How a Deficiency Balance Can Affect You

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mortgage 11
HIGHLIGHTS
  • Understand what a deficiency balance is.
  • Review what may make you responsible for a deficiency balance.
  • Examine the potential tax implications that come with a forgiven debt.

Some lenders may forgive a deficiency balance on a mortgage, but not all do.

Even after closing out your loan with your lender, through either a short sale, deed-in-lieu of foreclosure, or a foreclosure, your problems may not be behind you. Depending on the original terms of your loan as well as the state you live in, you may end up with a significant financial liability or a tax liability. You may owe your former lender(s) if the sale proceeds did not pay the entire balance you owed on all loans that were secured by your property. The difference between what you owed and what the home sold for is called a deficiency balance.

Some lenders may forgive a deficiency balance, but not all do. It is often an unsound economic decision for a lender to sue you for the deficiency balance. For one, you may not have any resources to pay them. You likely would not have defaulted on your mortgage if you could have afforded to pay it.

Some states protect their citizens with anti-deficiency laws. Rules vary from state to state.

Non-Recourse or Recourse Loan

An important factor in whether you can be liable for a deficiency balance is whether your loan is a non-recourse loan or a recourse loan. A non-recourse loan restricts your lender’s ability to collect on your defaulted loan to the assets used to secure the loan. For your mortgage loan, it is likely that the home itself was the only security. If you have a non-recourse loan and your lender forecloses on you, then it cannot get a deficiency judgment and attempt to collect on it. It can only sell the home and keep the proceeds.

Most non-recourse loans are restricted to loans used to purchase a primary residence. If your lender foreclosed on your investment property or vacation home, you likely are liable for the deficiency balance. You could also be liable for the deficiency balance if you had taken out a loan on a primary residence and the home was no longer your primary residence.

A recourse loan is one where the lender has the legal means to collect the deficiency balance from you. Your lender can pursue collections, including suing you to get a deficiency judgment against you, which can lead to a levy on your wages. Your lender can also sell or assign the debt to a collection agency that can come after you to collect on the debt. Your lender may or may not decide to pursue collections, if it has the legal authority to do so. There is no sure way for you to know. Lenders realize that if you went through a foreclosure or short sale that you may have a severe financial hardship which makes collecting on the debt difficult. If your lender takes the time, expense, and effort to get a judgment against you, it may never be able to collect. Therefore, it may not even pursue collecting in the first place.

Some states are non-recourse states, while other states are recourse states. In non-recourse states, your lender generally cannot come after you for any balance that remains after the proceeds from the sale of your primary residence home are applied to your outstanding mortgage debt. Still, even within non-recourse states, things are not black and white. Loans that were not used for purchase money can become a recourse loan even in a non-recourse state. Check the terms of your loan. In fact, it is a good idea to know whether your loan will be a recourse or non-recourse loan, before you take out the loan.

Tax Implications

In some cases, you lender my write of the debt, deciding instead of trying to collect it from you. A debt that your lender wrote off can result in a tax liability for you. A 1099-C is a notice to the IRS that the financial institution has forgiven or canceled a debt of $600 or more. If the financial institution issues a 1099-C to you, then it has forgiven the debt and you must report the dollar amount shown on the 1099-C as income on your income tax return. Fortunately, the Mortgage Forgiveness Debt Relief Act of 2007 allows taxpayers to exclude income from the discharge of debt on their principal residence. The forgiveness is restricted to mortgage debt that you incurred to purchase your home. If you took out cash from the equity in your home in a refinance, as many Americans did during the real estate boom period, you are not covered by the Mortgage Forgiveness Act. Even if you cannot use the protections of the federal act, you may still be able to avoid declaring the dollars listed on the 1099-C. Check with a CPA, tax attorney, or tax professional to see if you meet the IRS rules regarding your assets and liabilities and can use the IRS Form 982 to avoid declaring the 1099-C as income.

