There are numerous realtors who promise to obtain a short sale for your underwater property, claiming that this will allow you to walk away from the property without further liability, while preserving your creditworthiness. They tell their clients that California is a “non-recourse” state, so that the lender cannot come after the borrower for a deficiency judgment (i.e, an attempt to collect the difference between what is owed and the amount realized in the short sale). [*]
You may be surprised to learn that there is no definitive case or statutory law determining whether the lender has a right to seek a deficiency judgment after a short sale. (But, see Update at the end of this article). The deficiency laws expressly apply to instances where there is a foreclosure, and do not mention cases of short sale. While there are arguments to be made that that the law was intended to apply in those cases, one should be cautious when approaching a short sale, especially where the lender includes language in the short sale agreement reserving rights that they “may pursue a deficiency judgment”. The safest approach is to negotiate with the lender to get them to agree in writing not to pursue a deficiency judgment.[†]
California Civil Code § 580d[‡] – the anti-deficiency statute — applies, on its face, to instances where the lender sells the property “under a power of sale contained in the mortgage or deed of trust”, i.e., in cases of non-judicial foreclosure. Thus, this code section does not expressly apply where there is a short sale *
Does other law provide similar protections in non-foreclosure cases? Code of Civil Procedure 580b, also provides for protection against deficiency judgments, but in cases “after a sale of real property… for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment…”[§] Does this apply to short
sales? Clearly, it applies to foreclosures, which are “under a deed of trust or mortgage.” But, in a short sale, there is no sale under the power of sale in the deed of trust. The issue is whether a short sale constitutes a “sale of real property… for failure of the purchaser to complete his or her contract of sale”. One could argue that it does, but one could also argue that, since a short sale is a voluntary sale by the borrower, without any action by the lender except to agree to it, then the property is not being sold “for failure. . .to complete the contract of sale”.
Another key statute is Civil Procedure Code § 726(a), [**] which provides what is known as the “one form of action rule”: the statute states that, where there is a mortgage, this is the only type of judicial action the lender can pursue to collect the debt represented by the deed of trust – judicial foreclosure. Courts have determined that with the section implies a “security-first” rule: a creditor must first proceed against the security for the debt prior to trying to enforce, by judicial action or otherwise, the underlying debt. Thus, one cannot sue the borrower directly on the underlying promissory note without first foreclosing on the real property. Thus, other than judicial foreclosure, the only alternative is to foreclose using the power of sale in the deed of trust.
Apart from this “one action rule” there is another rule with which it is often confused, the “single action rule”, which states that one cannot pursue the same legal right in more than one judicial action. Hence, once a lender pursues judicial foreclosure, it cannot thereafter also sue on the underlying promissory note.
Many observers conclude that section 726 would prevent a lender from obtaining a judgment for the deficiency after a short sale, and that this section could be interposed as a defense to such a lawsuit. The argument is that a judicial foreclosure is the only judicial remedy allowed under the statute, and the only one allowing a deficiency judgment. Since the lender must first seek to go after the security interest, and in order to do so, it must institute one or the other forms of foreclosure, the right to a deficiency cannot survive: if the lender seeks to foreclose by power of sale, it waives the deficiency; if it does so by judicial foreclosure, then that is it’s “one action”, and it has no right to institute a new action.
But, on the other hand it could be argued that the one action rule does not apply. First, in the case of a short sale, the foreclosure has not gone through to conclusion, and the matter is resolved before any foreclosure sale. Furthermore, recall that section 726 applies to enforcement of a debt or right secured by a mortgage. If a lender institutes its action on the promissory note for the deficiency after a short sale, the action is not against a debt secured by the mortgage since the borrowers themselves have voluntarily done away with the mortgage in the short sale. By the same token, there is no problem with the security first rule, as there is no security to pursue. Neither has the lender instituted any prior judicial action, so the single action rule is satisfied. one since there has been no foreclosure of any kind. so it still has one action left.
Some lenders maintain the position that they could proceed after a short sale, and even include language reserving the right to do so in their short sale agreements. As yet, none have pushed it to the point of creating precedent one way or the other on the issue.
Given the lack of caselaw deciding the point, the most that can he said is that there probably is no right to seek a deficiency in short sale situations. Without clear precedent, the only way one could be sure a lender would not proceed against you for the deficiency after a short sale would be for the lender itself to agree in writing, to waive the deficiency. If they are reluctant to do so, this means that they may go after you it the law becomes clarified.
[*] This article deals only with the case of a purchase money loan which has not been refinanced. It does not consider instances of second deeds of trust or refinanced firsts, wherein it is much more likely that the lender can obtain a deficiency judgment. Nor does the article deal with the tax consequences of short sale and foreclosure; the IRS may deem that some or all of the loan written-off is income, and so taxable. .
[†] This article is not intended to constitute, and does not constitute, legal advice. Moreover, the article is not intended to constitute, and does not constitute, a solicitation for the formation of an attorney-client relationship; no attorney-client relationship is created through your receipt or use of this article. Anyone accessing the article should not act upon it without first seeking legal counsel. Further, the materials are general in nature, and may not apply to particular factual or legal circumstances.
[‡] “No judgment shall be rendered for any deficiency upon a note secured by a deed of trust or mortgage upon real property or an estate for years therein hereafter executed in any case in which the real property or estate for years therein has been sold by the mortgagee or trustee under power of sale contained in the mortgage or deed of trust.”
[§] “No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for not more than four families given to a lender to secure repayment of a loan which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser.”
[**] “There can be but one form of action for the recovery of any debt or the enforcement of any right secured by mortgage upon real property or an estate for years therein, which action shall be in accordance with the provisions of this chapter. In the action the court may, by its judgment, direct the sale of the encumbered real property or estate for years therein (or so much of the real property or estate for years as may be necessary), and the application of the proceeds of the sale to the payment of the costs of court, the expenses of levy and sale, and the amount due plaintiff, including, where the mortgage provides for the payment of attorney’s fees, the sum for attorney’s fees as the court shall find reasonable, not exceeding the amount named in the mortgage.”
After this article was written, On September 30, 2010, the Governor signed Senate Bill 931, which finally eliminated the uncertainties discussed above. In essence, the law states that there will be no deficiency judgment on residential (less than 4 units) property where the lender agrees to the short sale. Of course, they are not required to agree to the short sale.
Civil Code § 580e.
(a) No judgment shall be rendered for any deficiency under a note secured by a first deed of trust or first mortgage for a dwelling of not more than four units, in any case in which the trustor or mortgagor sells the dwelling for less than the remaining amount of the indebtedness due at the time of sale with the written consent of the holder of the first deed of trust or first mortgage. Written consent of the holder of the first deed of trust or first mortgage to that sale shall obligate that holder to accept the sale
proceeds as full payment and to fully discharge the remaining amount of the indebtedness on the first deed of trust or first mortgage.
(b) If the trustor or mortgagor commits either fraud with respect to the sale of, or waste with respect to, the real property that secures the first deed of trust or first mortgage, this section shall not limit the ability of the holder of the first deed of trust or first mortgage to seek damages and use existing rights and remedies against the trustor or mortgagor or any third party for fraud or waste.
(c) This section shall not apply if the trustor or mortgagor is a corporation or political subdivision of the state.