Time to Walk Away or Stay and Fight the Good Fight
You’ve been a proud California home owner for years. But, you recently lost your job and are finding it difficult to keep up with your mortgage payments. Worse yet, your house is “under water.” No, that doesn’t mean it’s located in a flood zone. It’s foreclosure real estate law parlance signifying that the fair market value of your home is less than the loan amount(s) due, so the proceeds generated on sale of the home is insufficient to pay-off your lender. Don’t feel ashamed. You’re not the only home owner facing the prospect of losing your home. While foreclosures are down from a year ago, statistics still show a staggering amount of Californians struggling with the “white-picket fenced” American dream. It may be time to “walk away” from your property, but you need to know your rights under California foreclosure real estate law. The two main financial concerns under foreclosure real estate law that California homeowners should consider before deciding whether to “stay and fight” or strategically “walk away” from their under water real property concern taxes and the potential that the lender will pursue a “deficiency judgment.” We address legal liability for deficiency judgments in this blog post. Next week, we’ll examine the tax concerns.
Liability for “Deficiency Judgments” under CA Foreclosure Real Estate Law
A foreclosing lender has a right to seek a “deficiency judgment” against a defaulting borrower under California foreclosure real estate law in certain circumstances. The liability of a defaulting borrower by a lender seeking a deficiency judgment depends on the type of loan the borrower possesses and the procedure used by lender.
Loan Types – Non-Recourse vs. Recourse
There are two different loan types – non-recourse and recourse – that carry differing legal and tax liability implications under California foreclosure real estate law.
A non-recourse (or “purchase money“) loan is a loan taken out to purchase real property. When a borrower defaults on a non-recourse loan obligation, the lender can only recover the home itself as repayment of the debt. Defaulting borrowers face no personal liability under California foreclosure real estate law. This means that a borrower won’t be sued for a deficiency judgment by a non-recourse lender.
A recourse loan is a loan that’s secured against real property after the buyer’s purchase of the property.
A word of caution here. Refinancing a non-recourse loan may transform the loan into a recourse loan under California foreclosure real estate law (see details below).
“Non-Recourse Loan” Case Example
Single Non-Recourse Lender
Benny Borrower purchases a home for $500,000, putting 20% down ($100,000) in cash and borrowing a $400,000 purchase money “non-recourse” loan to cover the remaining purchase price. Borrower loses his job and is unable to make his mortgage payments. The non-recourse lender proceeds with a non-judicial (commonly called “trustee sale”) foreclosure. At that time, the property’s value dropped to $350,000 and Borrower had paid down the mortgage to $390,000.
The difference between the amount the lender gets back from the borrower (or the fair market value of the property – $350,000) and the loan amount at the time of the foreclosure ($390,000) represents the amount that the borrower is “deficient” (here, $40,000). Can the lender seek a $40,000 deficiency judgment against Borrower? No. The lender can only take back the property as full satisfaction of the debt owed by Borrower. Why? Borrower’s loan is a non-recourse loan (that was never refinanced). Borrower faces no personal liability and cannot be sued by Lender for the $40,000 deficiency.
Two Non-Recourse Lenders
Let’s change the facts. Assume in this scenario that Borrower purchases a $500,000 home and again puts 20% down. Borrower takes out two non-recourse loans – $300,000 from Lender 1 and $100,00 from Lender 2 – to purchase the property. The home drops in value to $200,000, at which time the amounts due on loan 1 and loan 2 are $250,000 and $50,000, respectively. Borrower decides to “walk away” and stops paying the mortgages. Lender 1 forecloses and gets the property worth $200,000. Even though Borrower is $50,000 “deficient” in payment to Lender 1, Lender 1 cannot sue Borrower to recover the $50,000 deficiency because the loan is non-recourse. Lender 2 also cannot file suit against Borrower for the $50,000 due because the Loan 2 is also non-recourse. Loan 2 is “sold out” of any and all rights to sue Borrower and/or recover any equity (as there is none left after Lender 1 forecloses) from Borrower.
