If you're 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. But homeowners who complete 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 to avoid 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 loan. The difference ($50,000) is the deficiency.
In many states, the lender can seek a personal judgment against the borrower 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 using standard collection methods, like garnishing 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 in certain circumstances.
Assuming your state doesn't have a law prohibiting a deficiency judgment following a short sale, you might be able to avoid having to pay back a deficiency by taking one of the following tactics:
If you're liable to pay the deficiency after a short sale, you can 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 might 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 short-sale approval, ask it to forgo the right to seek a deficiency judgment. If your lender agrees, this provision must be included in the short sale agreement. The agreement must expressly state that the transaction is in complete 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 might call you or send letters stating that you still owe money. These letters could come from an attorney’s office or a collection agency, and will demand that you pay off the deficiency. Your lender or the collector might even try to intimidate you into making payments. But without an actual deficiency judgment from a court, the creditor can't freeze your bank accounts, garnish your wages, or place judgment liens on other property you own.
To get a deficiency judgment, the creditor must file a lawsuit. But lawsuits are expensive, and many borrowers who complete a short sale to avoid a foreclosure are judgment proof. ("Judgment proof" means you don’t have much in the way of cash reserves or other assets that a creditor can take to pay off the judgment.) Creditors typically sue for a deficiency judgment only if they think you have sufficient assets or funds to repay the debt. If you can’t afford to pay the deficiency, it's 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 an IRS Form 1099-C, you might have to include the forgiven debt as taxable income.
Tax laws are complicated, an exception or exclusion 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 have questions about how foreclosure works or different ways to avoid foreclosure, like with a short sale, talk to a foreclosure lawyer. A HUD-approved housing counselor can also answer questions about foreclosure alternatives.