Short Sale Deficiency judgments and California law
When we get inquiries from underwater homeowners, there are always questions about deficiencies and the law in California that determines whether or not the homeowner will receive a deficiency judgment upon completion of a Short Sale. For more information on Short Sales or to discuss your options on situation, please email Rama.
When a distressed property owner is facing foreclosure or considering a short sale, whether or not there will be a deficiency is a critical inquiry. What are the rights of the lender and the owner after a short sale or foreclosure? Can the lender go to court to obtain a judgment? And when does the owner not owe the lender anything at all? These questions are foremost in the mind of the distressed property owner.
A deficiency is simply the difference between the outstanding loan balance and the proceeds received by the lender (or the fair value of the property). A deficiency judgment is a court order for the same amount plus costs. To obtain a deficiency judgment, the lender must file a lawsuit against the borrower/owner and go through the judicial court process. Once having obtained a judgment for the deficiency, the lender can enforce the judgment through all the various collection procedures including liens on real property, seizures of bank accounts or garnishment of wages.
On a practical level, a lender may simply try to collect the deficiency through a collection agency without obtaining a judgment. However, if the borrower refuses to pay, the lender will be forced to go to court to get a judgment or just give up trying to collect.
The general rules governing deficiencies are as follows:
1. “One Action Rule”: “There can be but one form of action for recovery of any debt or the enforcement of any right secured by a mortgage upon real property.”
When a borrower defaults, California law requires a lender with a secured interest in real property to take only one action whether it is to conduct a trustee’s sale, sue for the balance of the debt, or judicially foreclose against the borrower. This is known as the “one form of action” rule or “one action rule.”
While this section appears to give a lender a choice of how to proceed to collect the debt, it has been interpreted to mean that a lender must pursue the secured real estate first (“security first rule”). In other words, suing on the note as the first collection method is not allowed (unless the lender is a sold-out junior).
2. No deficiency judgment is allowed by the foreclosing lender following a non-judicial foreclosure (i.e., trustee’s sale), regardless of the type of property foreclosed. No deficiency judgment is allowed when the type of loan is either (a) purchase money for an owner-occupied residential one-to-four unit dwelling (“owner-occupied purchase money”) or (b) seller financing (“seller carry-back”).
2. No deficiency judgment is allowed by the foreclosing lender following a non-judicial foreclosure (i.e., trustee’s sale), regardless of the type of property foreclosed.
There are two types of foreclosures in California: the first type is “judicial,” in which a lender goes to court, gets an order to foreclose and then seeks to be awarded a judgment for the deficiency, if no waiver or prohibition applies. This process is considered “one action”. In addition to this complicated, expensive and slow judicial process, there is period of redemption following the judicial foreclosure for the borrower: three months if sales proceeds sufficiently satisfied indebtedness or one year if sales proceeds were insufficient. For all these reasons, judicial foreclosures are rare, and subsequent deficiency judgments following such foreclosures are as well.
The second is “non-judicial,” meaning no court action is required. The property is sold by exercise of power of sale as written into a deed of trust. This is also referred to as a trustee’s sale. Due to the lack of judicial involvement, this method is cheaper and faster than its judicial counterpart. Because CCP § 580b prohibits deficiency judgments for owner-occupied purchase money and seller carry-back loans, foreclosing lenders are dis-incentivized to pursue judicial foreclosures in those cases. Due to this disincentive, cheaper cost and faster pace, trustee’s sales constitute the vast majority of foreclosures in California. And when there is a trustee’s sale, no deficiency judgment shall be rendered
The key to this rule is that it applies to a trustee’s sale and doesn’t depend on the type of loan or the type of property being foreclosed. For example, for a vacant land property with a refinanced senior loan, if a lender forecloses at a trustee’s sale, then that lender will not be able to claim a deficiency judgment. It simply doesn’t matter what kind of loan it was or what kind of property it is.
There are two things to keep in mind with this rule: first, it only applies to a foreclosing lender. If there are two loans on the property, and a second (i.e., junior) lienholder forecloses first, it is only that second lender which is affected by this rule.
Second, if a junior lender loses its security as a result of a senior lienholder foreclosing first, then any junior lienholder is considered as a “sold-out” junior. The sold-out junior has yet to exercise its one action against the borrower per CCP 726(a) but the security is gone. Only then is the sold-out junior allowed to collect on its now unsecured note by suing on the note (depending on the other deficiency judgment rules, especially the next one immediately below).
3. No deficiency judgment is allowed when the type of loan is either (a) purchase money for an owner-occupied residential one-to-four unit dwelling (“owner-occupied purchase money”) or (b) seller financing (“seller carry-back”).
These two rules prohibit deficiency judgments based on the character of the loan at the time it is made. A loan made for the purchase of residential property containing one-to-four units, one of which the borrower intends to occupy, and which loan is secured by that same property, is called an owner-occupied purchased money loan. For such loans, the lender may only pursue the security, and will not be allowed a deficiency after either a trustee’s sale or a judicial foreclosure.