“Refinanced” Non-Recourse Loan
How do things change under California foreclosure real estate law if Borrower refinances the “purchase money” loan? Assume the original facts where Borrower obtains a single non-recourse loan for $400,000 to buy a $500,000 home. The home rises in value after purchase, so Borrower refinances the loan to get a better interest rate. Unfortunately for Borrower, soon after refinancing the market collapses and the property declines in value to $200,000. The loan principal is still $400,000.
The anti-deficiency protections of California foreclosure real estate law hold that “purchase money” non-recourse loans that were refinanced before January 1, 2013, transform into “recourse” loans on a refinance. The result? Lender can pursue a deficiency judgment for $200,0000 against Borrower via Judicial Foreclosure only. By pursuing Non-Judicial Foreclosure, Lender waives its right to a deficiency judgment. Non-recourse loans that were refinanced (not including a “cash out refinance“) after January 1, 2013, maintain their non-recourse status and do not change into recourse loans; therefore, Lender cannot go after Borrower regardless if Judicial or Non-Judicial Foreclosure (commonly called “Trustee Sale“) is pursued.
Any refinanced loan in which Borrower takes “cash out” is subject to a Lender seeking a deficiency judgment via Judicial Foreclosure regardless of when (before or after January 1, 2013) Borrower refinances. “Cash out” means that the lender advances new principal which is not applied to any obligation owed under the purchase money loan or to fees, costs or related expenses of the refinance.
Will a recourse Lender seek judicial foreclosure to recover a deficiency? Probably Not. It’s expensive, time-consuming (roughly 18 months) and risky because Borrower can file Bankruptcy to discharge unsecured debt. By pursuing Non-Judicial Foreclosure (a much quicker and cheaper procedure – roughly 4 months), Lender 1 waives the right to seek a deficiency judgment from Borrower under California foreclosure real estate law, but is saved the time, cost and risk of pursuing Judicial Foreclosure.
“Recourse Loan” Case Example
Owen Owner purchases a home for $600,000, putting $200,000 down, and obtaining a non-recourse loan of $400,000 (Loan 1) to cover the remaining purchase price. Six months after the purchase with the real estate market booming, buyer obtains a HELOC for $100,000 (Loan 2) for “personal use” (pay part of kids tuition, buy wife Porsche, go to Disney World, etc). The property declines in value to $350,000 a couple years later. The principal owed on Loan 1 is still $400,000. Borrower defaults on Loan 1. Loan 1 forecloses and gets the property back only. Lender 1 cannot sue borrower to obtain the $50,000 “deficiency” (difference between fair market value $350,000 and loan amount $400,000 at the time of foreclosure) because Lender 1 is a non-recourse lender. Remember, however, that if Owner ever refinances, Loan 1 may pursue the $50,000 if (and only if) Lender employs a Judicial Foreclosure procedure.
“Sold Out Junior” Recourse Lender
What happens to Loan 2? Loan 2 is a “recourse” loan because it was not used to purchase the real property. Rather, Owner acquired Loan 2 after purchasing the real estate. Loan 2 is considered a “sold out junior” under foreclosure real estate law. Loan 2, who is “sold out” of its right to pursue any equity in the home after Lender 1’s foreclosure, can sue Owner personally and seek a “deficiency judgment” for the $100,000 due. The question remains? Will Loan 2 sue? Maybe – maybe not. Can the borrower settle? Probably. Are you confused? Most likely. I don’t blame you. This stuff’s confusing. We’ve touched on some of the basic main points regarding legal liability under California foreclosure real estate law, but there are plenty of intricacies we didn’t get into with Borrower and Owner. It’s wise to consult an attorney that’s versed in the nuances of California foreclosure real estate law to before deciding how to proceed.
Mortgage Insurance Reduces Deficiency Judgement Amount
Lenders right to recover a deficiency judgment is reduced by the amount that was reimbursed by the mortgage insurance carrier. Owner has the right to know whether and how much the mortgage insurance covered Lender’s loss under RESPA.
Stay tuned. Even though you may have dodged the legal bullet, taxes are a different story altogether. Part II of California foreclosure real estate law is all about a defaulting borrower’s tax liability.