In this blog, I’ll provide a simple explanation of California’s mortgage and anti-deficiency laws which allow individuals to walk away from their homes. In addition, I will touch on some of the issues that borrowers need to be aware of in making any sort of financial decision concerning their mortgage.
We’ve all heard that individuals and families today are “walking away from their mortgages” when their house is “underwater,” but many don’t know what this means. A house is “underwater” when its fair market value is less than the outstanding mortgage. Many individuals who are in this position see their mortgage payments producing no equity and feel it is imprudent to keep throwing good money after bad. Thus the question becomes, “Can I get out of this mess?” In answering this question a borrower must consider two primary considerations: 1) Is the lender foreclosing judicially or by trustee’s sale; and 2) is the loan a purchase money deed of trust?
Is the lender foreclosing judicially or by trustee’s sale?
California law allows lenders to foreclose on properties judicially (i.e. by filing a complaint with the court) or by power of sale (otherwise known as a trustee’s sale). The vast majority of foreclosures performed in California are by trustee’s sale. California law allows lenders who judicially foreclose on property the ability to seek a “deficiency” judgment, which is the amount of the outstanding mortgage less the fair value of the property. For example, if the outstanding mortgage is $350,000 and the fair market value of the property is currently $225,000, the deficiency judgment would be $125,000. If the lender forecloses judicially, the borrower is allowed to remain in possession and possibly redeem (“buy-back”) the property for up to one year after the foreclosure sale for the price the lender received at the foreclosure sale.
If, on the other hand the lender forecloses by trustee’s sale, California law statutorily prohibits the lender from seeking a deficiency judgment. However, under this foreclosure procedure, the borrower is likewise prohibited from redeeming the property or possession of the property. As you can see, the statutes work a “give and take” with lenders and borrowers.
Is the loan a purchase money deed of trust?
There are generally two kinds of purchase money deeds of trust which are subject to anti-deficiency laws. In the first, a note and deed of trust is executed by a buyer and payable to the seller for the purchase price of the home. This is generally known as “seller financing.” In the second, a note and deed of trust is given by a buyer to a third party lender (a bank) for part of the purchase price of an owner-occupied residential property containing four or fewer units. This is the more commonly understood method of financing.
Under California law, these two methods of financing prohibit the lender or seller from seeking a deficiency judgment. However, purchase money anti-deficiency protections could be lost if the loan is not a “standard” transaction, such as a construction loan or in some cases of refinancing.
How do these protections relate to people walking away from their homes?
Banks are generally unable to obtain deficiency judgments from foreclosures who walk away from their homes because the loans made were for purchase money. Because the bank cannot seek a deficiency, there is no reason for them to go through the more cumbersome process of judicial foreclosure. These individuals may walk away knowing that their lender can’t go after them for anything more than the property itself.
However, walking away will impact the borrower’s credit since the bank will eventually foreclose on the property. In addition, individuals need to be aware that these actions could trigger “cancellation of debt” income, which could mean that they would need to pay income taxes on the amount of debt that has been forgiven. Forgiveness of non-recourse debt is not subject to cancellation of debt income and the 2007 Mortgage Forgiveness Relief Act provides taxpayers with additional protections for up to $2 million dollars (expires in 2012). It is a good idea for homeowners to know exactly what kind of debt their mortgage represents before making any decision.
Before deciding to walk away, homeowners need to be aware of their options and understand their ramifications. We encourage all individuals who face any sort of mortgage difficulties to seek the assistance of an attorney who is experienced in the real estate field. By being informed, individuals can make their own path through the mess instead of allowing the path to make itself.