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Short Sales and California Anti-Deficiency Laws

I have had several issues arise recently in several short sale transactions where the potential liability to our clients for a deficiency judgment was in question. The following comments relate to the anti-deficiency statutes in the State of California CCP § 580b thru (d) .  A deficiency is the difference between the amount owed and what the lender was able to recover through foreclosure. These issues were discussed with an attorney with the California Association of Realtors on their legal hotline and an article on their website.

1. In California,  lenders have two choices in foreclosing on a property.  Non-Judicial foreclosures are where  the lender forecloses under the rights in their deed of trust and are processed without court intervention, with the requirements for the foreclosure established by state statutes. Under a non-judicial foreclosure, the lender initiating the foreclosure can not later sue for a deficiency judgment, based on what is called the "one-action rule".  Judicial foreclosures are where the lender sues for foreclosure under their rights of sale under the mortgage and pursues the foreclosure through a law suit through the courts. In this situation, the lender may also sue for a deficiency. In California, however, a lender may not pursue a deficiency for loans that qualify as a "Purchase Money Mortgage".

To qualify as a purchase money mortgage in California, the loan must be obtained at the time of purchase of the borrowers principal residence. This can include a second mortgage obtained at the time of purchase.  Although the legal issue as to whether a home equity line of credit used to purchase a home would qualify as a purchase money mortgage has not yet been fully addressed through case law, most attorneys believe that if the loan was only used to purchase the property and additional draws for other purposes were not taken, the home equity line should qualify as a purchase money mortgage.  If the initial loan was refinanced, even if no additional proceeds were drawn and the refinance was only a change in interest rate or terms, the new loan would not qualify as a purchase money mortgage and would be recourse. This is a major issue with those borrowers who have recently modified their loans which are in default, because they may have unknowingly converted their purchase money non-recourse loan to a fully recourse loan, and exposed themselves to a potential large deficiency judgment.

If a second mortgage is a purchase money mortgage, and the first mortgage forecloses out the second mortgage,  the second mortgage is precluded from pursuing a deficiency judgment as the borrower is protected by California anti-deficiency laws. Under Code Civ Proc, § 580b, the holder of a note secured by a purchase money second trust deed may not recover even though the second trust deed had become worthless by reason of a sale conducted under the senior first deed of trust. Barash v. Wood (1969, Cal App 2d Dist) 3 Cal App 3d 248, 83 Cal Rptr 153, 1969 Cal App LEXIS 1377.

2. If the first and second mortgages are recourse and not purchase money mortgages, and the property is foreclosed on in a non-judicial foreclosure, it is important as to who initiated the foreclosure.  If the first forecloses on the property and wipes out the second mortgage, the first mortgage holder can not pursue a deficiency, however the second mortgage holder can pursue a deficiency judgment against the borrower.  If the second mortgage holder forecloses on the property and takes over the property, they would not be able to pursue a deficiency judgment.  In California, this is known as the "one-action" rule.  A lender can not both go through a non-judicial foreclosure ( foreclose on the deed of trust )and then sue to collect a deficiency judgment, however they could choose to go through a judicial foreclosure where they are not simply foreclosing on the deed of trust through a trustees sale, but instead are suing the borrower for title as well as a deficiency judgment.  This is not often done as it is much more expensive and time consuming to go through a judicial foreclosure.

3. If a mortgage satisfies the conditions of a purchase money mortgage under these statutes at the time the mortgage is made,  then if the property is later converted to an investment property and rented out, the status of the mortgage as a purchase money mortgage is not changed.

4.  In obtaining a release from the lien of either a first or second lender in a short sale, even if the loans are purchase money mortgages, it is imperative that a full release from both the mortgage lien as well as the promissory note is obtained, otherwise the lender may pursue a deficiency judgment since the lender did not go through foreclosure.  Releasing the lien on the property is not enough since the property just serves as security for the promissory note.  You must get a full release on the note as well.  Often times a second mortgagee will negotiate with the borrower as to what they will require to be paid, either from the sale proceeds ( as allowed by the first mortgagee) or from the seller contribution, but this may be just for obtaining their release of the lien, and you need to make sure they will also give a full release of the promissory note, otherwise they could pursue a deficiency judgment after the short sale is closed.

In a short sale where the first mortgage loan is not a purchase money mortgage and is recourse, the borrower must weigh their exposure to a deficiency judgment if they do a short sale without a full release of liability for any deficiency, compared to the advantages of doing a short sale ( primarily less effect on the borrowers credit rating ).  This is because if they simply allowed the non-judicial foreclosure, they would not be exposed to a deficiency judgment from the first mortgage holder. Since the short sale is a contractual arrangement and not a foreclosure, the foreclosure rules and anti-deficiency protections of the "one-action rule" would not apply.

