How a Deficiency Balance Can Affect You

Bills.com Team
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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.
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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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61 Comments

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  • SM
    Oct, 2012
    Sheila
    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.
    0 Votes

    • BA
      Nov, 2012
      Bill
      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.
      0 Votes

  • TH
    Aug, 2012
    Tracy
    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.
    0 Votes

    • BA
      Aug, 2012
      Bill
      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.
      0 Votes

  • LS
    Jun, 2012
    Leslie
    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!
    0 Votes

    • BA
      Jul, 2012
      Bill
      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.
      0 Votes

  • TS
    Apr, 2012
    Trish
    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.
    0 Votes

    • BA
      Apr, 2012
      Bill
      Homeowners face two potential issues following a short sale or foreclosure:
      1. 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.
      2. 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.

      0 Votes

  • TR
    Apr, 2012
    Tom
    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?
    0 Votes

    • BA
      Apr, 2012
      Bill
      Two questions:
      1. Was the deficiency balance forgiven? If yes, then the Mortgage Forgiveness Debt Relief Act may apply.
      2. 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.

      0 Votes