October 18, 2017

Contents of this page are courtesy of CHRISTOPHER W. STEWARD, ESQ. A Professional Law Corporation
2204 Garnet Avenue Suite 301 San Diego, CA 92109 (619) 297-8480 cstew@att.net

The Basics of California Short Sale, Foreclosure & Anti-Deficiency & Short Sale Law

I have had several issues arise recently in transactions where the potential liability to our clients for a deficiency judgment was in question through either a foreclosure or a short sale. A deficiency is the difference between the amount owed and what the lender was able to recover through foreclosure. The following comments relate to the anti-deficiency statutes in the State of California CCP § 580b thru (d) as well as recent California legislation adding section (e) to CCP §580.

1. New Short Sale Law & Anti-Deficiency Protection.

A new California short sale law took effect on July 15, 2011. The California legislature enacted a revision to the Code of Civil Procedure §580(e) which is much more consumer friendly by extending short-sale anti-deficiency restrictions to all lienholders who approve short sales. The good news is that now any lender that approves a short sale is statutorily prohibited from coming after the borrower later for a deficiency. Second mortgages, thirds, refinances, home equity lines of credit (“HELOC’s”), home improvement loans are all now subject to anti-deficiency protections. However, you need to be sure that the conditions are met to protect against anti-deficiency.
The conditions are simple but extremely important. Before the junior lienholder is considered as having waived its right to seek a deficiency, both of the following must occur:

1. The junior lienholders have to agree in writing to the short sale; and
2. The junior lienholders have to receive a payment of monetary consideration towards its loan from the proceeds of the sale of the property.

If both of the above conditions are not met, a junior lienholder can ignore and refuse to accept the terms of the short sale. In that case, the first lienholder may then choose to proceed with the non-judicial foreclosure. While the first lienholder will be prevented from seeking a deficiency under the so-called one-action rule, the junior lienholder can still try and collect on the deficiency. Alternatively, the junior lienholder could just release its lien without demanding a payment, allowing the short sale to proceed. Since the lienholder did not receive any payment from the proceeds of the sale, its right to seek a deficiency judgment would remain.
Because of the potentially drastic financial effect of a short sale that doesn’t meet the conditions of the new law, you should be very careful in negotiating a short sale with a junior lienholder involved. If you do not get the junior lienholder to sign off and pay some monetary consideration to the junior, you risk liability for deficiency even after you close a short sale approved by the first lienholder. If you have first and second liens held by the same bank, you should negotiate a short sale that releases liability for both mortgages.
In all cases where you are signing a short sale approval letter with a lender in California for a property that does not have a clause for all lienholders to sign granting a full release of liability or states that the borrower is still liable for any deficiency as called for in the loan documents, it is a good idea to also provide a statement attached to the letter with the following wording:
“____________________(“Borrower’s” ) execution of the Short Sale Approval Letter dated ______________ between ________________ and ______________________ for the premises located at _______________________________ does not constitute a waiver of Borrower’s rights under the anti-deficiency statutes of the State of California for purchase money and junior mortgages”

2. Foreclosure of Purchase Money Loans.

In California,  lenders have two choices in foreclosing on a property.  Non-Judicial foreclosures are where the lender forecloses under the rights in their deed of trust and are processed without court intervention, with the requirements for the foreclosure established by state statutes. Under a non-judicial foreclosure, the lender initiating the foreclosure can not later sue for a deficiency judgment, based on what is called the “one-action rule”.  Judicial foreclosures are where the lender sues for foreclosure under their rights of sale under the mortgage and pursues the foreclosure through a law suit through the courts. In this situation, the lender may also sue for a deficiency. In California, however, a lender may not pursue a deficiency for loans that qualify as a “Purchase Money Mortgage”.

To qualify as a purchase money mortgage in California, the loan must be obtained at the time of purchase of the borrower’s principal residence. This can include a second mortgage obtained at the time of purchase.  Although the legal issue as to whether a home equity line of credit used to purchase a home would qualify as a purchase money mortgage has not yet been fully addressed through case law, most attorneys believe that if the loan was only used to purchase the property and additional draws for other purposes were not taken, the home equity line should qualify as a purchase money mortgage. If the initial loan was refinanced, even if no additional proceeds were drawn and the refinance was only a change in interest rate or terms, the new loan would not qualify as a purchase money mortgage and would be recourse. This is a major issue with those borrowers who have recently modified their loans which are in default, because they may have unknowingly converted their purchase money non-recourse loan to a fully recourse loan, and exposed themselves to a potential large deficiency judgment.

If a second mortgage is a purchase money mortgage, and the first mortgage forecloses out the second mortgage, the second mortgage is precluded from pursuing a deficiency judgment as the borrower is protected by California anti-deficiency laws. Under Code Civ Proc, § 580b, the holder of a note secured by a purchase money second trust deed may not recover even though the second trust deed had become worthless by reason of a sale conducted under the senior first deed of trust. Barash v. Wood (1969, Cal App 2d Dist) 3 Cal App 3d 248.

3. Foreclosure of Non- Purchase Money Loans.

If the first and second mortgages are recourse and not purchase money mortgages, and the property is foreclosed on in a non-judicial foreclosure, it is important as to who initiated the foreclosure.  If the first forecloses on the property and wipes out the second mortgage, the first mortgage holder can not pursue a deficiency, however the second mortgage holder can pursue a deficiency judgment against the borrower.  If the second mortgage holder forecloses on the property and takes over the property, they would not be able to pursue a deficiency judgment.  In California, this is known as the “one-action” rule.  A lender can not both go through a non-judicial foreclosure (foreclose on the deed of trust) and then sue to collect a deficiency judgment, however they could choose to go through a judicial foreclosure where they are not simply foreclosing on the deed of trust through a trustees sale, but instead are suing the borrower for title as well as a deficiency judgment.  This is not often done as it is much more expensive and time consuming to go through a judicial foreclosure.

4. Owner Occupied, Later Converted to Investment Rental.

As stated above, California law requires a dwelling to be the owner’s “principal residence” to have purchase money loan anti-deficiency status. However, if a mortgage satisfies the conditions of a purchase money mortgage under these statutes at the time the mortgage is made,  then if the property is later converted to an investment property and rented out, the status of the mortgage as a purchase money mortgage is not changed.

© 2012 Christopher W. Steward, APLC. – Representing Owners, Investors, Lenders, Brokers and Agents In Real Estate Matters.

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TAX ADVICE: Foreclosure, Short Sales and related transaction may carry tax implications. This office does not provide tax advice. Please consult with your tax advisor for any tax-related questions or concerns. Any state or federal tax advice expressly or by implication contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing, or recommending any transaction or matter discussed herein.
Christopher Steward is not affiliated in any way with California Lending & Realty, or California Lending Company Inc.

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