FORECLOSURE/SHORT SALE BROCHURE

This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

There are two types of foreclosure in California: Trustee's Sale, and Judicial Foreclosure.

JUDICIAL FORECLOSURE is rare and has many disadvantages to the lender. It is not an expedited process (as is the Trustee's Sale), but involves court proceedings, orders, appraisals, and an auction. It takes much longer and costs much more than a Trustee's Sale.

The real difficulty with Judicial Foreclosure is that it allows the Borrower a 1 year "right of redemption" in which he is allowed to buy the property back from the successful bidder. This makes purchases of such property more uncertain and tends to lower the bidding.

The advantage to the lender of Judicial Foreclosure is that a deficiency judgement against the Borrower is allowed. [See exception below for personal residence.] The auction proceeds are used to reduce the debt (including penalties, attorneys' fees, and costs); judgement is entered against the Borrower for the balance.

Whether the deficiency judgment is collectable is another problem for the lender.

TRUSTEE'S SALE is the easy method of foreclosure. It's fast and inexpensive. However, NO DEFICIENCY JUDGEMENT IS ALLOWED.

In a Deed of Trust the borrower (Trustor) gives the Trustee (typically a title company) the right to sell the property if the Buyer defaults.

The first step is a Notice of Default. It states the amount in default. 90 days is given to cure the default by catching up on all late payments, penalties, and costs.

After the 90 days expires, the lender files a 21 day Notice of Trustee's Sale, at which time an auction is held, usually at Court, with limited publicity resulting in a greatly depressed price. After it is over, the former owner must be evicted if he refuses to leave.

The Borrower can still catch up on all late payments until 5 business days prior to the sale. Within the last 5 days, the only way to stop a sale is by payment in full of the entire balance.

EXCEPTION Personal Residence = No Liability

By State law there is never personal liability for a purchase mortgage for a personal residence. The owner can "walk away" from the property with immunity from personal liability regardless of the method of foreclosure.

Deed in Lieu of Foreclosure

This is a short-cut, when the owner accepts the inevitable and gives the property back to the Bank. However, many lenders now refuse to take a Deed in Lieu of Foreclosure. They get "cleaner" title if they foreclose, effectively wiping out all other claims to the property.

Bankruptcy

Many borrowers stall until the last minute and then file bankruptcy to stop the sale. If there is no equity in the property the lender eventually will make a "Motion for Relief from the Automatic Stay" to allow the foreclosure to proceed. This takes time and costs the lender more money.

Foreclosure after Sale

"I sold the property. The loan is still in my name. The buyer was supposed to make all the payments. Now the Bank is foreclosing and sending me notices."

As discussed above, if the lender uses the Trustee's Sale, it waives any right to seek a deficiency judgment against anyone.

Therefore, a seller who is still on the mortgage for his former property has little (if any) real risk of liability for a deficiency.

The next concern is, "But will it affect my credit?"

If the former owner can prove that the loan was current when he sold the property, although it may show on a credit report, a letter to the credit agency explaining that the foreclosure was after a sale, usually works.

"SHORT SALE"

Most lenders are in the money business and would rather not own real estate. If the value of the property has decreased, some lenders cooperate and allow a sale of the property, instead of forcing a foreclosure.

If the debt is greater than the property's value, in order to sell it and turn the lender's interest into cash, the lender must agree to accept less than full payment as satisfaction of the debt.

Many lenders realize that some money soon is better than less money (since foreclosure auctions usually bring low prices) later, especially if the debt continues to increase during the pendency of the foreclosure.

TAX CONSEQUENCES

There are two elements of profit: `true profit,' and relief from debt income. `True profit' is computed as if the property were sold for its value; relief from debt income is taxable if the debt exceeds the property's value.

A foreclosure, Deed in Lieu, or a short sale (involving recourse debt) are taxed identically.

If the debt is $200,000 and the property's value is $180,000, the owner's `true profit' is taxed as if he had sold the property for $180,000; relief from debt income is taxable on the $20,000 debt in excess of the property's value.

If the owner's "cost basis" is less than the value, he has a taxable `true profit.'

["Cost basis" is determined by examining the property's initial cost, plus capital improvements, less any deferred profit from prior tax deferred sales (from the 2 year rollover of a primary residence or §1031 for investment property). If the property cost $250,000 and profit of $100,000 was rolled over from prior sales into this home, its cost basis is $150,000.]

The other kind of taxable income is `relief from debt income,' based on the difference between what is owed and the value of the property, $20,000 ($200,000 debt, less $180,000 value).

Relief from debt income is taxable only to the extent that the debt relief results in solvency. If the owner has a negative net wealth before and after the sale, nothing is taxable. Alternatively, if he has negative net worth before, and $3,000 net worth after, up to $3,000 is taxable.

If the owner is in bankruptcy, no relief from debt income is taxable.

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