If the financial institution issues a 1099-C to you, it will probably not pursue you for the deficiency balance because it has deducted the loss on the loan from its taxes. However, there is no guarantee the financial institution will not pursue you for the deficiency balance and then later amend its tax returns.

Negotiate

Consider negotiating with your creditor in an attempt to reach an out-of-court settlement on the debt. The good news here is collection agents purchase deficiency balance collection accounts for 1 or 2 cents on the dollar. (This is in contrast to credit card collection accounts, where the industry standard is 6 or 7 cents on the dollar. If necessary, enroll the debt in a debt negotiation program. (Go to the Bills.com debt relief savings center for a no-cost quote.) Another option is to negotiate the debt yourself. Consider opening negotiations at 5 cents on the dollar for a lump-sum settlement. This amount may sound small, but given the fact the collection agent bought the collection account for a penny or two on the dollar, this amount gives the collection agent a handsome return on their investment.

Summary

If a creditor pursues you for a deficiency balance, make sure you understand which financial and tax responsibilities can follow you, even after you lose or sell your home. Speak with an attorney or a tax specialist to your rights and liabilities under your state's laws. The last thing you want is for a problem you thought was behind you to rear its head with IRS collection notices or a wage levy from a judgment an aggressive creditor obtained.

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Comments (79)


Scott B.
Chicago, IL  |  April 17, 2014
If someone has a mortgage deficiency judgment for a foreclosure in Illinois for $70k and moves to Florida, can the bank collect, garnish wages, etc.?
Bills.com
April 17, 2014
A judgment creditor could domesticate the Illinois judgment in Florida, then go after you, consistent with the laws governing debt collection in Florida.
Shelly S.
Joliet, IL  |  April 05, 2014
Illinois: We went through foreclosure in 2010 with Bank of America (1st) and US Bank (2nd). BoA bought out the 2nd and then sent it to Green Tree Servicing to collect. We initially had an offer to pay $7k but that was then taken back and it was back up to $45k. For the past 4 years we have been trying to negotiate with GTS to no avail, they would not come down at all. Today I received a letter from a lawyer stating that BoA wants to claim still 100% of the debt or face litigation. Do I still have a leg to negotiate on here? Everything I have read is that this sold-out junior is an unsecured debt and the banks will negotiate, am I in the clouds? Is anyone else going through this with BoA?
Bills.com
April 08, 2014
Ignore everything you read online except for this advice: Consult with an Illinois lawyer who has experience with mortgage litigation. Illinois is not a no-recourse state, but judges apparently have wide discretion in allowing or not allowing deficiency judgments. An Illinois lawyer experienced in this specialty of the law with knowledge of how courts in your area decide cases like these will be more valuable and useful to you than our opinion.
Jessie R.
Philadelphia City, PA  |  March 06, 2014
Hi, I own a home in Philadelphia that's been my residence since purchase in 2006. The house is underwater by 60-80k. I lost my job in 2012 and after my unemployment ran out, I took whatever savings I had left and put it into starting a new business so I could have steady income again. I also stopped paying my mortgage. The home is not in a good area and I have a child who will need to start school soon. The loan is FHA. In October 2013, we moved some of our stuff out of the house in order to de-clutter and put it up for sale. We began staying with my in-laws because it is very close to my new business and they watch my kids while I'm at work anyway. I submitted the non-HAMP (I think) application to the lender to get a short sale approved and we put the house on the market. On the application, I had to check whether the house was owner occupied, vacant, or tenant occupied. I checked owner occupied because most of our furniture and belongings are still in the house and we continue to maintain it, but we sleep at my in-laws. A modification was recently denied and now it's under consideration for short sale. The bank has also filed a foreclosure action against me and the process server has filed affidavits with the court that the house is abandoned/vacant because no one was there to accept service. the short sale form expires every 90 days and I have to tick the box again. 1)Not sure if I should keep stating it's owner occupied? 2)maybe just allow foreclosure?
Bills.com
March 27, 2014
The rules for occupation are vague, at best.

