Mortgage and Deficiency Liability

A mortgage is simply a creditor's lien against a piece of real property whose purpose is to secure larger loans, most often purchase money loans. A mortgage is only valuable to the extent there is equity in the property, factoring in any senior liens/mortgages against the property. Depending on the type of mortgage and when it was recorded against the property, a creditor may have different remedies in the event of borrower default.

In the realm of residential real property, purchase money mortgages make up the bulk of all mortgages. A purchase money mortgage is a mortgage in which the loan funds are used to purchase the property that becomes the underlying security for the loan. In California, purchase money mortgages (limited to purchases of residential property containing no more than four familial units) are non-recourse, meaning that the lender's remedy in the event of borrower default is limited to the equity securing the mortgage. Therefore, in the event of a foreclosure on a non-recourse loan, the lender may not pursue the borrower personally for any deficiency on the loan, i.e., in the event the proceeds from the foreclosure sale fall short of the loan's principle balance. Section 580 of the California Code of Civil Procedure, contains an anti-deficiency statute which bars deficiency judgments on foreclosures of purchase money mortgages (§580[b]), and more recently, short sales involving purchase money mortgages (§580[e]). However, in the event the borrower commits waste by damaging the property or removing fixtures or appliances that were once part of the house prior to giving up possession, a lender may be entitled to a deficiency.

There are two notable exceptions to section 580 worth discussing. The first is where a purchase money mortgage has been refinanced. Due to strict interpretation of the language contained in section 580(b), a refinanced purchase money mortgage is no longer considered a purchase money mortgage, as the loan funds were not used to purchase the property in question, but rather to pay off a loan that had been used to purchase a property. As such, refinanced loans are not subject to section 580(b), meaning that a deficiency judgment may be sought where a lender forecloses on a refinanced loan (there is discussion in the California legislature to amend section 580(b) to include refinanced purchase money mortgages, but nothing has gone into effect as of the date of this article).

The other exception to the anti-deficiency statute is where a borrower takes out a second mortgage or home equity line of credit, borrowing against any equity realized in excess of a first deed of trust (e.g., where the value of the property increases beyond the principal balance on a senior mortgage). These loans are not protected by California’s deficiency statute, and as such, may entitle the lender to a deficiency judgment in the event of a shortfall. These are referred to as “recourse” loans. Even if the loan is used as purchase money for a different property, section 580(b) does not apply.

In order for a lender to obtain a deficiency judgment when it is available, it must seek to judicially foreclose on the property. Most deeds of trust, however, contain a “power of sale” clause, which enable the lender to foreclose non-judicially on a property, most commonly through a trustee sale. Non-judicial foreclosures are much more efficient than judicial foreclosures, the former not requiring any court action.

One major drawback of the non-judicial foreclosure is the inability to obtain a deficiency judgment on a recourse loan. Pursuant to California’s “one form of action” rule, if a lender non-judicially forecloses on what is otherwise a loan not protected by section 580(b), it has exercised its one form of action, and may not subsequently seek a money judgment in a lawsuit on a deficiency. The judicial foreclosure proceeding allows for a foreclosure and deficiency judgment (if otherwise available) in one action. Thus, if a lender has exercised its power of sale and forecloses non-judicially on a recourse loan, it cannot obtain a judgment on the deficiency. To put things in perspective, the vast majority of residential foreclosures in California are non-judicial.

But what happens if a senior mortgagee forecloses on a property that is also encumbered by a junior mortgage such as a home equity line of credit (HELOC)? The most common situation these days is where a purchase money lender forecloses on a property that is “underwater”, or whose mortgages are under-secured, by reason of the waning housing market, but the borrower had also taken out a second mortgage or HELOC subsequent to the purchase of the property. Any time a senior mortgagee forecloses on a property, the sale wipes out all junior liens. Thus, in the example above, the second mortgagee would lose its deed of trust by way of a senior mortgage foreclosure. However, this does not mean that loan is extinguished. The borrower is still personally liable on the loan, and can be sued for the full amount. Since the lender for the junior mortgage did not exercise its one form of action, it may do so by way of a collections lawsuit.

In the event a lender obtains a deficiency judgment on a recourse loan or other money judgment through any of the procedures just discussed, the borrower may be forced to file bankruptcy to discharge any lingering liabilities left over from a foreclosure or short sale. Even if the lender agrees to forgive the deficiency on a loan, the borrower may receive a Form 1099-C from the lender, and would have to treat the forgiven debt as income for the particular tax year, which can by itself force the borrower into bankruptcy (debtors in a Title 11 bankruptcy proceeding can specifically avoid the tax penalty).

As always, venture to conduct your own research before taking the advice of a lender when it comes to mortgage liability.