Additionally, a seller who financed by carrying back a loan as part of the purchase price of the real property (i.e., seller carry-back) is prohibited from obtaining a deficiency judgment against a defaulting borrower. Keep in mind that the seller carry-back rule applies to any type of property (e.g., owner-occupied residential one-to-four, investment, or commercial), while the owner-occupied purchase money rule applies only to residential one-to-four unit property that is occupied by an owner.
These rules apply no matter what type of foreclosure it is or how the loan was positioned. If a senior lienholder forecloses, and as a result a junior lien is wiped out, then the junior lienholder cannot collect on the debt by pursuing the borrower personally if that second loan is either an owner-occupied purchase money or seller carry-back.
The rule has also been interpreted to include not just sellers but also previous lenders who allow their liens to be assumed in order to effectuate a sale. Thus, even these prior lenders are prevented from obtaining a deficiency judgment.
4. No deficiency judgment is allowed for a refinance of a purchase money loan for an owner-occupied residential one-to-four unit dwelling, made on or after January 1, 2013, except as to any cash-out portion of the refinance.
This rule is an extension of the protection afforded purchase money loans to the refinancing of those same purchase money loans, but it only applies to refinanced loans made on or after January 1, 2013, and not to any cash-out. As explained above, rule three grants anti-deficiency protection to purchase money loans made for owner occupied residential 1-4 properties. Rule number four extends this same protection by applying it to any refinance of such a loan as long as the refinance was applied to the obligations owed under the original purchase money loan or to any fees, costs or related expenses of the refinance.
There are however two circumstances where the refinance will not receive anti-deficiency protection. 1) The refinance must be made on or after January 1, 2013. Any earlier refinance may still be subject to deficiency claims. 2) And the refinance must be used to pay off obligations owed under the original loan. Any cash-out portion of the loan (or as the law states “new principal”) may not receive protection from deficiency claims.
Just as in rule number three, the anti-deficiency protections for refinanced loans apply whether or not a judicial or non-judicial foreclosure is used; whether or not the refinanced loan is in senior or junior position; or whether or not the refinancing lender is the foreclosing lienholder or is a wiped out junior.
5. No deficiency shall be owed nor deficiency judgment rendered following a short sale on a residential-one to-four unit property.
These new rules came into effect on July 15, 2011 under CCP § 580e. Simply stated, this law prohibits a lender who holds a deed of trust on real property from either claiming a deficiency or seeking a deficiency judgment from a borrower/seller after having agreed to a short sale. The law applies broadly to deeds of trust on residential one-to-four unit properties.
The type of loan is irrelevant. It doesn’t matter if the loan is made to purchase a property for the owner’s occupancy (i.e., owner-occupied purchase money); to refinance an existing loan to make home improvements; or to pull equity out of a real estate asset (i.e., home equity line of credit) in order to buy goods, pay off debts or make investments.
The type of use of the property is irrelevant. It doesn’t matter if the property is occupied by its owner or a tenant. The property can be purchased for an investment or as a flip.
The lender’s position in priority of title is also irrelevant. This law applies to a senior lienholder as well as to any junior lienholder.
However, the type of owner is relevant. This law does not protect an owner/borrower which is an LLC, corporation, partnership or political subdivision of California.
Finally, this law not only prohibits a lender from going to court to claim a deficiency judgment after a short sale, but it even prohibits the lender from calling up the borrower/seller and trying to collect upon a deficiency. Should a lender seek to collect in such a situation, it would additionally be a violation of the California Fair Debt Collection Practices Act (Civil Code § 1788).
6. A lender may not require a borrower/seller as a condition to agreeing to a short sale to pay money other than from the proceeds of sale.
This final rule is part of the above mentioned new law CCP § 580e. Along with the rules prohibiting deficiencies and deficiency judgment on short sales, this law also prohibits collection of additional money from the borrower/seller during the short sale process. The lender is prohibited from requiring the borrower/seller to pay any additional compensation apart from the proceeds of sale as a condition of granting the short sale approval.
B. Calculating the Deficiency Judgment
Due to limitations placed by CCP § 580d, deficiency judgments, with limited exceptions such as sold-out juniors, are only permitted following judicial foreclosures. Even on the rare occasion a deficiency judgment is rendered, there are limitations on the amount of a deficiency following a judicial foreclosure. The amount of the deficiency judgment allowed is the lesser of:
- The amount by which the debt exceeds the fair value of the property at the time of the foreclosure sale; or
- The amount by which the debt exceeds the sales price of the property at the foreclosure sale. (CCP § 726(b)).
For example, if a lender was owed $300,000 at the time of the foreclosure sale and a successful bidder at that sale paid $225,000, but the property’s fair value was $250,000, then the maximum deficiency judgment allowed would be only $50,000. This is the case because the difference between the debt and the fair value ($300,000 – $250,000 = $50,000) is smaller than the difference between the debt and the sales price ($300,000 $225,000 = $75,000).
