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In California, what are the consequences of a short sale, or foreclosure? Will I still have to pay the bank if I go into foreclosure? Will I still have to pay the bank if I do a short sale? Will I owe any tax on the debt forgiven? These are the questions most often asked by struggling California homeowners.
The answer to these questions cannot be fully answered in this article as the rules are very fact specific. That said, in general, California offers greater protection to struggling homeowner's than many other states due to its anti deficiency and short sale protection laws and at least through December 31, 2013 the federal government has provided some additional protections.
Congress Extends Mortgage Forgiveness Debt Relief Through 2013.
First everyone should know that the IRS typically requires individuals to treat debt that forgiven, or written off, including mortgage debt that is forgiven or extinguished due to a short sale, foreclosure, or loan modification as taxable income. When debt is cancelled, the lender is usually required to report the amount of the canceled debt to the individual and the IRS on IRS Form 1099-C, Cancellation of Debt. As a consequence of the severe housing crises that emerged in 2007, Congress passed the Mortgage Debt Relief Act of 2007 (the "Act"). Under the Act, mortgage debt that is reduced through a loan modification and mortgage debt up to $1 million ($2 million for married filing joint) that is forgiven in connection with a short sale or foreclosure on a qualified personal principal residence of 1 to 4 units would temporarily not be taxable. This law was set to expire on December 31, 2012. On January 1, 2013, Congress extended the Act's debt relief provisions through December 31, 2013.
The remainder of this article will explain the difference between a Short Sale and a Foreclosure and how California's anti-deficiency laws limit what a bank can take from the borrower in each context.
What Is A Short Sale (a.k.a. Short Pay)?
A short sale is a transaction in which a homeowner seeks to sell a residence for less than the amount the homeowner owes to its lenders. To sell the home, the homeowner must first get approval from the lender(s) because the amount a buyer will be willing to pay will often not be sufficient to pay off the outstanding loan balance(s). This is why some short sales are referred to as short pays.
New California Short Sale Laws Prohibit Deficiency Judgments In Many Cases
Effective January 1, 2011, California Code of Civil Procedure §580e provides that if a lender agrees to a short sale of a residence of 1 to 4 units owned by an individual (not a corporation, limited liability company, or limited partnership), the first lien holder (first mortgage) must accept the agreed-upon payment as the full payment for the outstanding loan balance. In other words, as of January 1, 2011 if a lender holding a first deed of trust provides written consent to a short sale for an agreed price, the lender is prohibited the lender will be obligated to accept the sales proceeds as full payment on the outstanding balance of the loan and discharge the remaining amount owed on the first trust deed. This law applies only to: (1) first trust deeds on (2) owner-occupied and residential investment properties that are one to four units (3) titled in the name of individuals as opposed to corporations, limited liability companies and limited partnerships and (4) loans that are purchase money loans, refinanced loans, or hard money loans. This law does not preclude the lender from seeking damages for fraud, or waste, from the borrower, nor does it provide any protection to second mortgages, home equity lines of credit, or HELOCS.
Because CCP §580e did not address the problems faced by struggling California homeowners who have second mortgages, home equity lines of credit, or HELOCs, California passed SB 458, which became effective on July 15, 2011. Pursuant to SB 458, secondary (junior) lien holders (second mortgages) are prohibited from pursuing a deficiency judgment against any homeowner that receives written pre-approval for a short sale on a residence of 1 to 4 units that closes escrow after July 15, 2011. The new law only applies to borrowers who are individuals (not corporations, limited liability companies, or limited partnerships) and residential properties of up to 4 units.
Example: Assume that a seller (an individual condo owner) owes $350,000.00 on a first mortgage and $50,000.00 on a home equity line of credit (HELOC). Assume further that a buyer offers to purchase the residence for $300,000 and both the first and second mortgage holder agree to accept the short sale price offered. Under SB 931, only the first mortgage holder was prohibited from suing the borrower for any deficiency and the second mortgage holder despite agreeing to the short sale could go after the borrower for the balance owed on the second mortgage. With the passage of SB 458, as of July 15, 2011, if both the first and second mortgage lenders approve the short sale, neither is permitted to sue the borrower for any deficiency.
In sum, if an individual homeowner receives the written preapproval of its lender(s) to perform a short sale on a personal residence of 1 to 4 units at an agreed price, the lenders are now statutorily prohibited from coming after the borrower later for a deficiency even if the mortgage was a refinance, second, or HELOC. If the lender(s) pre-approve a short sale, there can be no deficiency.
Are California’s New Short Sale Anti-Deficiency Laws Retroactive?
