If you are a homeowner having trouble making your mortgage payments, a short sale might sound like the perfect solution—the bank agrees to accept a sale price for less than your mortgage debt and you avoid foreclosure. However, homeowners who have completed a short sale are often shocked to find out later that their lender is seeking a deficiency judgment against them.
In a short sale, you sell your home for less than the total debt balance. 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 amount owed. Short sales are one way for borrowers can avoid foreclosure. (Learn more about short sales to avoid of foreclosure.)
Because the sale price is “short” of the full debt amount in a short sale, the difference between the total debt and the sale price is the “deficiency.”
Example. Suppose you're approved by your lender to sell your property for $200,000, but you owe $250,000 on the mortgage. The difference ($50,000) is the deficiency.
In many states, the lender can seek a personal judgment against you after the short sale to recover the deficiency amount. Generally, once the lender gets a deficiency judgment, it may collect this amount—in our example, $50,000—from the borrower by doing such things as garnishing your wages or levying your bank account.
While many states have enacted laws that prohibit a deficiency judgment following a foreclosure, most of these laws don’t address loss mitigation transactions, like short sales.
A few states, like California, do prohibit deficiencies after a short sale. (For more information on laws and pending legislation that prohibit a deficiency following a short sale see States that Prohibit Deficiency Judgments Following Short Sales.)
Assuming your state doesn't have a law prohibiting a deficiency judgment following a short sale, there are several ways you can avoid having to pay back a deficiency:
If you're liable to pay the deficiency after a short sale, one possibility is to file bankruptcy to eliminate the debt. If you qualify, a Chapter 7 bankruptcy discharges the deficiency relieving you of the debt, while a Chapter 13 bankruptcy will usually require that you pay a portion of the total amount owed. Bankruptcy may not be a good idea if a deficiency judgment is your only debt, but it could be a good option if you have multiple debts that you can't afford to pay.
Some lenders will agree to waive the deficiency. When negotiating with your lender for approval of your short sale, ask the lender to waive its right to seek a deficiency judgment. If your lender agrees, this provision must be included in the short sale agreement. To eliminate your liability for the deficiency, the agreement must expressly state that the transaction is in full satisfaction of the debt or include similar language.
If your lender refuses to waive the deficiency entirely, you can offer to settle the deficiency for a smaller amount. Lenders are sometimes willing to agree to accept a smaller amount because collecting a deficiency debt can be a lengthy and costly process. It is often easier for the lender to accept a reduced lump sum than to try to collect the full amount. Or, you can also negotiate to repay a reduced deficiency debt in installments over time.
After the short sale is completed, your lender may call you or send letters stating that you still owe money. These letters may come from an attorney’s office or a collection agency and will demand that you pay off the deficiency. Your lender or the collector may even try to intimidate you into making payments. However, without an actual deficiency judgment, the lender cannot freeze your bank accounts, garnish your wages, or place judgment liens on other property you may own.
To get a deficiency judgment, the lender must file a lawsuit. But lawsuits are costly and most borrowers who are forced to complete a short sale of their homes to avoid a foreclosure are judgment-proof. (This means they don’t have much in the way of cash reserves or other assets that a creditor can take to pay off the judgment.) A lender will only sue for a deficiency judgment if it thinks you have sufficient assets or funds to repay the deficiency. If you can’t afford to pay the deficiency, it is possible that your lender won’t bother to file a lawsuit.
If the lender forgives the amount of the deficiency (say, as part of a settlement) and issues you a IRS Form 1099-C, you might have to include the forgiven debt as taxable income. (Learn more about short sale tax implications.)
Tax laws are complicated and there are exceptions and exclusions that could save you from having to report canceled debt as part of your income. If you have tax questions, consider talking to a tax attorney. If you can't afford an attorney, you might qualify for free or low-cost assistance from a Low Income Taxpayer Clinic.