Springfield Business Journal Articles


Deficiency Judgments - The Rest of the Foreclosure Story

Real property owners in financial distress often have no choice but to give up their property – whether through foreclosure, short sale, or deed in lieu of foreclosure. However, many people think that the story ends once they lose their house or other property. Unfortunately, there are several more chapters to go.

First, let’s deal with some definitions. Foreclosure is the process by which a lender terminates an owner’s right to property through a judicial process involving a forced sale, usually at public auction, with the proceeds being used to pay off the mortgage debt. Easy enough. A short sale occurs when property is sold, but the lender agrees to take a discounted payoff with the mortgage being released even though the lender receives less money than is actually owed. Finally, with a deed in lieu transaction, the property owner voluntarily deeds the property to the lender, who accepts the deed and in return agrees to release the owner from liability for any mortgage debt.

Turning first to foreclosure, all too often borrowers assume that once their property is sold there’s no more liability. Unfortunately, however, it’s the rare foreclosure sale that brings in enough money to pay off the underlying debt. Court costs, attorneys’ fees, and other expenses get added to the debt. And, a public auction generally doesn’t bring in top dollar. The difference between the amount of debt and what the foreclosure sale brings in is called the deficiency, and the bank is generally awarded a “deficiency judgment.”

Armed with this judgment, a lender is entitled to continue to pursue you for the amount of the deficiency. However, because borrowers think that the process ended with the sale of the property they often ignore these “post judgment” proceedings – inevitably to their peril. Lenders can garnish your wages, demand financial records, and seize certain assets. Failure to respond to certain post judgment proceedings can actually result in warrants being issued for your arrest. And, these post judgment proceedings can come years after the deficiency judgment is granted. Certain lenders will periodically monitor your credit report to determine if, and when, its’ worthwhile to collect on a deficiency judgment. Moreover, many lenders sell these accounts – sometimes long after a foreclosure sale. That new account owner may be more apt to pursue collection of the deficiency judgment. The bottom line - don’t get lulled into a false sense of security.

Short sales also present a pitfall for the unwary. Many property owners assume that just because a lender releases a mortgage for less than the full amount due that they are absolved from liability. Nothing could be further from the truth. Once the mortgage is released, any remaining debt owed that lender still exists – it’s just now categorized as unsecured debt. The lender can still sue you, and ultimately get a judgment, for the amount of debt not paid off by the short sale. Once armed with a judgment, the creditor can proceed just as described above regarding a deficiency judgment. Of course, the debt might also be reported to a credit reporting agency.

What’s the property owner to do? If you don’t ask, you don’t get. In other words, the savvy owner addresses this issue prior to the short sale by asking the lender for a release. If the lender is unwilling, it still might be possible to negotiate a release from any remaining liability by payment of a reduced amount – perhaps even structured over a period of time. If successful, don’t just take somebody’s word for it – either get a copy of the actual promissory note marked “paid” or demand a written release or other proof of debt satisfaction. If unsuccessful in your attempts to get released from any liability, at least you will know that the process isn’t over.

A deed in lieu of foreclosure, unlike the first two options, actually results in a forgiveness of any debt owed that is not covered by the value of the property. For a financially distressed borrower, this is quite often the best possible result. Lenders, however, will generally be averse to agreeing to a deed in lieu unless they are convinced that there’s little or no possibility of ever collecting on the “difference” and/or the actual costs and fees incurred in a foreclosure. Further, if there are second or third mortgages, or other liens, it’s virtually impossible to pull off a deed in lieu.

But wait – there’s even more bad news. If you get your lender to absolve you from the deficiency in a short sale, or you convince your lender to do a deed in lieu of foreclosure, it involves your creditor forgiving some amount of debt. In the eyes of the IRS, forgiveness of debt equals income that is taxable. That’s right – you might owe tax even though you never actually received any money.

What are your options? First, thanks to a recent federal law, any such debt that is forgiven between 2007 and 2012 will not be taxed as income, but only if it related to your primary residence. Rental property and commercial property are ineligible for the relief. Also, any loans secured by your primary residence, but not used to improve that residence, are not eligible for this relief.

Second, in certain instances farm related debt that is forgiven will not be taxable.

Finally, if you were insolvent when the debt was forgiven, you may not owe any tax. You are deemed to be insolvent when your total debts exceed the fair market value of all your assets.

Finally, people often prefer a short sale or deed in lieu of foreclosure to an actual foreclosure because the former won’t show on a credit report. That’s usually not true – even if the debt is forgiven.

The issues confronting borrowers in financial distress can be quite complex. As with most situations, there’s no excuse for not being informed of the issues or for failing to seek the help of professional advisors.

Thomas C. Pavlik, Jr.
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