July, 2007

As we noted in Foreclosure Law, foreclosure is the process by which a bank or lender takes possession of collateral used to secure a loan. Put another way, foreclosure happens to a homeowner when he or she doesn’t pay their mortgage. And, in California Foreclosure Law, we looked more closely at the law and process surrounding foreclosure in California.

Anti-Deficiency Laws Protect Real Estate Debtors

An anti-deficiency law is a law that states that a lender in a real estate transaction cannot pursue a judgment against the borrower if the borrower defaults on the underlying real estate loan and the lender fails to recoup the entire amount of the loan.Section 580b Anti-Deficiency Protection for Purchase Money Mortgages for 1-to-4 Unit Properties Section 580b prohibits a deficiency judgment against a borrower who incurred a loan to purchase a residential property (as opposed to a refinance), and if that property is one-to-four units. Refinance loans do not fall within 580b–so refinancers beware, you might be giving up some anti-deficiency protection if you refinance your original purchase money loan. Nevertheless, refinancing borrowers may still enjoy anti-deficiency protection by virtue of Civil Code 580d.

An example will illustrate: Assume a borrower borrows $500,000 from a lender to purchase a property costing $550,000. Soon after, the borrower falls behind in his payments, and the bank is forced to foreclose, and the home is ultimately sold for $400,000. The $100,000 that the lender lost on the deal is called a “deficiency” or “deficiency judgment.” In California, in some circumstances, the bank can not sue the borrower for the amount of the deficiency–hence the term “anti-deficiency protection.”

California’s anti-deficiency rules are found in Section 580 of the California Civil Code. There are two separate provisions, and the two provisions overlap slightly:

Section 580d Anti-Deficiency Protection for All “Trustee’s Sale” Foreclosures

Section 580d sets forth far broader anti-deficiency protection. Section 580d protects all borrowers from anti-deficiency protection in foreclosures that are “power of sale” or “trustee’s sale” foreclosures–as opposed to a judicial foreclosure. We discussed judicial foreclosures, and we noted that judicial foreclosures are very rare, and is almost never used in residential foreclosures.

And so, with such powerful anti-judgment protection for borrowers, what happens to the loan that the lender made? In short, the lender takes a loss on the loan, and the borrower, while immune from lawsuit, gets a very serious negative mark on his or her credit.

There is another curious after-effect to a California foreclosure where lender is blocked by the anti-deficiency rules: the lender issues a 1099 to the borrower in the amount of the lender’s loss on the loan. The 1099 is issued for “cancellation of debt” income–which is, technically speaking, taxable income under the US tax laws. Credit card companies often issue 1099s for “COD” income when they write off a bad debt. The lender, by issuing a 1099, can write off the lost loan and reduce its taxable income.

A foreclosed borrower faced with a sizeable 1099 can still maneuver and avoid a stiff tax bill: the foreclosed borrower may exclude the amount of the forgiven debt from his or her income. The borrower must file IRS “Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.” If the borrower is insolvent at the time of the forgiven debt, the IRS may forgive the liability.

If faced with such a 1099–get some professional guidance, it’ll go a long way.

3 replies
  1. mick james
    mick james says:

    I thought 580b protection applies only if the buyer is a resident which you don’t mention. Is that correct? What about a buyer who was initially a resident but who has moved out and rented the home before defaulting?

  2. thundercow
    thundercow says:

    My understanding was that it is the intent of the purchaser when the loan is made–it has to be used initially as a primary residence.

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  1. […] of $20,000–what they do depends on state law (more on this below, and in our article on anti-deficiency) and the circumstances of your individual case. This example is over-simplified, actually, the bank […]

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