I would argue you still occupy the property because your personal items are still on site, you have the sole right to occupy the property, you still maintain the property, and I would imagine are still paying the utilities and so on. The fact you sleep elsewhere is irrelevant in my humble opinion.

I hasten to add that's my definition of occupation, which may not square with your mortgage servicer's.
Jeff F.
Altamonte Springs, FL  |  February 08, 2014
I have a FHA condo loan located in Florida. It was a primary residence and to make a long story short we left it due to structural issues with mold. We wanted to short sale the condo but the bank denied everything. It is now 2014, and now I'm worried about the 1099-c. Can they include all the back due interest, their lawyer fees, plus late fees with the 1099-c amount? Also there was a comment in the article about negotiating with the creditor to pay 5% of the charge off amount. Can they still 1099-c me if I pay them 5%? Can they double dip and hit me twice with a 1099-c plus sue?
Bills.com
February 11, 2014
It is possible for fees allowed by your contract and state law to be added to the balance due on your home loan, which may be shown in your 1099-C. Original creditors sell collection accounts for a small fraction of their face value. We don't know how much mortgage deficiency balances fetch, and our guess is about 10 cents on the dollar.

Let's simplify the facts here to illustrate how a 1099-C is supposed to work. Let's say you borrow $1 million from a bank. You repay the bank $600,000 and then default on the rest. The bank, by law, must issue you a 1099-C for the $400,000 amount it moved from its current accounts ledger to the bad-debt line on its general ledger. The bank still has the right to collect the $400,000 from you, or it may sell the collection account to a collection agent. If you never repay the $400,000, you must file the 1099-C and deal with the tax consequences. If you eventually repay the $400,000, both you and the bank may need to file amended tax returns.

To answer your last question directly, the bank may issue a 1099-C and file a breach of contract lawsuit against you.
Mike B.
Lincoln, CA  |  January 27, 2014
I purchased a home in Lincoln, CA in April 2005 at the height of the market. I have an interest-only first and interest-only HELOC second. The first is due to adjust next year and the second will be due (balloon payment). I am approximately $200K underwater and have tried for loan modifications and was denied twice. The servicer is Wells Fargo and the owner is BofA. I can afford the monthly payment now, but will not when it adjusts and won't have the money for the balloon payment. I quit paying on both loans to Wells Fargo last July and am now in default and pre-foreclosure. My original purchase loan was refinanced soon after I moved in.

I am new to this and am uncertain on if I am doing the right thing. Should I attempt to short sale instead of full foreclosure? Will Wells Fargo be able to come after me for the difference on the first and the second? I do not necessarily have a hardship to explain away my decision to stop paying, other than living nearly paycheck to paycheck.
Bills.com
February 07, 2014
You mentioned the property is situated in California. See the Bills.com article California Deficiency Balance to learn your rights and liability for the deficiency balance. Ask any follow-up questions you may have on that page.
Ryan G.
Crystal Beach, FL  |  January 26, 2014
I bought a house in NC in 2001 as my primary residence, a 100% finance with a first and second mortgage. Several years later, due to rapid decline in the economy, I moved to Florida for a better job and attempted to rent the house and continued paying the mortgage. The mortgage changed hands three times over the next few years and After three renter fiascos and falling behind on the mortgage, I attempted to do a loan modification but the bank refused to work with me since I didn't live there. In 2008, after several more attempts to do a loan modification, they sold the second mortgage off to a predatory debt collector and immediately foreclosed on the first mortgage. The house shows in public record as having sold (under market value) for $20k more than the first mortgage balance and the second balance was less than $14k at the time. I am now being sued by the debt collector who bought the second under Florida debt law.
  1. Should it fall under FL law or NC law with regard to statute of limitations?
  2. Do they have any right to collect?
Bills.com
January 27, 2014
Two questions, three answers.
  1. In Florida, the statute of limitations for written contracts is 5 years, and for property-related actions it's 7 years. In North Carolina, the statute of limitations for written contracts, mortgage contracts, and promissory notes is 3 years.
  2. It is unclear to me which state statute of limitations law applies to your facts. Your lawyer will need to argue that North Carolina's statute of limitations law applies because you and the property were situated there when you signed the loan, and that all parties had the expectation that NC law would apply if a dispute ever arose from that loan contract.
  3. Under the Fair Debt Collection Practices Act, a collection agent must file a lawsuit against a consumer in either the jurisdiction where the contract was signed, or in the consumer's present jurisdiction. Therefore, a quick glance at your facts would suggest the debt collector complies with federal law when it filed its action against you in Florida, your new state of residence.