If a full release from the promissory note is not able to be obtained, or if the lender insists on including language in their short sale approval letter that they can pursue a deficiency in accordance with law,  unfortunately there is no case law currently on point in California as to whether a lender may pursue a deficiency judgment on a purchase money mortgage after a short sale. This is because the anti-deficiency statutes in California specifically relate to a foreclosure sale and do not mention short sales.  Most attorneys that I have spoken to believe that lenders would have a difficult time prevailing in a lawsuit pursuing a deficiency after a short sale for a loan that was a purchase money mortgage.  They believe that a court would have a hard time allowing a lender to contractually work around the anti-deficiency statutes when there is no consideration given by the seller. This is a very complex area of law and a competent real estate attorney should always be consulted when facing this issue.

Wells Fargo seems to be taking the approach of granting full releases of both the promissory note and the mortgage lien for purchase money mortgages, once any seller contribution is negotiated.  Bank of America and Chase are both holding the line on granting full releases of any deficiency after agreeing to the amount of sales proceeds that would go to them as well as a seller contribution to release their lien, and leaving it to their recovery departments to make the decision as to whether to pursue a deficiency based upon the laws of the state the property is located in. When signing a short sale approval letter with a lender in California for a property that has a purchase money mortgage that does not provide a full release of liability or states that the borrower is still liable for any deficiency as called for in the loan documents, it would be a good idea to also provide a statement attached to the letter with the following wording: "

"____________________("Borrower's" ) execution of the Short Sale Approval Letter dated ______________ between ________________ and ______________________ for the premises located at _______________________________ does not constitute a waiver of Borrower's rights under the anti-deficiency statutes of the State of California for purchase money mortgages"

Update:

SB 931 Bill Passed by the California State Senate on August 23rd 2010, which provides Short Sale Deficiency Protection for First Mortgages in a short sale transaction , was signed by the Governor on September 30th and will become effective for transactions after January 1, 2011. See my blog entry SB 931 Short Sale Deficiency Protection Bill Signed by California Governor

 

This legal chart provided by the California Association of Realtors is intended to provide a quick and easy guide to determine when a borrower may be liable for a deficiency judgment.  There are other factors and conditions which may change the result (such as fraud by the borrower and bad faith waste) and as noted above, these issues are complicated and sometimes ambiguous as they relate to short sales.  For more details see the legal article, Deficiency Judgments and California Law.

Residential 1 - 4 units, Owner Intends to Occupy a Unit in the Secured Real Property Non-owner Occupied or Other Real Property

Lender Purchase Money Loan
(non-recourse loan)

 
Seller Financed Purchase Money Loan
(non-recourse loan)

 
Refinance (Non-Purchase Money Loan)
(recourse loan)


 

Lender Purchase Money Loan
(recourse loan)

 
Seller Financed Purchase Money Loan
(non-recourse loan)

 
Refinance (Non-Purchase Money Loan)
(recourse loan)


 
NO
deficiency judgment if senior or junior lienholder*

Cal. Code Civ. Proc. § 580b
NO
deficiency judgment if senior or junior lienholder*

Cal. Code Civ. Proc. § 580b
YES
deficiency judgment if judicial foreclosure

NO
deficiency judgment if trustee's sale foreclosure

Cal. Code Civ. Proc. § 580d
YES
deficiency judgment if judicial foreclosure

NO
deficiency judgment if trustee's sale foreclosure

Cal. Code Civ. Proc. § 580d
NO
deficiency judgment if senior or junior lienholder*

Cal. Code Civ. Proc. 
§ 580b
YES
deficiency judgment if judicial foreclosure

NO
deficiency judgment if trustee's sale foreclosure

Cal. Code Civ. Proc. § 580d

* If a senior lienholder forecloses on the property, the "wiped out" junior lienholder who no longer has a secured note may not sue on this promissory note for those categories indicated in the chart.

The above information is provided for educational purposes only and is not intended to be definitive legal advice. The specific facts of a case can have significant impact . Anyone going through a short sale or foreclosure should obtain legal counsel from a licensed real estate attorney.

For more information about Palos Verdes and South Bay Real Estate and buying and selling a home on the Palos Verdes Peninsula, visit my website at http://www.maureenmegowan.com . I try to make this the best real estate web blog in the South Bay Los Angeles and the Palos Verdes Peninsula. I would love to hear your comments or suggestions.

Comment balloon 6 commentsMaureen Megowan • January 27 2010 02:47PM
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