How a Deficiency Balance Can Affect You

By Daniel Cohen Nov 01, 2012

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 (61)

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.

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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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Tracy H.
Gerrardstown, WV | August 12, 2012

I received a demand to pay letter from a FL lawyer regarding a 2nd mortgage originally held by Bank of America for a VA contract. My 1st mortgage was also held by Bank of America. My house was foreclosed in June of 2009. The 1099-A only reflected amounts regarding the 1st mortgage. We attempted a short sale with the bank before foreclosure. The Realtor submitted a buyer's offer twice to no avail. The offer was for $20,000. more than the payoffs for both loans but after agent commission etc there was still a $10,000. balance. A negotiator never contacted us. It was an automatic denial. They were too inundated with processing apps to even deal with the housing crisis. The buyers got early entry but the demand letter does not reflect any rents the bank may have received. The buyers still attempted to work with Bank of America after the foreclosure to no avail. The FL lawyer is threatening to obtain judgment under FL law. This was a VA contract for both mortgages. Don't they have to sue me under VA law? Am I entitled to get a value determination on a second mortgage deficiency held by the same bank to see if I can get out of the deficiency? The city assessment at the time of foreclosure was more than enough to cover the payoff amounts for both.

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Bills.com
August 13, 2012

When you write "VA," I assume you mean "Virginia" and not "Veterans Administration."

Virginia does not have an anti-deficiency law. If a deficiency remains after the sale of the land securing the debt, the creditor can file an action at common law based on the original contract and receive a judgment for the unpaid amount. I do not see how a Florida court would have personal jurisdiction over a Virginia or West Virginia resident in the situation you described. The only way it could would be if the mortgage contract you signed stated words to the effect of, "If there is ever any dispute that arises from this loan, we agree to litigate this is Florida," but that seems unlikely. If the Florida lawyer bought the collection account from Bank of America, he or she is functioning as a collection agent. Under the Federal Debt Collection Practices Act, a collection agent must file an action against a consumer in a court convenient to the consumer. If the lawyer knows the law, it is unlikely he or she will file an action against you in Florida.

The lawyer violates the FDCPA by threatening legal action he or she has no plans to carry out. My advice? Consult with a lawyer in your present state of residence about formulating a possible defense against any action taken by the lawyer. Be sure to bring any documents you have regarding Bank of America's refusal to consider a short sale. If you can show the bank was negligent in not allowing a short sale, you may be able to argue you owe the short sale deficiency amount, and not the deficiency that resulted from the foreclosure.

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Leslie S.
Royal Center, IN | June 30, 2012

We were foreclosed on in 2005 on our primary residence in Indiana. We have been making payments on a deficiceny deficit since, under the constant threat of being taken to court for a wage garnishment (the court date is re-scheduled every 90 days). Recently, the leagal assistant representing the mortgage company has stated that we must attend court because of 2 returned check payments. The checks were cleared through our bank and the payments were made. The LA asked for us to send our bank statement so the bookeeper could look it over, based on the bookeeper's decision of whether or not the payments were made, the LA will decide if we have to appear in court on July 3, 2012. Stating also that the bookeeper is only in the office on Weds and Thurs.--We do not want to go to court, we have been paying for the last 7 years. We had written and asked the LA to ask the lender if they would now consider a 1099-C, the LA never responded to that request. We are financially strapped. We don't know what to do at this point and feel extremely threatened and afraid of going to court. Should we seek legal advice ourselves? Can we request that the court date be continued, so that we can have time to research our options. We believe the LA is being extremely aggressive and threatening. Please advise! We do not own a home now, we rent!

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Bills.com
July 02, 2012

I would be interested to learn if the creditor has a judgment in hand against you. If it does, then the threats of wage garnishment are real. If it does not, then the garnishment threats are hot air.

Keep in mind the legal assistant has a job: Cajole you to make payments. If that means being aggressive, so be it.

Time to level the playing field and hire a lawyer who has experience with real property. I am loath to suggest the following, but the circumstances you described give me no choice: When interviewing local lawyers, consider choosing the one with the most aggressive negotiation style. Customarily, a collaborative, collegial negotiating style works best for all parties. But when faced with a mad pit bull negotiator, you need to be armed equally.

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Trish S.
Akron, OH | April 18, 2012

Hi I live in Ohio and am getting ready to do a short sale and they mentioned sending me a 1099-C and I have been trying to find out if Ohio is a debt forgiveness state or not so I know if I would have to pay taxes on this money or not. I did refinance the house once and paid off credit cards so I don't know how this would affect the 1099-C. If I have to pay taxes on this as income I am better off letting them foreclose and file Chapter 7 bankruptcy. Any help you can offer would be appreciated.

