Deficiency Judgments – Do the Banks Really Sue Homeowners?

Deficiency JudgmentsWhat is a Deficiency Judgment

A deficiency judgment is an unsecured money judgment against a borrower whose mortgage foreclosure sale did not produce sufficient funds to pay the underlying promissory note, or loan, in full. The availability of a deficiency judgment depends on whether the lender has a recourse or nonrecourse loan, which is largely a matter of state law. In some jurisdictions, first mortgages are non-recourse loans, but second and subsequent ones are recourse loans.

Deficiency judgments are court orders that make you personally liable for unpaid debt. They are often associated with foreclosures, when a homes selling price is not enough to cover the loan balance. Let’s take a closer look at what deficiency judgments are and if you should expect one.

Deficiency Judgment Overview

When you default on a loan and the lender repossesses your property, the value of the property may not pay off the loan. For example, you might owe $100,000 on your home, but it only sells for $80,000. You’re $20,000 short.

The lender  has the right and may take further legal action against you. Legal action to collect the remaining amount is called a deficiency judgment.

How much is the  Deficiency Judgment?

It will be no surprise that the unpaid debt ($20,000 in the example above) is part of the deficiency judgment, however, lenders can also sue for the costs associated with the foreclosure (including the unpaid interest, unpaid property taxes and homeowner’s association dues, attorney fees, etc.) and pursuit of the deficiency judgment.

Is a  Deficiency Judgment Likely?

If your lender is allowed to pursue a deficiency judgment, there is no way to know whether or not they will. The likeliest candidates for deficiency judgments are so- called rational or strategic defaults. In those cases, people who are current on their mortgages decide to walk away from a property because its value has sunk so far below their loan balance they have no hope of recouping the loss. In most cases, your lender will not go to the trouble. Legal action is expensive and time consuming, and people who just suffered a foreclosure often don’t have the assets or income needed to satisfy a deficiency judgment. If you had the resources, you wouldn’t have missed your payments in the first place.

For some loans, deficiency judgments aren’t even an option. State laws dictate whether or not lenders can pursue deficiency judgments after foreclosure. If a loan is a non-recourse loan, a deficiency judgment is out of the question. Click here for more information on recourse loans and individual state laws.

If the  Deficiency Judgment is Successful?

If your lender successfully wins a deficiency judgment against you, you are personally liable for the amount of the judgment. You are legally required to satisfy the deficiency judgment, and the lender can go after you if you don’t. They may be able to garnish your wages or take personal items (not necessarily your home, car, or other essential items).

Retirement accounts are generally not at risk in a deficiency judgment, but you should check with a local attorney if you are at risk.

Does PMI Help you Cover the Deficiency?

No. Private Mortgage Insurance (PMI) cannot protect you from deficiency judgments. It is meant to protect a lender against the losses from a mortgage default. A PMI is required if you make a down payment of less than 20% on your loan.

Is There a Way to Avoid Deficiency Judgments?

Yes. If you can stop foreclosure, you can avoid the judgment. In case you’re having difficulty in making mortgage payments and a foreclosure is imminent, you can look for various loss mitigation options like loan modification or short sale, etc. A loan modification can reduce your mortgage payments and help you save the home. A short sale allows you to sell your home for less than your current mortgage obligation.

A short sale does not help you retain the home. But when successfully negotiated by an experienced short sale agent it waives off the lender’s right to collect the deficiency. This helps you avoid a judgment. However, you should not believe in verbal agreements. If the deficiency is forgiven, ask your lender to  state this in writing before you proceed with the short sale.

That said, even though the banks are allowed to sue homeowners for the deficiency, they rarely choose  to pursue a deficiency judgment. Why would the banks decline this right? It boils down to cost and the effects of negative publicity. As mentioned  legal process takes a long time and there are hefty costs involved  with such action.  Furthermore,  there is no guarantee the lenders can successfully claim back their money through income garnishment or asset liens  as the majority of these borrowers ended up in foreclosure because of a hardships and were unemployed, have emptied bank savings and have no other valuable assets. For such situations, the banks and lenders have more to lose by pursuing deficiency judgments and the banks simply aren’t interested in throwing good money after bad. Quite simply, if there is little chance of collecting back the money owed, a deficiency judgment after foreclosure will only create more losses for both the homeowners and the mortgage lender.

If the banks have reason to believe that these homeowners are in true financial hardship and this is the reason for their missed mortgage payments, then the banks will probably write off these debts due to the fact the resources required to pursue after foreclosure deficiency judgment are better directed  towards high return investments, or making additional loans.

