Real Estate Law
In this article
Homeowners considering a short sale might worry a lender can come after them in court for the loan balance. When a short sale occurs, a property generally sells for less than the original price, resulting in a deficiency balance. This leaves a chunk of missing money between your original loan and the money the short sale received. For example, if your home loan is $250,000 but the home sells for $200,000 in a short sale, your original loan would have a $50,000 loan balance left.
A lender obviously wants their full money back because their business relies on lending money and receiving the money back with interest. Your lender taking you to court depends on whether you live in a judicial or a non-judicial foreclosure state. This could effect your credit score and credit report, accordingly.
If you are anticipating or currently experiencing a short sale or foreclosure, you should seek an experienced real estate attorney to guide you along the way.
Non-Judicial Foreclosure Sale
A non-judicial foreclosure or "mortgage walkaway trustee sale" is when:
- Your lender forces you to foreclose on your home
- Your lender agrees to a short sale
- Your lender cannot hold you personally responsible for their financial loss, such as the $50,000 used in the example above
- You cannot buy back the property after the sale, and the process is usually faster and cheaper than a judicial foreclosure sale.
Some states have exceptions for borrowers and homeowners who have significant other assets. This could include a homeowner needing to sell cars or a boat to help make up the cost. Generally, homeowners will sell these assets before losing their home.
In a judicial foreclosure state, your mortgage company will go to court and do the following:
- Explain to a judge why they want to foreclosure on your property
- Present evidence and argue why this is the best idea
- File a complaint
- File a notice called a "Lis Pendens" which has details about the debt total, why a foreclosure is warranted, and how taking your home is the best security for the loan
The judge will review all this information and make a decision. If they agree with the mortgage lender, they will "grant" the judicial foreclosure.
The next step is the court issuing a judgment against you. This means they will formally order that you pay back the total amount owed on the mortgage payments. At this point, the amount you owe may also include the legal costs of going through the judicial foreclosure process.
In a judicial foreclosure, you may have a right of redemption, meaning you may be able to buy back the property from its new owner.
One Action Rules
Most states limit the rights of lenders to:
- Foreclose on a property
- Seek a personal judgment against the borrower, which involves a court order
Taking more than one action is limited through laws, commonly called "one-action rule" or "single-action rule." These rules force creditors to take only one action for the recovery of debt. This means they can't foreclose on your property and, at the same time, claim that you are personally responsible for the money they lost from the loan's deficiency balance.
States that have one-action or single-action rules work with state deficiency-judgment statutes; for example, in California, lenders may only foreclose on the real estate that secures the debt in lieu of taking personal action against their debtors.
Why Would Lenders Agree to Short Sales?
Short sales are a good idea for banks and other lenders trying to:
- Avoid foreclosure
- Take the foreclosed property into their inventory of homes to sell
- Cut their losses by avoiding a lengthy and expensive foreclosure process
- Avoid attorney's fees, property taxes, and other administrative costs
Based on the benefits above, lenders will generally agree to let the property go in a short sale for a discounted price. Getting a home to sell for under five to ten percent of its fair market value is not uncommon in short sales, so the sale price might be lower than typical real property prices.
Will Lenders Accept the Short Sale as "Payment in Full" for My Loan?
It depends. Your lender can decide that you or your property do not qualify for a short sale. It is never required for a mortgage company or bank to accept a short sale to satisfy your loan amount.
If this happens, you might need to look at other options, such as:
- Sell your house in a traditional sale
- Declare bankruptcy, e.g. Chapter 13 or Chapter 7 bankruptcy
- Request a loan modification
- Request to refinance your home
- Work with a real estate attorney or other professional to file applications for short sales
If your short sale request is denied, you can increase your chances of being approved by your lender if you work with an experienced attorney or other professional who is familiar with how to present your best possible case for a short sale.
Will I Owe Tax on the Deficiency After a Lender Agrees to a Short Sale?
Typically the debt is taxable if someone cancels or forgives the debt. When it comes to your primary residence, there are laws in place that will prevent you from being taxed on:
- Money from discharging debts on your home
- Mortgage restructuring
- Mortgage debt forgiveness during a foreclosure
These rules are from the Mortgage Debt Relief Act of 2007.
Tax Consequences: The Mortgage Debt Relief Act
The Mortgage Debt Relief Act applies to forgiven debt from 2007 to 2020 following multiple extensions since its inception; Congress also recently extended debt relief through to 2025 by virtue of the Further Consolidated Appropriations Act of 2021. Accordingly, the Qualified Principal Residence Indebtedness (QPRI) Exclusion now allows mortgage debt to be excluded up to $750,000 ($375,000 if married and filing separately), though for debts from earlier than December 31, 2020, the exclusion has been $2 million ($1 million if married and filing separately).
However, the exclusions don't apply if the debt discharge is from:
- Services performed for the lender
- Any reason not directly related to a decline in the home's value
- Any reason not related to the taxpayer's financial condition
Paying taxes on your debt forgiveness will also depend on your state's tax laws and the applicability of federal laws to your specific circumstances. There may or may not be taxes owed at the state or federal level for debt forgiveness from a short sale. Accordingly, you should consult with both legal and accounting professionals to ensure that you a complete picture relating to your unique financial circumstances.