Protected: nonrecourse mortgage debt
First, let’s define the two kinds of mortgage debt dealt with in California’s anti-deficiency statutes. All debt is categorized as either:
- nonrecourse; or
Nonrecourse debt is one of two types of mortgage debt:
- purchase-money debt of any priority (first, second or even third trust deed), defined as mortgageswhich fund the purchase or construction of a homebuyer’s one-to-four unit primary residence; or
- seller-financed, also called installment or carryback paper, on the sale of any type of real estate when the debt is secured solely by the property sold. [Calif. Code of Civil Procedure §580b]
A lender holding a nonrecourse debt may not pursue the homeowner personally to collect for a deficiency in the secured property’s value to fully pay off the nonrecourse debt following any type of foreclosure, judicial or nonjudicial.
A few notable exceptions: anti-deficiency protections aside, the lender who underbids at the trustee’s sale may pursue an owner for those loan losses caused by the owner’s bad-faith waste of the property, defined as reckless or malicious injury to the property. Remember those pictures of concrete poured down toilets, stripped cabinets and landscape destruction? [Cornelison v. Kornbluth (1975) 15 CA3d 590]
Additionally, while the lender may not pursue a homeowner for a deficiency in the value of the property on purchase-money paper, the Federal Housing Administration (FHA) or Veterans Administration (VA have recourse against the homebuyer who signed an FHA or VA guarantee agreement for losses under their mortgage default insurance programs (MIP). Practically speaking, the FHA and the VA rarely pursue deficiency judgments; however they have the legal right to do so. [Carter v. Derwinski (9th Cir. 1993) 987 F2d 611]
Unprotected: recourse mortgage debt
Recourse debt is any debt which is not classified as nonrecourse debt. A lender may pursue a homeowner for a loss due to a deficiency in the price of the secured property on a recourse debt only through judicial foreclosure, and then only if:
- the court-appraised value of the property at the time of the judicial foreclosure sale is less than the debt; and
- the bid is for less than the debt owed. [CCP §580a]
The clearest classification (but not the only one) of a recourse debt is this: any loan secured by other than a one-to-four unit residential property is recourse debt. Thus, loans secured by second homes, apartments (five or more units) or non-residential properties are recourse debt.
Editor’s note —A seller carryback note and trust deed is not included in any definition of a loan, as it is a credit sale. Remember, carryback paper is nonrecourse debt regardless of the type of property securing the note, as long as the debt is secured solely by the property sold. [CCP §580b]
However, determining the recourse/nonrecourse status of the debt on one-to-four unit residential properties under the mortgage workout arrangements of the Millennium Boom and housing crisis takes a bit more review.
Deficiency for second trust deeds?
As defined above, purchase-money paper includes a second (or more junior) trust deed which funded the purchase price or construction of the homeowner’s one-to-four unit primary residence, e.g. the “piggy-back” second. Home equity lines of credit (HELOCs) are also purchase money, insofar as they fund the purchase, construction or remodel of a homeowner’s one-to-four unit primary residence. [CCP §580b]
After the purchase, further encumbrances of the property for reasons other than a remodel (such as HELOC draws for non-property related uses) are considered recourse debt.
Editor’s note — While the statutes do not explicitly cover HELOCs as such, this logical extension of anti-deficiency law is in keeping with the liberal interpretation required to protect homeowners from undue loss on efforts to improve/maintain their principal residences. [Bank of America v. Graves (1996) 51 CA4th 607]
Refinanced purchase-money debt: recourse or not?
Refinanced purchase-money debt only retains its purchase-money nonrecourse status if:
- the lender of the original purchase-money debt is the refinancing lender [Union Bank v. Wendland (1976) 54 CA3d 393];
- the refinanced debt is substantially the same debt as the original purchase-money debt [DeBerard Properties, Ltd. v. Lim (1999) 20 C4th 649]; and
- the refinanced debt is secured by the same property as the original purchase-money debt. [Goodyear v. Mack (1984) 159 CA3d 654]
In absence of any of the three conditions (e.g., cash-out refinances), the refinanced debt is considered recourse debt subject to a lender’s money judgment for any deficiency in the value at the time of the foreclosure sale, but only if the lender chooses to complete a judicial foreclosure.
The case law surrounding this is varied and the courts have called upon the legislature to clarify the scope of anti-deficiency protection on this point. If passed, the pending 2012 California Senate Bill (SB) 1069 would definitively extend purchase-money status (and thus, nonrecourse status) to loans which refinance purchase-money loans. SB 1069 is slated for initial hearing on May 1, 2012.
What about loan modifications?