It is possible for a Florida court to use North Carolina rules when deciding a case. Therefore, it is possible for the 3-year statute of limitations to apply. However, you fight an uphill battle when arguing that another state's laws apply to a case heard in a local court.

Consult with a Florida lawyer who has civil litigation experience immediately. He or she will analyze your facts more deeply than my quick overview here, and explain how Florida courts decided similar cases.

Kris N.
Tampa, FL  |  November 07, 2013
We just got a notice to send in all our assets etc. to a lawfirm regarding a foreclosure on a house we build in 2006 in Florida. He said if we don't give him the copies of tax records, bank statements, income etc. He will be taking more action. Do we mail him everything? Ignore it? Are they just threats? Do we see a foreclosure lawyer, real estate lawyer or bankrupcy lawyer? We are terrified.
Bills.com
November 11, 2013
The lawyer's request may have the force of state law behind it. Or, it may not. Consult with a bankruptcy lawyer in your state immediately, and bring the lawyer's notice to your meeting. I am not suggesting bankruptcy is your best answer here. A bankruptcy lawyer will be able to tell you in a few minutes what, if any, response you need to make to the notice. A bankruptcy lawyer will also outline your options for resolving the debt.
Seb G.
Napa, CA  |  August 04, 2013
We own a rental property in Napa, CA (our primary residence from 2003 to June 2010) that we are thinking of either going into a short-sale or foreclosure. We originally purchased the home with two loans, refinanced in 2005, combined the original two loans into our current first and took a home equity loan to do improvements in our backyard.
  • First loan balance = $500K
  • Second loan balance = $46K
  • Estimated current appraised value = $400K

Three questions:

  1. If we do a short-sale and got into a purchase agreement with a buyer this year, but we do not close until 2014, does the Mortgage Forgiveness Debt Relief Act still apply or do we have to close by Dec 31, 2013 for that to help us?
  2. After reading the messages and articles in your website, I am not quite sure if our first and second loans are still non-recourse, given that we refinanced (but used to for home improvement) and that this is a rental property (but have been our primary residence a little less than two years out of the most recent five). If we go into foreclosure, can our lenders go after us for the deficiency balance?
  3. In the foreclosure scenario, can if the lenders don't go after the deficiency balance, are we liable to pay income taxes on it?

Thanks so much.

Bills.com
August 05, 2013
Consult with a California lawyer who has tax or mortgage negotiation experience for a thorough analysis of your situation.
  1. It is my understanding that, for the purposes of MFDRA, once the contract is finalized that date is significant. The closing date is important because that's when all of the title-related events occur, but the date when the sales contract is signed by all parties and final is the key date.
  2. You mentioned California. California's anti-deficiency laws are tricky because they evolved over time and some key twists and exceptions were shaped by case law. A good example is the refinance rule. California courts will not apply the anti-recourse rule if the homeowner refinanced. In other words, the anti-recourse rule for foreclosures applies to the original purchase money loans only. Here, you refinanced, which gives the lender recourse on these loans if it/they foreclose.
  3. Congress wrote MFDRA to protect owner-occupiers. The question becomes, "What exactly is an owner-occupier?" We do not know. We wrote the following on the Bills.com Mortgage Forgiveness Debt Relief page:
    We do not know what standard the IRS uses to determine residency for the purposes of the Mortgage Forgiveness Debt Relief Act. One argument we have read online is the IRS should use the same standard for residency when determining any capital gains taxes owed:

    "if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its sale,"

    However, that is an argument and not a statement issued by the IRS.
    Short answer: We don't know if you have tax liability if you allow a foreclosure on your Napa rental property.

