Deficiency Judgment

The Deficiency Judgment

Definitely one of the biggest factors in any Short Sale situation is the Deficiency Judgment. It is such a monumental topic that it deserves its own discussion. 

First off, what is a Deficiency Judgment?  Ballentine’s Law Dictionary describes a deficiency judgment as, “…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.”  In other words, a deficiency is the shortfall (difference) between what the Property sells for and what the total loan balance is. An example is a Bank foreclosing on a $100,000 note/mortgage.  In an effort to be outbid, the Bank will bid less than owed (say $80,000), because they do not want the Property.  They will then levy a “deficiency judgment” against the Homeowner, for the remaining $20,000 due.

As a matter of fact, Banks are not in the Real Estate business, but instead in the money business.  They are not interested in Real Estate specifically, and are not watching “market trends.” Their main interest when it comes to Real Estate is how much money they can make, and “Return on Investment” figures. Even when it comes to helping a Homeowner with a delinquent loan, the Bank really is only interested in the most cost effective solution, or the option/avenue that “makes” the most $$.  Especially when the Bank isn’t the owner of the loan itself, it can be argued that they only care about how their own portfolio looks. It can be because of these reasons, among other things, that Deficiency Judgments are levied.  This is not to say that Banks are heartless and run by Scrooges; since they don’t even have to offer any loan workout programs. Instead, it is mentioned merely as information necessary to sufficiently understand Banks, and why they do what they do. 

Not everything is Bank driven though. It is important to note that by and large, Banks are servicing loans on behalf of an Investor, who will dictate servicing guidelines.  Bank of America, for example, services loans for over 500 investors!  Sometimes then, it is the investor who mandates a deficiency judgment be levied, not the Bank.

The whole idea behind levying a deficiency in the first place, is to minimize losses incurred by loan defaults. Historically, deficiency judgments after Foreclosure were rare to see; Banks did not believe it was worth their time.  Among other things, there was not a lot of research available to show recovery rates, or how to identify a “good” candidate for a deficiency. Furthermore, most markets were appreciating pre-2008, so lenders could typically make 100% of their loan back through the REO sale.  Now that the markets have changed though, we are seeing a lot more deficiency judgments appear; in part because of the market crash, but also because of “strategic defaulters.” Freddie Mac defines a strategic defaulter as, “Someone who had the means but chose to go into default, that there were no extenuating circumstances that affected their ability to pay. If you’re choosing not to pay off your mortgage, but you’re paying other bills, we would consider that strategic default.”

In addition to knowing the “whats” & “whys” of Deficiency Judgments, it is also important to understand the “whens;” under what particular circumstances are deficiencies levied?  While there are no specific rules or guidelines, it is generally safe to assume that judgments are levied when someone is delinquent on payments.  This is assumed because Deficiencies arise out of settlement agreements, which usually would only take place during delinquency, e.g. Foreclosure, Short Sale, or Deed in Lieu.  The exact timing though, on how long it takes for the Bank to levy a deficiency will vary from State to State.  Some States have a 3 year Statute of Limitation (AK, DE, NH, etc.), while others have up to 15 years (e.g. KY) to pursue!  Needless to say then, that in some circumstances, lenders will wait up to a decade before suing the Homeowner; plenty of time for the homeowner’s finances to be repaired & maximizing the Bank’s chances to collect.

However, just because a Foreclosure Auction (or Short Sale, or DIL) was completed, does not necessarily mean a deficiency judgment will be levied.  There are many different factors that come into play when a Bank is considering the deficiency, including but not limited to: The property, the homeowner, the investor, the bank, the loan type, the number of liens on title, lien position, amount owed, current market value, etc.   Thankfully though, a short sale makes it possible to avoid the potential deficiency altogether; as long as a good negotiator is involved. Indeed, negotiating the deficiency away is (or should be) one of the short sale company’s top priorities.

One way to avoid the potential deficiency is to ensure the Approval Letter contains this type of verbiage.  It will need to state explicitly that the mortgagee & investor will waive their right to pursue the homeowner for any loan shortfall, and that they will accept the short sale as payment in full.  It is important to note here though, that some loan types & lenders do not need such verbiage included in their approval, since a deficiency waiver is a pre-requirement of the program itself (e.g. FHA).   Even if the deficiency is waived though, there may still be a financial obligation or liability to the property & loan, by way of Taxes.  These potential Taxes are a result of what the IRS considers “Phantom Income.”

            Investopedia.com explains “phantom income” this way; “The creditor essentially ‘pays’ the delinquent borrower the amount of debt forgiven, which is why creditors send Form 1099-C to the borrow showing the amount of ‘income’ that he or she received as forgiven debt.” An example of this in layman’s terms could be a successful Short Sale for $80,000, where there is $100,000 owed.  If the lender agrees to waive the remaining loan balance (deficiency), they could then interpret it to mean they paid 20k to the borrower.  This 20k the bank “paid,” is considered taxable income by the IRS. So any loan shortfall, deficiency, or forgiven debt will still need to be accounted for, regardless of what the Short Sale Approval letter states.

            Is it possible to avoid both the deficiency & tax consequences?  YES.  In 2007, Congress passed “The Mortgage Forgiveness Debt Relief Act,” which exempted certain transactions & homeowners from the tax implications on forgiven debt.  Because there are too many eligibility criteria to list though, we recommend going here (http://www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief-Act-and-Debt-Cancellation-) to find out more on this particular topic.  It warrants noting though, that as of yet, Congress has not extended this Act past 2013; although it is fairly likely.

            The deficiency judgment is a crucial piece of the Short Sale; one which has monumental implications for the Homeowner.  It is absolutely vital that the Short Sale company you are working with understands this topic in minute detail, so that they can sufficiently tackle the obstacle with ease.