The same logic is used when considering whether the modification of a purchase-money loan retains its nonrecourse status. If the modified loan is secured by the same property as the original purchase-money loan, modification of payments, interest rates or due dates do not change the purchase-money status of the modified loan. [DeBerard, supra]
The extension of nonrecourse status to the lender’s continuation of the same debt under different terms for repayment is important. Nonrecourse status means any debt forgiven on the modification (fingers crossed for potential principal reductions as part of the loan mod process) of a nonrecourse loan is exempt from taxation as cancellation of debt income.
Under the Mortgage Forgiveness Debt Relief Act (the Act), federal rules (and the state-adopted rules) currently provide relief from taxation on cancellation of debt income for both recourse and nonrecourse debt, but these protections are set to expire at the end of this year. [26 Code of Federal Regulations §1.1001-2; Internal Revenue Code §108; Calif. Revenue & Taxation Code §17144.5]
Additionally, a lender cannot require, much less enforce, a homeowner’s waiver of his anti-deficiency protection as a condition of granting a loan modification when the loan remains secured by the same property. The result would simply be a magic trick performed by the lender to flip nonrecourse into recourse status — an unenforceable departure from the legislative intent of anti-deficiency statutes. [Palm v. Schilling (1988) 199 CA3d 63]
Special rules for shortsales
In response to the massive surge of negative equity single family residence (SFRs) and the increase in lender-despised shortsales, the California legislature extended anti-deficiency protections to individuals who negotiate short payoffs (shortpays) with their lenders and close a shortsale to get rid of their homes.
Now, regardless of the recourse or nonrecourse status of the mortgage, a lender who agrees to accept a shortpay from an owner-occupant seller of a one-to-four unit residential property is barred from seeking a money judgment against the seller for any loss incurred on the shortsale. [CCP §580e]
Watch out, though: if the Act (and the California adoption of the Act) is allowed to expire at the end of 2012, income derived from the discount on the cancellation of debt will become taxable for sellers who shortpay lenders on recourse debt, unless they can prove to the Internal Revenue Service (IRS) they are insolvent. Fortunately (and unfortunately), most underwater California homeowners can meet this requirement of having their total liabilities (mortgage debt included) exceed total assets. [IRC §108]
Lender’s choice of recovery
So, after reviewing all the “ifs,” “ands” or “buts” above, a homeowner who has a nonrecourse mortgage on his hands is exempt from the lender’s collection by obtaining a money judgment for any deficiency in the property’s value to fully satisfy the mortgage, and from any ensuing cancellation of debt income, regardless of the fate of the Act. [26 CFR §1.1001-2; CCP 580b]
A homeowner with a recourse loan is not necessarily destined to be hounded by the lender’s debt collectors forever. One last, significant protection lies in the lender’s choice of mortgage debt recovery.
In response to a homeowner’s default, a lender must first foreclose on the property to satisfy the debt before attempting any other kind of collection effort, its bargain under the power of sale and put option in the trust deed. [CCP §726(a); Walker v. Community Bank (1974) 10 C3d 729]
The lender’s ability to seek a deficiency after foreclosure depends upon its choice of foreclosure remedies, of which there are two:
- judicial foreclosure; or
- nonjudicial foreclosure, also called a trustee’s sale.
A lender can only get a money judgment for a deficiency (and associated attorney and filing costs) if he completes a judicial foreclosure, and then only if:
- the loan is recourse paper; and
- the property value is less than the amount of the mortgage at the time of the judicial foreclosure sale. [CCP §580c, 580a]
However, the borrower has the right to redeemthe property – recover title – within one year after the judicial foreclosure sale by paying the amount of the bid (plus interest). The money judgment for any deficiency in the property value if awarded to the lender is a separate debt, unconnected to the right to redeem the property for the price bid at the foreclosure sale. [CCP §729.030]
Judicial foreclosures are lengthy and expensive for lenders. The also risk further decline in a property’s value during litigation and the one-year redemption period after the foreclosure sale and being unable to recover a separate money award for the deficiency (the “blood from a stone” argument some of our readers have put forth in discussions on this site).
If the lender chooses instead to foreclose nonjudicially via a trustee’s sale (and in California, all seem to be doing so, suing only on any guarantee of the note they may hold), it loses its right to pursue any loss on the note. Lenders trade the right to complete a judicial foreclosure for a cheaper, faster trustee’s sale. Additionally, the homeowner’s right to redeem the property by payment of the debt in full is terminated on completion of the trustee’s sale. [CCP §580d]
Note that anti-deficiency protection under a trustee’s sale or a shortsale does not change the initial classification of the recourse debt to nonrecourse debt. Thus, any cancellation of debt income by way of a discount on recourse paper is still taxable, unless exempted by federal and state tax law (as noted above).
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