You did not ask, but California's anti-deficiency rules for short sales are not the same as the state's foreclosure rules. In brief, the California state legislature wants distressed homeowners to use short sales, and outlaws the collection of deficiency balances on junior or senior mortgages or deeds of trust if there's a short sale.

As I mentioned at the start of my answer, your best source of information is a tax or mortgage lawyer. I realize my answers are not definite yeses and noes and that is because your situation and the laws are complex and need more analysis than what I can provide.

John R.
Vista, CA  |  June 18, 2013
I had an FHA loan in Maine in 2011. Since then, I was transferred to California. Upon moving to CA in April 2013, my ex-girlfriend has remained in the home and attempted to pay me rent to meet the mortgage payments. She has not been faithful in paying, so I put the home up for the sale. The asking price would have payed for the closing / agent fees and amount owed on the note. Three months later and with no prospects, my agent suggested dropping the price to an amount which would leave me with a debt. Meanwhile, the ex stopped paying when she found out the home was for sale. I am now delinquent 1 month on the mortgage and about to be late on my second. When I view a map of my street, my property is valued at what I borrowed, while every other house on the street is valued $30k higher. I don't understand that. But anyway, my question is would I be better off seeking DIL or short sale verses paying a property manager to try to find someone to rent?
Bills.com
June 18, 2013
Start with a heart-to-heart with your real estate agent. Ask why the property has an estimated value less than its neighbors. It may be it has one fewer bedroom or bath, or perhaps the condition of the property has deteriorated in the last two years. Your ex/tenant may have trashed the place. You may have much to gain by evicting the ex/tenant and spending a bit on cleaning the property, trimming the trees, putting on fresh coat of paint, and completing preventive maintenance your ex may have forgotten to perform. It is also more likely your house will sell if there's no occupant prospective buyers need to tiptoe around when they view the property.

Simultaneously with evicting your deadbeat ex, you have nothing to lose by discussing a short sale or deed in lieu of foreclosure with your mortgage servicer to learn if it offers attractive terms.
Sheila M.
Lake Stevens, WA  |  October 30, 2012
I'd like to hear your comments on deficiency balance responsibility on the foreclosure of an investment property in Washington State. In other research I've done online it appears to me that if our lender chooses to foreclose non-judicially they cannot come after us for deficiency even though this is a rental. I understand that we will have tax liability but right now I'm interested in the deficiency balance. Although the rental property is in Washington state our primary residence is in California. Washington laws would apply right? Thanks.
Bills.com
November 01, 2012
Because the land is situated in Washington, Washington foreclosure law applies despite your residence elsewhere. My exposure to Washington law is limited, so therefore you should consult with a Washington lawyer who has experience in foreclosure law to receive guidance.

According to the 2011 paper Recourse and Residential Mortgage Default: Evidence from U.S. States (PDF), Washington has the following rules regarding mortgage deficiency balances:
“Lenders may foreclose through either a judicial or non-judicial process. If the lender wishes to pursue a de…ciency judgment, however, it must pursue judicial foreclosure and pursuit of a de…ciency judgment triggers a 12-month right of redemption. Furthermore, the judicial foreclosure process is substantially more time-consuming than the non-judicial process. Deficiency judgments can also not be obtained if the property has been abandoned for 6 months or more which we view as one way a strategic defaulter could evade a deficiency judgment relatively easily. We classify Washington as a NON-RECOURSE state. The relevant statutes are in Title 61, Ch. 61-12 of the Revised Code of Washington.”
You asked if Washington's anti-deficiency rule applies to owner-occupied property only, or if it also applies to vacation/investment property. Excellent question. In a brief search, I was unable to find court cases on this point. This brings me back to the second point in my reply — consult with a Washington lawyer. Please return here and share what you learn.
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