J.D. Harvard Law School ‘73
M.A. Columbia University
B.A. Yale University
Mediator, Judge Pro-Tem
Certified Family Law Specialist
licensed by the State Bar of California
Stan is a member of the
San Diego North County Bar Association.
Licensed to practice in California, Maryland, Washington D.C., & Georgia
What happens when the bank forecloses on a home loan and the property sells for less than the loan balance at the foreclosure sale?
If we were back in the Roaring Twenties the home owner would be liable for the deficiency. This personal liability caused so much hardship during the following Great Depression that the California legislature enacted anti-deficiency laws. One eliminates deficiency liability if the loan is foreclosed by a trustee’s sale. Another eliminates liability entirely if the loan was used to purchase the property. Bear in mind that even if the anti-deficiency laws did not exist, the bank would have to foreclose first before going after the ex-home owner.
No deficiency liability after trustee’s sales.
After a default, foreclosure can occur by a trustee’s sale without a lawsuit in as little as fifteen weeks, or by a court judgment after a lengthy lawsuit called judicial foreclosure. After judicial foreclosure the borrower has the right to buy back the property for a year by paying off the deficiency. The lawsuit and this right of redemption make lenders avoid judicial foreclosure like the plague, so in practice, home loans are always foreclosed by trustee’s sales. As a result a California home owner has no personal liability for a deficiency on a home loan after it’s foreclosed.
No liability at all on purchase money loans.
In the good old days when home owners had only one home loan the additional elimination of liability on purchase money loans was insignificant, because the elimination of deficiency liability after trustees’ sales made it redundant. But now that two loans are the norm, it can be a home owner’s salvation.
Second loans are seldom foreclosed, because after foreclosure the lender or any other buyer at the foreclosure sale can only keep the property by making the payments on the first loan. So if there are two loans and the home owner defaults, the first loan - not the second - will be foreclosed (without deficiency liability), and the “sold out” second will become an unsecured loan due immediately.
Thanks to the elimination of liability on purchase money loans, if the sold out second was used to purchase the home the ex-home owner will not be liable for it. Otherwise he would be. If the outstanding balance is large, this could lead to bankruptcy.
A footnote on taxes.
When a home owner has lost his home through foreclosure, but has no liability for a deficiency under the anti-deficiency laws, the IRS adds insult to injury by treating the amount of the deficiency as forgiven debt and taxing the home owner as if it were actual income, except when the loan was a purchase money loan or it was used to improve the property. This has been true since 2007 under federal law.If you purchased your home with an “80/20" loan package and never refinanced your second, you will be doubly protected should you lose your home in foreclosure.
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