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What Is a Deficiency Judgement in a Foreclosure | Debt After Foreclosure

Will I Owe a Debt After Foreclosure?

Well, let’s begin with a different question: will I be sued after a foreclosure? Whether you can be sued after a foreclosure depends on whether your state is a deficiency state or an anti-deficiency state (you want anti-deficiency).

What is Anti-Deficiency in a Foreclosure?

An anti-deficiency law is a law that states that a lender in a real estate transaction cannot pursue a judgement 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. The “deficiency” is the shortfall that a bank gets stuck with if a foreclosure sale does not yield enough to cover the amount of the mortgage loan. Sound too good to be true? Nevertheless that is the law in some states, most notably California. You can read about California Anti-Deficiency Law.

There is actually a fairly sound policy reason for anti-deficiency. Before and during the great depression, lenders were free and easy with mortgages–and property appraisers played right along (sound familiar?). When a borrower foreclosed, the lender got the property, and then got to go after the poor borrower’s last remaining assets. This pushed many families into poverty. Anti-deficiency laws place the burden on lenders, as if to say: “you, lender, are best positioned to properly appraise a property, so don’t lend beyond that value, or you’ll be stuck without recourse.

Will I Be Sued?

In an anti-deficiency state, you will not be sued because the bank does not have the right–you are free to begin your financial life anew.

But, in a deficiency state, the lender does have the right to sue you. However, believe it or not, not all lenders will sue for deficiency. Statistics are not available, but the chances are better than 50% that you will not be sued for deficiency. What else can a lender to do? If they sue on the deficiency, they might win a judgment that will never be paid; a foreclosed borrower is not exactly sitting on top of the world at that moment. Or, they might force the borrower into bankruptcy, and again the lender gets nothing. And, suing evicted and foreclosed families is hardly a great business to be in.

What is most common is that the lender reports the foreclosure on the borrower’s credit report, and forgives the debt. This forgiveness of debt has other consequences, as you can read in the next article in the series,
1099 After Foreclosure | Cancellation of Debt Income.

Portions of this article were contributed by Northwest Indiana Bankruptcy Lawyer Jonathan Petersen.

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Foreclosure Law | Foreclosure Help | Stop Foreclosure

What Is Foreclosure? 

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.

Foreclosure is not always a court action. There are two types of foreclosure: judicial foreclosure and trustee’s sale (non-judicial) foreclosure. Some states use one or the other, and some states (like California), use both. Judicial foreclosure is just like it sounds: it is a lawsuit by a bank against a lender to secure a judgment of foreclosure. This means paperwork, court proceedings, motions, orders, appraisals, and a formal auction. As such, judicial foreclosure is more expensive for a bank, and takes longer.

A trustee’s sale is a walk in the park for a bank: The trustee names in the deed of trust (mortgage) simply needs to record a public notice of default to initiate a non-judicial foreclosure against the owner. No court intervention is required. If the owner doesn’t pay in a certain amount of time, the trustee can schedule a public sale of the property.

Homestead Protection

If you are sued for a debt that is not related to your home, you may enjoy homestead protection–a large amount of the equity in your home may not be reachable by outside creditors–but homestead protection does not protect you from the amount that you owe to lenders who have mortgages against your property. We discuss homestead protection in this article: Homestead Exemption.

Deficiency Judgments

Deficiency Judgments are legal judgments available (in only some states) to banks and lenders if the foreclosed property does not yield enough money at a foreclosure sale to satisfy the entire mortgage loan. That’s a mouthful, so the following explanation should make it clearer. Say you buy a property with $20,000 down, and you borrow $80,000 from First Bank. You fall behind, and First Bank forecloses on the property and the property yields $70,000 at a foreclosure sale. Well, the bank is still out $10,000. That “deficiency” may be the subject of a deficiency judgment if the bank wants to pursue it. That said, banks don’t always have the right to pursue deficiency judgments, and even when they do, they don’t always seek deficiency judgments. We discuss deficiency judgments at length generally, and with respect to California read Deficiency Judgement, Anti-Deficiency Laws, California and Elsewhere.