Senate Bill 458 officially became law on July 15, 2011 and applies to all short sales that close after that date. If you signed a short-sale agreement before July 15, 2011 are you protected? If your short sale closed escrow before July 15, 2011 are you protected? How the California courts will answer these questions is unknown. Arguably it can go either way. On one analysis you could argue that the wording of the statute suggests that a lender who has not yet obtained a deficiency judgment is prohibited from recovering any deficiency from a seller. According to the statute: “No deficiency shall be owed or collected, and no deficiency judgment shall be requested or rendered for any deficiency. . . .” On the other hand, the lender may argue that the law was enacted as emergency legislation as of July 15, 2011, and specifically states: “to mitigate the impact of the ongoing foreclosure crisis and to encourage the approval of short sales as an alternative to foreclosure, it is necessary that this act take effect immediately,” not retroactively. How the California courts will rule remains to be seen. You can read the Full Text of the Bill here.
How Will A Short Sale Affect My FICO Score?
The affect a short sale will have on your credit score is typically the same as a foreclosure. However there are a number of factors that can make the effect of a short sale less severe, especially how delinquent you are in your current mortgage. If the homeowner was not delinquent and there are no delinquent payments, your credit score should not be that severely impacted and in such instances borrowers are typically able to get approval for an FHA loan rather quickly. However, typically one’s FICO score will be dinged 100 to 300 points after a short sale and the borrower will have to wait an average of 2 years before qualifying for a new home loan. After a short sale, however, there are many things an individual can do to raise their FICO score.
How Does Foreclosure Work in California: Private Sale (a.k.a. Trustee Sale) vs. Judicial Foreclosure?
In California there are two types of foreclosures: (1) Trustee Sales and (2) Judicial Foreclosure. When a home buyer seeks to purchase a property, the buyer will often get a loan (execute a promissory note and deed of trust). The deed of trust contains a clause that gives the Trustee (the lender) the power to sell the borrower’s property (the collateral) if the borrower fails to make the loan payments to the lender. This is called a private right of sale (Trustee Sale), which is often the easiest, most economical, and fastest way for the lender to foreclose on a property. When a lender uses this private right of sale to foreclose, the lender is often precluded under California’s anti-deficiency laws set forth in California Civil Code of Procedure Sections 580(a)-(d) from seeking a deficiency judgment against the borrower and instead must accept the collateral (the property) as full satisfaction of the debt. However, please be aware that if the borrower has more than one lender, or more than one mortgage, a junior lienholder may still be able to seek a deficiency judgment.
As an alternative to the trustee sale, a lender may opt to forego its private right of sale, and seek instead judicial foreclosure. Under a judicial foreclosure, the bank will file a lawsuit (summons and complaint) in Superior Court asking the court to foreclose on the loan, sell the property at a public auction, and issue a judgment against the borrower for the difference between the "fair market value" of the property and the outstanding loan balance (the deficiency judgment) in favor of the lender. The lender can then seek to enforce that deficiency judgment by attaching the borrower’s other assets (e.g. other real estate, bank accounts, wages, etc..). The problem here for most lenders is that in California a lender cannot obtain a deficiency judgment under California’s Anti-Deficiency Laws if the underlying debt comes from a loan used to acquire (purchase) owner-occupied residential property up to four units.
How California’s Anti-Deficiency Laws Work in the Foreclosure Context.
In California if you (the borrower) acquired a first and second mortgage to purchase (as opposed to refinance) a residential property of up to four units, you are protected under California’s anti-deficiency laws set forth in California Civil Code of Procedure Sections 580(a)-(d). These anti-deficiency laws prohibit a secured lender (including a seller with a carry-back loan) from suing the borrower for a deficiency judgment when (1) the borrower acquired the loan to Purchase (as opposed to a refinance) owner occupied residential property of up to four units; (2) the lender foreclosed; and (3) the proceeds from the foreclosure sale are less than the borrower's secured debt (the "deficiency"). For example, if a borrower secured a mortgage from two lenders to buy a $500,000 home, each taking back a Deed of Trust or mortgage (first for $400,000 and second for $100,000), the borrower defaults, the holder of the first deed of Trust forecloses, the property sells at auction for $350,000 leaving a deficiency of $50,000 to the first mortgage holder and a deficiency of $100,000 to the second mortgage holder. Under California Code of Civil Procedure §580b, the holders of the first and the second deed of trust will both be barred from seeking relief directly against the borrower for the deficiency. See, Brown v Jensen, 41 C.2d. 193 (1953).
