Short Sales and Deficiency Judgments Under the New Rules in California

On July 11, 2011, the governor signed a new law that prohibits second and third mortgage holders from pursuing deficiency judgments after they have agreed to a short sale.  This amends California Code of Civil Procedure Section 580e which prohibited the same practice by holders of first mortgages.

Deficiency Judgments

If a lender forecloses on property and the sales price brings in less than the balance owed, the lender, in some cases, may sue the borrower for the difference.  Under California law the lender is prohibited from this practice if; (1)the property is residential, (2)the proceeds of the loan were used to purchase the property and (3)the property was occupied by the borrower.  Residential property is defined as a dwelling for not more than four families.  This has the effect of making a residential mortgage non-recourse debt, which means the owner can walk away from a mortgage without worrying that the lender will attempt further collections.  This rule does not apply if the property was refinanced or if the property is sold in a short sale.  Until 2011 this rule also did not apply to short sales.

The Current Law

On January 1, 2011, a new law became effective that prohibited first mortgage holders from pursuing deficiency judgments if the lender had agreed to a short sale.  This is true even if the property has been refinanced or not used as the borrower’s residence.  Apparently some lenders were agreeing to accept less than the full amount of the indebtedness and then suing the borrower for the shortfall.  The borrowers sold their house in a shot sale with the understanding that they were free of the related debt, but then the banks claimed the borrower’s other assets to satisfy the deficiency.

The new law, enacted on July 11, 2011, extends this protection to holders of second and third mortgages.  This will protect property owners who owe more than the fair market value of the property in some cases and hurt them in other situations.  Sellers will not be surprised with an unexpected claim against their remaining assets after the sale, but the new law may make lenders more reluctant to agree to a short sale.

This protection is not available to any seller who commits fraud with respect to the sale or is responsible for waste of the property.  It is also not available if the seller is a corporation, limited liability company or limited partnership.

As always with new legislation, it is uncertain how the courts will interpret this in various situations.  The law states that it applies when the property is sold.  This seems to preclude the favorable treatment in the case of a deed in lieu of foreclosure.