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Bills.com
April 18, 2012

Homeowners face two potential issues following a short sale or foreclosure:

Deficiency Balance: If the property sells for more than the balance of the loan, the difference between the two is call a surplus. If the property sells for less than the balance of the loan, this is called a deficiency. Some states have anti-deficiency laws that bar a lender from trying to collect the deficiency balance from the borrower. We summarize each state's laws on the Bills.com Anti-Deficiency page.
Forgiven-Debt Income. If a financial institution that lends money as its business forgives or cancels a debt worth more than $600, it must issue a 1099-C, and the borrower must declare this as income on their tax return. However, the Mortgage Forgiveness Debt Relief Act and CODI can be used to cancel this imputed income.

Note that a state's anti-deficiency laws and the Mortgage Forgiveness Debt Relief Act concern the same thing — a mortgage deficiency balance. However, the state law focuses on collecting the debt, and the federal law focuses on the federal income tax implications.

You asked about bankruptcy and mentioned Ohio. Consult with an Ohio lawyer who has bankruptcy experience to learn more about your rights and liabilities, and whether you qualify for a chapter 7 or chapter 13 filing.

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Tom R.
Ocala, FL | April 16, 2012

If I settle on a second mortgage on my primary residence and still live there, is the difference between the settlement amount and amount owed taxable? Or, can this difference be forgiven and not be reported as income?

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Bills.com
April 16, 2012

Two questions:

Was the deficiency balance forgiven? If yes, then the Mortgage Forgiveness Debt Relief Act may apply.
Was the second used to buy, build or substantially improve your principal residence? If so, MFDRA applies.

Follow the link just mentioned to learn more. You may need to file a Form 982 with your tax return.

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Phaedra T.
Milwaukee, WI | March 14, 2012

I live in Wisconsin. My home has lost considerable value and I am currently underwater. The balance of my mortgage is $115,000 and I was advised my home was worth $45,000 in 2011. In March 2011 I contacted my lender regarding a Short Sale or Deed in Lieu of. I was advised they would not consider the Deed in Lieu of unless I had attempted the Short Sale first. I placed the home on the market for $45,000. My lender had an independent appraiser look at the house and advised it was worth no more than $40,000. The lender denied the Short Sale. I have other debts totaling over $160,000 so I filed Chapter 13 and advised the lender that I did not want the home and they gave me the impression they would move forward with the Deed in Lieu of. I vacated the property June 2011 and moved to a rental. The bankruptcy court granted my lender a stay in June 2011, so I believed that they would eventually take possession of the home. I learned in November 2011, (and not from my lender who never bothered to contact me), that they had made a business decision not to foreclose, they wrote off the loan and the home was still in my name. I however no longer wanted the home or the resposibility (and apparently neither did the bank). The lender suggested I do a short sale. I explained I had already attempted that earlier and they had refused. In the 9 months that the home has been vacant the value has continued to decline. I had it listed again, this time at $29,900. My question is this: when the home sells, there will of course be a deficiency balance, since I filed Ch 13 and orginally listed the lender, can they attempt to collect the remaining charged off balance? I feel that some of the actions taken by my lender were not above board, do I have any recourse? The recently received an offer of only $11,500 which I am going to accept, just to get the home out of my name, but in your opinion, do you think the lender will say no or were they just forcing me to do the leg work of getting rid of the house?

(0)

Bills.com
March 14, 2012

Consult with your bankruptcy lawyer about the settlement the lender offered. As a person under chapter 13 protection, any settlement you make with one of your creditors outside of the chapter 13 process may kick you out of the chapter 13 and expose you to liability and court sanctions.

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Shawn N.
Richmond, CA | February 24, 2012

I am a homeowner in CA who is underwater. I will try to be brief... We bought our home in 2004 with an 80/20 loan situation. After 1 year, we refinanced to consolidate the loans and improve the terms to a 30 year fixed interest rate. We did take a bit of money out when we refinanced in order to do some home improvements. Now, 8 years, and 2 extra kids later, we have outgrown our home and need to move. We are trying to explore all our options. We are presently considering purchasing a new home (we are preapproved...) with an FSH loan, then attempting to short sell our home. I am having a hard time understanding if the mortgage forgiveness act and CA SB 458 will protect us. If the loan non-recourse loan, I am under the impression that our additonal assets (ie: new property) would not be at risk. If the loan is a recourse loan, would our assets be at risk? ...even in CA? Finally, if our loan is a recourse loan and the above protections do not apply to us, and we do not proceed with purchase of another property, what are our options? Does a homeowner with a refinanced loan that is underwater have ANY options of getting out of their property?

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Bills.com
February 27, 2012

Please see the Bills.com article Is My HELOC a Recourse or Non-Recourse Loan in California?, which discusses California's anti-deficiency laws in some detail.

Let me cut to the chase, as it were, and give you a short answer: In California, if you refinance a home loan, you lose California's anti-deficiency protection. Here, you mentioned a refinance, which is a recourse loan in California.

