What protections are available in case of a deficiency balance after foreclosure?
Some states have anti-deficiency laws that protect purchasers of residential real property used as his/her primary residence in accordance with a “purchase money mortgage.” A purchase money mortgage is a loan agreement under which a purchaser of a property pledges the property to the seller for the unpaid balance of the purchase price.When there is a deficiency, it means that when the property is foreclosed, the amount owed on the mortgage is greater than the value of the property. The deficiency is the amount of the loan that won't be repaid through the foreclosure sale of the property.
Anti-Deficiency Laws and Protections
Under anti-deficiency laws, if a mortgage is a purchase money mortgage for the purchase of a dwelling occupied by the purchaser, the purchaser 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. There is no protection when the property is not used as the primary residence of the purchaser.
Most states in this country have laws protecting a purchaser of a home intended for his or her own personal residence. These laws protect the purchaser from any deficiency on a loan used to acquire the home in its initial purchase, 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.
Anti-Deficiency Laws and Purchase Money
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 your state concerning "purchase money" loans, and the property is lost in a foreclosure where the winning bid at auction is less than what is owed on the loan, then the property owner could very well be subject to a deficiency judgment for monies owed the lender.
The result is quite different if the initial loan for the residence purchased by the property owner was “purchase money” and if 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, the lending institution making the loan for the residence to be occupied by the property owner 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 on the property 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 as a matter of law by the senior lien that is being foreclosed upon. 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 foreclosed upon in two main ways. Most states recognize judicial foreclosures and non-judicial foreclosures. A judicial foreclosure occurs when a loan is not current for real property and the lender files a lawsuit in state court seeking to foreclose upon the property. The lawsuit is filed against the property owner. The property owner needs to file a timely answer asserting applicable affirmative defenses to the action.
If the foreclosure process is by way of a non-judicial proceeding (no lawsuit filed) where the lender provides the property owner with the notice of default and an opportunity to cure (catch-up on the payments) but the property owner fails to do so, and where a foreclosure results, 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.
Short Sales and Long-Term Consequences
If a property owner is facing a foreclosure of his or her property, the property 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 short sale transactions, the lender signs a "short sale addendum" agreeing to the established sales price of the property and agrees to accept a lower amount. In most cases, a short sale is reported as “settled,” on your credit report not “paid in full.” “Settled” means that you reached an agreement with the lender to repay only a portion of the total amount owed. The remainder is written off as a loss by the creditor. This will have a negative affect on your credit score and could remain on your report for up to seven years. However, 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.
In the event of a short sale the property owner needs to be aware that there could be possible tax consequences for him or her due to the "forgiveness of debt" issue where the balance that could have been asserted as a deficiency in the foreclosure, but cannot due to a state's anti-deficiency laws, could be deemed "income" to the property owner. In this case, the income would be considered a "taxable event."
Deficiency Balances Post-Foreclosure
In the event a property owner faces an actual foreclosure sale, he or she needs to determine if the loan being foreclosed upon is "purchase money" or not. If the loan is "purchase money," the owner must determine whether the state where the property is located has anti-deficiency laws. He or she must also determine whether or not 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 take note of how the bidding process works and the final selling price of the property in relationship to what is owed on the loan being foreclosed upon.
Post-Foreclosure Deficiency
If there is a deficiency on the foreclosed property's sale that is 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. The lending institution may sue for any deficiency owed on the property loan. 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.
The best thing that a homeowner can do when his or her property becomes subject to a foreclosure is to consult with an experienced real estate attorney. An experienced real estate attorney can discuss options and determine if the homeowner is protected by any anti-deficiency statutes or statutes concerning non-judicial foreclosure proceedings.