Why Foreclosed Homeowners Receive 1099s for Cancelled Debt First, the basics: if you owe a debt to someone else, and that debt is forgiven, the IRS Code treats that forgiven debt as income to you. Does it make sense? Sure, because you have just received something that you did not have before. And so, when a homeowner loses a property in foreclosure, banks will typically charge off (forget about) the mortgage loan and simply issue to the former borrower a 1099 for the amount of the loan that the bank forgave. For example, if you bought a house with a $100,000 loan, and the bank received $80,000 in a foreclosure proceeding, that leaves $20,000 to collect from you, the borrower. Now, the bank might sue you for the $20,000, or the bank might simply forgive the debt. If the bank forgives this debt, the bank will issue you a 1099 for the amount of $20,000–what they do depends on state law (more on this below) and the circumstances of your individual case. This example is over-simplified, actually, the bank may also include in the 1099 expenses, fees, late fees, and whatever other fees originally appeared in your loan contract.

More Information on Foreclosure and Anti-Deficiency

For more information, see our full article on 1099s and cancelled debt entitled 1099 After Foreclosure – Cancellation of Debt & Anti-Deficiency.

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Deficiency Judgement, Anti-Deficiency Laws, California and Elsewhere

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.

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California Foreclosure Law | Foreclosure in California

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.In California, there are two types of foreclosure: judicial foreclosure and trustee’s sale (non-judicial) foreclosure. Judicial foreclosure is very rare, and is almost never used in residential foreclosures. Judicial foreclosure is just like it sounds: it is a lawsuit by a bank against a lender to secure a judgment of foreclosure. This means paperwork, court proceedings, motions, orders, appraisals, and a formal auction. As such, judicial foreclosure is more expensive for a bank, and takes longer. There are other important differences to the homeowner that we’ll cover in a moment.
 
A trustee’s sale is a walk in the park for a bank: The trustee names in the deed of trust (mortgage) simply needs to record a public notice of default to initiate a non-judicial foreclosure against the owner. No court intervention is required. If the owner doesn’t pay in a certain amount of time, the trustee can schedule a public sale of the property.

Judicial Foreclosure vs. Trustee’s Sale Foreclosure (Non-Judicial Foreclosure)

But now to the important differences between judicial foreclosure and a trustee’s sale:
1. In a judicial foreclosure, the borrower is entitled to a 1-year “right of redemption” by which the borrower enjoys the right to repurchase the property from a successful bidder. This puts a real damper on the auction sale price, as one might imagine.
2. In a trustees sale, the bank cannot get a deficiency judgment against the borrower (on certain residential property). In short, that means the bank cannot sue the borrower for the difference between the bank loan and what the bank received at the trustee’s sale.

Anti-deficiency is a good deal for homeowners whose properties are “underwater,” (where the value is less than the total amount of the loans).

Foreclosure Defaults and Timelines

The short answer: a foreclosure in California takes about 7 to 9 months from when a borrower first misses a payment. When a borrower misses a payment on a mortgage loan, the bank springs into action. The bank will make telephone calls to the borrower and ask for payment. The representatives making these calls are low-paid hourly workers. They are trying to collect payment, but will also record what the borrower says into a database. At this stage, the lender is trying to establish whether the loan is in trouble or not, and try to get the borrower up to date. As a borrower falls further into default, the bank will continue collection efforts. After three or four months with no payments, the bank will send to the borrower a notice advising that foreclosure will begin in 30 days. Upon the expiration of that 30 days, the bank will file a “Notice of Default.” This notice (familiarly called an “N.O.D.”) is a key event in the foreclosure process: once the N.O.D. is filed, the wheels of foreclosure begin to turn. Keep in mind, though, that the N.O.D. won’t get filed until the borrower is 3 to 5 months behind in payments. Recently (in mid-2007), I have experienced lenders taking much longer to file N.O.D.’s–they do not appear to be in a rush.

After the N.O.D. is filed, the “redemption period” begins. The redemption period is simply a period of dormancy during which the borrower can “cure” the default by bringing his payments up to date. If the borrower does nothing, at the end of the redemption period, the “publication period” begins. The redemption period lasts 90 days from the N.O.D. filing.

The publication period lasts another 30 days beyond the redemption period. At the commencement of the publication period, the Trustee prepares a Notice of Trustee’s sale and published in a newspaper of general circulation in the city where the property sits. Up until 5 days before the trustee’s sale, the borrower enjoys a right to reinstate the loan by bringing all payments current.

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