If a lender forgives a deficiency balance, then the Mortgage Forgiveness Debt Relief Act, a federal law for federal income taxes, and the California version for California income taxes, both apply. However, that assumes the lender forgiving a deficiency balance, which you should not take for granted.

Your best option? Buy the new home and short sale the second, in which you negotiate with the lender in an attempt to convince it to forgive the deficiency balance. Explain that if it does not, you are prepared to file for bankruptcy, which will discharge the deficiency balance.

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Shawn N.
Richmond, CA | February 27, 2012

Thanks for your reply! One more question...if you end up in the "worst case scenario" having to file for bankruptcy, do you lose the second house?

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Bills.com
February 28, 2012

Let us assume the following chain of events:

Borrower owns House A with current home loan payments
Borrower buys House B
Borrower tries to sell or short-sell House A
Borrower short sells House A (or allows a foreclosure), and Lender does not forgive the deficiency balance
Lender pursues Borrower aggressively and files a lawsuit
Court gives Lender a judgment
Lender threatens to use judgment to garnish Borrower's wages, place a lien on House B, and levy accounts of Borrower
Borrower files for bankruptcy, and qualifies for chapter 7
Bankruptcy trustee discharges Borrower's debts, including the judgment
Borrower continues to pay home loan payments, but does not reaffirm mortgage/deed of trust

The Lender for House B has the ability to foreclose if Borrower stops making his or her monthly payments, just as it did before the bankruptcy. However, Borrower does not have personal liability for the home loan, nor will the home loan appear on his or her credit report.

Borrower's bankruptcy does not result in foreclosure if Borrower continues to make their monthly loan payments as agreed to in the loan contract.

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Shawn N.
Richmond, CA | February 28, 2012

Thank you! Great information!

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Kenneth Y.
San Marcos, CA | February 29, 2012

We're in kinda the same position. We're in California and we're trying to do a deed in lieu on a property in which we have a 1st and a 2nd that have both been refinanced. Our deed in lieu paperwork from the lender only applies to the first loan and the lender claims to have written off the 2nd. They say that there will be no collection attempts on the 2nd but they won't provide any paperwork that that effect. The 2nd is 74k. Should we believe them or do a short sale instead?

(0)

Bills.com
March 01, 2012

Whether you do a short sale, deed-in-lieu, or simply walked away, is there enough value in your home to pay anything to the second mortgage, after the first collects as much as it is able to collect? If not, trusting them is all you can do.

(0)

Wendi L.
No Miami Beach, FL | February 17, 2012

Question: I an currently undergoing foreclosure. I had two loans on the property. In a twist of fate, my first loan servicer purchased my second loan servicer. In June 2011, the second loan servicer cancelled my debt and issued a 1099-C. Then they were purchased in later 2011 by my first loan servicer. Now, I have gotten a 1099-C form from the second lender, but the first lender is sending me bills demanding that I pay the second loan (the amount that has been cancelled) along with the first loan. I already know that I will not incur taxes on the cancelled debt, but I was just wondering if my first lender coming after me for my second lender's cancelled debt is normal?

(0)

Larry M.
Orland Hills, IL | February 05, 2012

The short sale on my primary residence in IL closed in April 2011. The debt was forgiven on the 1st through BOA but I had a HELOC with Wells Fargo that wasn't forgiven for 30K. I attempted settlement but couldnt reach an agreement, which one of the reps tried since the debt was now unsecure but no luck. Wells has since sold/assigned the debt to a collection agency a few weeks ago. Since I no longer own the home I wanted to know what actions if any the collection agency can take against me?

(0)

Bills.com
February 05, 2012

You mentioned Illinois. See the Bills.com resource Illinois Collection Laws for a discussion of your rights and liabilities.

(0)

Qinah E.
Chicago, IL | January 09, 2012

They foreclosed on our rental property in October 2010. The mortgage was split between two banks (80/20). Bank 1 foreclosed and got the property. Bank 2 has a remaining balance, which was not delinquent at the time of foreclosure but we owe what I now know is called a deficiency balance. We have since "refinanced" into what I am assuming is just a regular 'personal loan' for the balance. We have been paying faithfully. My question now is...are any of these payments tax deductible since there is no RE interest or taxes to be gained from it?

(0)

Bills.com
January 10, 2012

Mortgage Interest is tax deductible for qualified homes, as defined by the IRS. Once the mortgage is paid off, including through a foreclosure, your unsecured loan is not eligible for a tax deduction.

However, I would like to add two points. Your mention that the property was a rental property, and not all rental properties are qualified homes. See the IRS publication 936 for more information. If the mortgage interest was deductible, upon paying off the mortgage, there may be prepaid points that are eligible for deduction.

In any case, I recommend that you consult with a tax professional.

(0)

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