In order to obtain a deficiency judgment, a lender must apply to the court for a deficiency judgment within three months of the judicial foreclosure sale.
A full credit bid at foreclosure is a bid made by the foreclosing lienholder, equaling the amount of the unpaid debt including principal and interest, as well as all costs and fees related to the foreclosure. Such a bid is considered full satisfaction of the indebtedness leaving no amount for a deficiency.
III. Exceptions to the General Rules
Of course in law, as in life, there are always exceptions to the general rules and such is the case with the law of deficiency judgments.
In spite of the anti-deficiency rules, a lender is permitted to sue a borrower for damages if the borrower fraudulently induced the lender into making a loan in the first place. This is true whether the foreclosure sale is judicial or non-judicial and whether or not the loan is purchase money. CCP §726 even allows for the collection by the lender of punitive damages up to 50 percent of actual damages.
In fact, a lender, induced by the fraud of a borrower to make a loan, may recover in tort for the fraud, even if the lender made a full credit bid at the foreclosure (and theoretically was satisfied to the full deficiency), if the fraud was proximately the cause of any cognizable loss.
However, if the loan is secured by a single family owner-occupied, residential property in an amount not exceeding $150,000, annually adjusted, then this exemption does not apply. In any event, whether or not there is fraud, CCP § 726(a) still requires a lender to pursue the security first before suing on the underlying note or debt.
B. Bad Faith Waste
Waste can be defined as the failure of the borrower to maintain the property. While the general anti-deficiency rules apply if the borrower has allowed a waste to occur, California courts have allowed actions for a deficiency judgment in the event the borrower has committed “bad faith waste.” This is true whether the foreclosure sale is judicial or non-judicial and whether or not the loan is purchase money.
Bad faith waste is an injury to the property by the action or inaction of the person in possession which is reckless, intentional, or malicious. Only the damage resulting from bad faith waste, as opposed to decline due to market conditions or ordinary waste, is recoverable. This recovery is a tort action and not a deficiency judgment and may be brought before or after a foreclosure.
C. Sold-Out Junior Lienholders
The security first rule does not prohibit a lender from suing directly on the debt when the security is legally worthless. Legally worthless is to be distinguished from economically worthless. For example, let’s say a buyer borrows $800,000 from a lender secured by a first trust deed in order to purchase a $1,000,000 property. Subsequently, the same person borrows an additional $200,000 secured by a second trust deed. The junior lienholder appraised the property at that time at $1,250,000. If market conditions change and the property drops in value to $800,000, and the borrower stops making payments on this second loan, the junior lienholder must pursue foreclosure rather than sue on the debt. While the junior security has no economic value, it is still legally valuable. On the other hand, if in our example, a senior lienholder foreclosed, resulting in the property being conveyed free and clear of the junior lien, then the junior security, in and of itself, has no value. In that situation, the junior lienholder can sue the borrower directly on the note as a “sold-out” lienholder.
The sold-out junior lienholder is unable to take advantage of this exception if the junior lien secures a standard purchase money loan.
Additionally, the worthless security exception does not apply if the lender itself has taken some action to make the security worthless. A court has held that a lender which had both a first and a third deed of trust on a property could not pursue the borrower directly on the debt secured by the third trust deed if the lender had caused the third lien to be relinquished by foreclosing on its own first trust deed. The two liens are merged and under the one action rule, the lienholder is prohibited from taking a second action against the borrower.
D. Exceptions to Short Sale Deficiency Rules
As previously stated, CCP §580e now prohibits deficiency and deficiency judgments following a short sale of residential one-to-four unit property. To qualify for this protection a number of requirements must be satisfied. For a borrower to be eligible for the short sale anti-deficiency protection all of the following must be met under CCP § 580e(a):
- Mortgage loan is solely secured by a deed of trust or mortgage;
- Mortgage loan is for a dwelling of not more than four units;
- Borrower sells the property for less than the outstanding loan balance;
- Lender provides written consent for the short sale;
- Title voluntarily transfers to a buyer by grant deed or other document of conveyance recorded in the county where the property is located; and
- Proceeds of the sale have been tendered to the lender or lender’s agent in accordance with the parties’ agreement.
Additionally, once these requirements have been met, there may be an exception any one of which will impair or defeat the anti-deficiency protection. CCP §§ 580e(a)(2), (c), and (d) list the exceptions:
- Waste to the real property;
- Cross-collateralized loans;
- Borrower is a corporation, limited liability company, or limited partnership;
- Borrower is a political subdivision of the state;
- Deed of trust, mortgage, or other lien securing the payment of a bond or other evidence of indebtedness authorized by the Commissioner of Corporations; and
- Deed of trust, mortgage, or other lien made by a public utility subject to the Public Utilities Act.
E. FHA and VA Loans
If a loan is insured or guaranteed by the Federal Housing Administration (FHA) or the Veteran’s Administration (VA), there may be personal liability after foreclosure regardless of the anti-deficiency protections. Federal law governing FHA and VA loans may override California’s anti-deficiency rules.
courtesy CAR legal