a timely answer asserting any applicable affirmative defenses to the action. In a non-judicial foreclosure, the lender provides the property owner with notice of default and an opportunity to cure (catch-up on the payments), but the property owner fails to do so, with a resulting foreclosure. Most states have laws preventing a deficiency judgment against the property owner in a non-judicial foreclosure. The legislative rationale is that a non-judicial foreclosure proceeds much quicker than a judicial foreclosure.

Consequences of Short Sales

If a homeowner is facing a foreclosure of his property, the borrower should ask the bank if it will approve a short sale. If a short sale occurs, the property owner sells the property to a third party with the written approval of the lender. The lender will receive a portion of what is actually owed on the home loan because the home's selling price is less than the amount owed on the loan, which includes all accrued interest, late payment penalties, and unpaid property taxes.

In most cases, the lender signs a "short sale addendum" agreeing to the established sales price of the property and agrees to accept a lower amount. The short sale is reported as “settled,” on your credit report but not “paid in full.” “Settled” means an agreement was reached with the lender to repay only a portion of the total amount owed. The remainder is written off as a loss. This will have a negative effect on your credit score and could remain on your report for up to seven years. Fortunately, California recently enacted a revised statute holding that any lender who accepts any amount on a short sale cannot sue the property owner for any deficiency regardless if the loan was not “purchase money.” Other states may have similar statutes. Although the homeowner is not subject to a deficiency, the defaulting borrower could still suffer adverse tax consequences. The IRS treats the unpaid balance that cannot be asserted as a deficiency (forgiveness of debt), as taxable income. 

Homeowner's Research

If a homeowner faces an actual foreclosure sale, he needs to determine if the loan being foreclosed upon is a "purchase money" mortgage. If so, the owner must determine whether the state where the property is located has anti-deficiency laws. He must also determine if the state has laws making a distinction for judicial versus non-judicial foreclosures and if a lender can claim a deficiency in either foreclosure process. The property owner should attend the foreclosure sale for several reasons. He should learn about the bidding process and the final sale price of the property compared to what is owed on the loan.

Possible Consequences of a Deficiency

A deficiency is imposed on the foreclosed property not subject to any anti-deficiency laws, or preclusion of a deficiency judgment under laws pertaining to a non-judicial foreclosure. The former property owner could face a lawsuit by the lending institution. Depending on the property owner's financial status, a bankruptcy filing could be the only way to prevent a possible deficiency judgment on a foreclosed property, where the lender is not precluded from pursuing the borrower under anti-deficiency laws or laws pertaining to non-judicial foreclosures. When a homeowner is facing foreclosure, it is best to consult an experienced real estate attorney.  The lawyer can discuss options and determine if the homeowner is protected by any anti-deficiency statutes or legislation concerning non-judicial foreclosure proceedings.