States That Prohibit Deficiency Judgments Following Short Sales

If you are a homeowner having trouble making your monthly payments, a short sale might sound like the perfect solution to avoid foreclosure. If you are considering this route, however, you might still be on the hook for any amount that exceeds the short sale price (called a "deficiency"). Most states allow lenders to obtain a deficiency judgment following a short sale, but a few states prohibit this.

Read on to learn which states prohibit deficiency judgments following short sales and what to do if you live in a state that allows a lender to obtain a deficiency judgment following a short sale.

What is a Short Sale?

In a short sale, the homeowner sells his or her home for less than the total debt balance remaining on the mortgage. The lender agrees to accept the sale proceeds and release the lien on the property. The proceeds of the sale pay off a portion of the mortgage balance. Short sales are one way for borrowers can avoid foreclosure. (Learn more about short sales to avoid of foreclosure.)

What is a Deficiency Judgment?

When you short sell your home, the total debt owed exceeds the sale price. The difference between the sale price and the total debt is called a “deficiency”.

Example. Say the total debt owed is $200,000, but the home only sells for $150,000 at the short sale. The deficiency is $50,000.

In some states, the lender can seek a personal judgment against the borrower to recover the deficiency. Generally, once a deficiency judgment has been obtained, the lender may collect this amount (in our example, $50,000) from the borrower by doing such things as garnishing wages or levying a bank account.

(To learn more about deficiency judgments in the foreclosure context, see our Deficiency Judgments After Foreclosure area.)

States With Pending or Existing Legislation Prohibiting Deficiency Judgments Following Short Sales

In most states, the lender can go after the homeowner for a deficiency after a short sale. But a few states prohibit this, or have pending legislation that, if it becomes law, would prohibit this.

Arizona

Arizona House Bill 2584, introduced in the Arizona House of Representatives on January 17, 2012, would bar lenders from seeking a deficiency judgment against certain borrowers after a short sale. However, the bill is currently held up in committee. Since the bill is still pending, there is no current Arizona law that would prevent a lender from obtaining a deficiency judgment following a short sale. To follow the progress of the bill, go to the Arizona State Legislature webpage at http://www.azleg.gov//FormatDocument.asp?inDoc=/legtext/50leg/2r/bills/hb2584o.asp&Session_ID=107.

California

California law prohibits a lender from obtaining a deficiency judgment following the short sale of a residential property that contains not more than four units. Junior lienholders are also prohibited from pursuing a deficiency judgment if they have agreed to the short sale. Cal. Code Civ. Proc. § 580e.

The effect of this law is that lenders who agree to a short sale can no longer:

• seek a deficiency judgment following the short sale
• require the borrower to sign a promissory note as a condition of the short sale, or
• require the borrower to contribute funds at the close of escrow as a condition of the short sale.

Oregon

Oregon passed House Bill 2916, effective as of June 23, 2011, which prevents a lender from collecting a deficiency following a short sale when an IRS Form 1099-C (Cancellation of Debt) is issued in connection with the sale. This means that if the lender reports to the IRS that it has cancelled all or a portion of a borrower’s debt in conjunction with a short sale, then the lender cannot file suit or seek payment for any deficiency following the sale.

What to Do if You Live in a State that Allows Deficiency Judgments Following Short Sales

If you live in a state that does not have a statute that prohibits a deficiency judgment following a short sale, the only way to avoid one is to negotiate a waiver of the deficiency. The short sale agreement must expressly state that the lender waives its right to the deficiency and that the transaction is in full satisfaction of the debt. If the short sale agreement does not contain this waiver, the lender may later file a lawsuit against you to obtain a deficiency judgment after the short sale is completed.