Homeowners that are facing true financial hardship usually need not worry about being brought to court by their banks even if the bank refuses to release their right to pursue the homeowner if  there is a deficit after the short sale or foreclosure sale. Even if the bank retains their legal right to pursue homeowners for the balance owed after the the short sale or foreclosure auction, we’ve yet to see a lender resort to doing so.

The situation is however different if the bank is aware that the homeowners are wealthy and possess other highly liquid assets. If the lender believes a homeowner has assets, they are less inclined to pursue the homeowner for a deficiency judgment, and rather  they will insist  that  the homeowner make a contribution to, or that they agree to sign a promissory note to cover a portion of this deficiency from the short sale. These contribution amounts vary based on the size of the loan, the value of the offer on the property, and what the bank believes the homeowner might actually be able to reasonably contribute.

It should be noted that deficiency judgments are entirely dischargeable as unsecured debts in a Chapter 7 bankruptcy filing. So even if homeowners do get sued after foreclosure, they may be able to get rid of the debt by filing Chapter 7. And with a huge debt of tens of thousands of dollars, it becomes easier to qualify for discharge, as the debt can easily outnumber the value of the borrowers’ assets.

What about Income Taxes?

Another problem with mortgage foreclosure is possible income tax consequences. The general rule is that when a lender forgives or cancels a debt the borrower can incur income tax on the amount of debt forgiveness. When you arrange a discount in your mortgage in order to sell your house (a so-called short sale) the mortgage lender will cancel part of your mortgage debt and you will receive a tax form 1099 telling the IRS that you have imputed income for the amount of debt reduction. You will also incur income tax liability for a deed in lieu of foreclosure. The taxable income will be the difference between the property value and the balance of the mortgage loan on the date you surrender the property to the bank.

A foreclosure may result in cancellation of debt income depending on whether the bank pursues a deficiency judgment. If the mortgage lender gets a deficiency judgment for the difference between the property value on foreclosure sale date and the mortgage balance the lender is not forgiving any part of the loan. If the bank chooses not to pursue a deficiency judgment, or pursues the judgment unsuccessfully, the borrower may incur income tax liability for debt forgiveness.

In December, 2007, Congress acted to protect many debtors from income tax liability associated with foreclosure avoidance. The Mortgage Forgiveness Debt Relief Act of 2007 states that homeowners will not be subject to income tax from release from mortgage liability if and to the extent the mortgage proceeds were used to buy or improve their primary residence. There is no income tax shelter from forgiveness of mortgage debts for  investment property, vacation homes, or mortgages used for businesses or to pay off credit card balances. The protection expired in December, 2012 however it has been extended every year sense. You should speak with an attorney or CPA familiar with the new law to see if you qualify for income tax protection.

For those borrowers who do not qualify for protection of the new Act there is an insolvency exception to imputed income from the cancellation of mortgage debt. If a borrower is financially insolvent when he surrenders the mortgaged property to the lender voluntarily or through foreclosure there will be no imputed income. A borrower who files bankruptcy is presumed to be insolvent, so that a bankruptcy debtor cannot suffer imputed income tax liability because the bankruptcy discharges personal liability under a mortgage note. More information is available from IRS Publication 908 and IRS tax form 982. Both forms can be found at irs.gov.

The tax law permits many real estate investors to offset imputed debt forgiveness income with corresponding tax losses. For example, if a lender forecloses on a parcel of income producing rental property the taxpayer may be able to report an operating loss to offset all imputed income from debt forgiveness in the same year that the mortgage lender issues the Form 1099. When a foreclosed property was not income producing, but was held solely for future appreciation (example: vacant land), the deduction from ordinary income of capital losses in excess of capital gain may be limited to $3,000 per year so that the total loss will have to be deducted over future tax years. You should consult your CPA to determine the tax impact of a mortgage foreclosure on your tax situation. The tax impact of foreclosure is not a legal issue.

Please call us at 614.332.6984 to address any questions you may have and to  discuss how we might assist you!

The Opland Group Specializes in Real Estate Sales, Luxury Home Sales, Short Sales in; Bexley 43209 Columbus 43201 43206 43214 43215 Delaware 43015 Dublin 43016 43017 Gahanna 43219 43230 Grandview Heights 43212 Hilliard 43026 Lewis Center 43035 Marysville 43040 43041 New Albany 43054 Pickerington 43147 Powell 43065 Upper Arlington 43220 43221 Westerville 43081 43082 Worthington 43235

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