California Code of Civil Procedure § 580(d) further prohibits deficiency judgments from otherwise unprotected borrowers, when a lender has foreclosed upon the secured property by a private, "power-of-sale" foreclosure proceeding, pursuant to the terms of the deed of trust. If a lender wishes to obtain a deficiency judgment against an unprotected borrower for an unpaid loan balance, California Code of Civil Procedure Section 580(d) requires the lender to initiate a judicial foreclosure, as set forth by statute, through the California court system. Lenders have long avoided the judicial foreclosure process because civil lawsuits are time consuming and expensive (require the retention of an attorney, often involve numerous procedural delays which can last upwards of four years, and may subject the lender to cross claims). However, with the decline in property values lenders will only seek a judicial foreclosure if: (1) a private sale will not yield sufficient funds to pay off the entire balance of the loan; and if (2) the loan was not a “purchase money loan” (loan secured for the purchase of a residential property of up to four units).
California historically has had a strong public policy against deficiency judgments. The primary purpose of the anti-deficiency statute is to prevent the overvaluation of property by placing the risk of inadequate security on the lender. By placing the risk on the lender, the legislature hoped to discourage risky lending practices and precarious land schemes. See, Spangler v. Memel, 7 Cal.3d 603 (1972). To further the purpose of the anti-deficiency statutes, the California courts have long held that home buyers cannot waive the anti deficiency protections afforded to them under California Code of Civil Procedure §580(b) either when the loan is made, or in a forbearance agreement. See, Jackson v. Taylor, 272 Cal. App. 2d 1, 5, (1969); Palm v. Schilling, 199 Cal.App.3d 63, 69 (1988) and Thompson v. Allert, 233 Cal.App.3d 1462, 1466-67 (1991).
Under certain circumstances, however, a California home buyer can lose his or her anti-deficiency protection. First, if a home buyer after purchasing a property later acquires a home equity line of credit (a.k.a. HELOC), the anti-deficiency statutes will not apply to the second loan. Second, if the home buyer enters into a short sale without the pre-written approval of the lender, the anti-deficiency statutes will not apply. Third, if the home buyer refinances the original purchase money loan, the home buyer may be at risk of losing the "anti-deficiency" protection previously guaranteed. It is also important to note that an otherwise protected borrower might still be subject to a lawsuit brought by the lender after foreclosure for such things as fraud (e.g. intentionally lying on the loan application) and waste (e.g. malicious, intentional, or reckless failure to physically maintain the property).
In sum, if the loan(s) on a property are the ORIGINAL purchase money loans that the borrower obtained AT THE TIME THE BORROWER PURCHASED THE PROPERTY, then California’s Anti-Deficiency Laws will apply and the lender (whether a bank or a seller carry-back) will be prohibited from suing the borrower for the deficiency if the lender forecloses, or if the lender provides written preapproval for a short sale. The lender will, however, still have the option of bringing a lawsuit against the borrower for fraud and/or waste.
2012 Update: Struggling homeowners should be aware that many banks, including JP Morgan Chase, Bank of America, and Wells Fargo Bank, are now offering many (but not all) homeowners huge monetary incentives to perform and close a short sale instead of allowing their home to merely fall into foreclosure.
Caution: BEFORE you sign your name on the dotted line of a listing agreement, or a purchase and sale agreement, please consider contacting a California real estate attorney to explain your options and answer your questions. Unlike real estate sales agents who are primarily concerned about their commissions, an attorney has no incentive to make a deal happen... their role when asked is to inform by answering your specific questions, explaining your options, explaining the meaning of the different clauses in the paperwork you may be asked to sign, and sometimes amending that paperwork all so you can make intelligent decisions that are best for you.
If you have fact specific questions, need specific legal advice, or would like the assistance of a California real estate attorney with over 20 years experience, please schedule a telephone consultation for as little as $99 by completing our Telephone Consultation Request Form and Melissa C. Marsh, Esq. will call you back at the time you select, or Send us an Email.
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Located in Los Angeles, California, the Law Office of Melissa C. Marsh handles business law and corporation law matters as a lawyer for clients throughout Los Angeles including Burbank, Sherman Oaks, Studio City, Valley Village, North Hollywood, Woodland Hills, Hollywood, West LA as well as Riverside County, San Fernando, Ventura County, and Santa Clarita. Attorney Melissa C. Marsh has considerable experience handling business matters both nationally and internationally. We routinely assist our clients with incorporation, forming a California corporation, forming a California llc, partnership, annual minutes, shareholder meetings, director meetings, getting a taxpayer ID number (EIN), buying a business, selling a business, commercial lease review, employee disputes, independent contractors, construction, and personal matters such as preparing a will, living trust, power of attorney, health care directive, and more.