Foreclosure

No one ever buys a home with the intention of one day losing it to foreclosure or being forced by circumstance into a short sale. Unfortunately, that is exactly the situation in which many homeowners find themselves. Financial struggles push thousands of homeowners into short sale or foreclosure every year. When the housing market collapsed in 2008-09, many found themselves upside-down in their mortgage and opted to simply walk away, leaving the bank to foreclose on the property and sell it for whatever a buyer would pay.

What many homeowners fail to realize is that repossession of a home through foreclosure does not necessarily release the homeowner from his or her financial obligation. Nor does a short sale always alleviate the debt owed to a lender. When a bank or other lender takes possession of a home through foreclosure, the objective is to sell the home to recover the balance owed on the mortgage. Often, the realized sale price may be less than the balance of the mortgage. Likewise, when a house is sold under short sale, the homeowner sells for less than what is owed, leaving a balance due to the lender.

Debt Liability and State Laws

So, what happens to the difference between what is owed and what the home sells for in a foreclosure sale or short sale? Typically, the homeowner is liable for the difference, known as the deficiency.  In some states, that debt can follow the homeowner for up to 20 years. Depending on state laws, the lender may have the right to pursue a legal judgment against a borrower for any deficiency, commonly known as a deficiency judgment. With or without a legal judgment, the lender can sell the debt to a third party collection agency, who can then pursue legal action against the borrower.

State laws regarding deficiency judgments vary. For example, Minnesota allows deficiency judgments, provided certain conditions are met. Lenders must meet different criteria, depending on whether the property is residential or agricultural. Additionally, lenders must file for a judgment within a specific time frame after the sale.  Most other states allow deficiency judgments, but impose limitations on types of mortgages, house size, time allowed between sale and filing, or other conditions. Few states bar deficiency judgments, although many require that a lender declare their intention to pursue a deficiency claim.

It’s Up to the Lender to Choose

Aside from state laws, the choice to pursue any difference between sale price and amount owed is up to each lender. Not all lenders pursue deficiency judgments against all borrowers, but rather use the threat as a deterrent against default. The Department of Housing and Urban Development (HUD), for example, mentions the possibility of a deficiency judgment in a pamphlet about avoiding foreclosure.  In many cases, lenders do not pursue deficiency judgment due to the time and expense involved in collecting the debt, not to mention the unlikelihood of receiving payment.

In 2009, the Federal Reserve Bank of Richmond conducted an extensive study regarding lenders and deficiency judgments. Specifically, the study created a model by which to determine how often lenders utilized deficiency judgments and how such practices affected borrower decisions to default. According to the study, the use of deficiency judgments is rare. This is partly due to regulations on time, fair market value and other state laws that make the process onerous and expensive for lenders. Furthermore, lenders typically pursue other, less expensive means to gain possession of a home in default, such as a voluntary surrender or conveyance of the property, known as a deed-in-lieu.

Ideal Candidates for Pursuing a Judgment

Although not always the case, lenders typically reserve pursuing a deficiency judgment, and the legal expenses involved, for only those borrowers from whom the lender can actually recover. For example, borrowers with considerable wealth are more likely to pay a deficit to protect other assets. Such borrowers are also less likely to file bankruptcy to escape paying the judgment, as this could result in forfeiture of assets. According to the Federal Reserve study, wealthy borrowers are also the most likely to respond to threats of deficiency judgment when facing default, with many opting for friendly foreclosures or short sales, as opposed to simply walking away from a property or contesting a foreclosure.

Wealth is not the only factor in whether a lender chooses to pursue deficiency. If the homeowner causes intentional damage to the home, by removing built-in appliances, cabinetry, major home systems, or otherwise vandalizes the home prior to foreclosure, the lender may pursue on the basis of waste. Many states protect lenders from unnecessary cost resulting from waste, but require including such damages as part of a deficiency judgment.

How to Avoid a Deficiency Judgment

Even though statistics show lenders rarely pursuing deficiency judgments, few homeowners are willing to risk whether their lender will pursue or not. In states with no recourse for lenders, borrowers are more likely to default, at a rate of more than 60 percent. These borrowers may have little regard for any balance remaining after the sale, owing to state restrictions. However, in states that do have recourse, borrowers are advised to address the issue of deficiency with their lender before the home is sold.

For example, with a short sale, the borrower must get the lender’s release in order to sell for less than what is owed on the home. As part of that release, the borrower can negotiate forgiveness for any deficiency. Likewise, homeowners can negotiate a non-judicial foreclosure, such as a deed-in-lieu, and also obtain deficiency forgiveness, prior to surrendering the home. Homeowners should be aware, however, that there may be income tax liabilities associated with any forgiven debt. The IRS offers information regarding relief from tax liabilities on mortgage debt forgiveness.  Borrowers should be advised to carefully weigh all the risks and benefits, including tax liabilities, before proceeding with any type of foreclosure or short sale.

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