The following is a general discussion of real estate loan liquidation as of this writing. You are encouraged to discuss this or any real estate transaction with your attorney or financial advisor.

Real Estate Loans

There are two basic types of loans: recourse(often called hard money") and non-recourse(usually called purchase money loans.  If your loan is recourse, it means the lender can in some instances foreclose, and then get a judgement against the borrower for the amount of its loss.  In other words, you have personal liability for the loan. 

If the loan is non-recourse, the lender can only foreclose and take the property.  You have no personal liability. 

First, whether you have personal liability depends on the State in which the property is located.  Second, it sometimes also depends on how the lender forecloses in that State.  First, the State in which the property is located.

Properties located in many States have purchase money protections for the borrower.  In these states, under certain circumstances, the lender cannot come after you for any of its loss. Some zealous loan collection departments will tell you differently, however in an attempt to intimidate you.

In California, for instance, there are two types of purchase money loans:

            1.    If the loan was (a) taken out to buy a personal residence (b) consisting of from 1-4 units - single family, duplex, triplex or fourplex, and (c) you moved into the property when you bought it, the loan is purchase money.  Even if you later move out and make it a rental.  The loan always stays purchase money. 

            Example 1:  You must meet all three requirements, however.  You buy a duplex and move into it at close of escrow.   The loan is purchase money. Later you refinance.   The refinance loan is not purchase money.  You did not take it out to buy the property, but perhaps to take out some equity, or to get a better interest rate. Refinance loans are always recourse loans.

            2.    If the seller carries back part of the purchase price in the form of a loan against the property, it is a purchase money loan.  It can be any kind of property - a single family home, and apartment building, vacant land, whatever.  Under some circumstances,  however, the loan can change from  purchase money to recourse.  

            Example 2:    You buy a piece of vacant land.  It is difficult to get a loan, so the seller agrees to carry back the first trust deed.  That loan is purchase money.  Later you get a construction loan, and the seller agrees to subordinate to the new loan.  That means he agrees to become a second lender instead of the first lender. The seller's loan now changes to a recourse loan on which you would have personal liability.

            In California, a lender can foreclose

                        1.      By Trustee's Sale or
                        2.     Judicially (through the courts).

In almost every instance, a lender will foreclose by Trustee's Sale because it is quicker, simpler, and cheaper than going to court to foreclose.  If a lender uses the Trustee's Sale method, there is no personal liability for a borrower, even if the loan is recourse.

"The foreclosure laws tend to be very parochial," said Lawrence Jacobson, a real estate attorney in Los Angeles. Said Jacobson: "I've been a real estate attorney nearly 40 years and I have yet to see a mortgage in California."

If yours is a purchase money state, the purchase money test also applies to seconds, thirds, etc.  In a recourse state, all loans are recourse, regardless of their position. 

     Example 3:     You buy a personal residence in California.  The bank makes you two loans, a first for $80,000 and a second for $20,000.  The loans have different interest rates.  Using the three-part test above, both are purchase money loans.   The lender can foreclose on either one; you have no personal liability on either.  

      Example 4:   Same example, except the bank sells one loan to another bank.   Both loans are still purchase money.  No personal liability.

        Example 5:   You buy a 16-unit apartment building.  The seller carries back a second trust deed as part of the purchase price.  The first loan is recourse (over 4 units), but the seller's loan is purchase money. 

        Example 6:  Same as Example 5, except that you take out a third loan to repair the roof.  The third loan is recourse.  If the seller forecloses and takes the property back, he takes it with the loan recorded before his, the first.  His foreclosure eliminates the third from the property.  Because the third is recourse, however, you still have personal liability for it. 

        Example 7:   Suppose you have a first loan of $100,000 and the second loan (recourse) is $30,000.  The property will only sell for $90,000.  What happens?  

Most likely the first lender will foreclose.  The second lender will then want payment.  You will have to negotiate or declare bankruptcy.  If the second loan is less than $20,000 however, the chances are slim that the lender will actually sue you.  There is not enough money involved to warrant hiring and paying an attorney. 

Government Loans

HUD, FHA, and VA lenders receive some sort of guarantee or insurance from the U.S. Government.  If you have a VA first mortgage, the Veteran's Administration(VA) is reasonable about accepting short sales.   Same for FHA.  If you have a HUD second, however, the lender is guaranteed to receive 90% of the loan if the buyer stops paying.  Thus the HUD lender has little incentive to accept a short sale.  It is easier for the lender to simply turn in a claim to HUD and get most of its money.

If a foreclosure takes place, the government usually takes the position that State laws regarding purchase money loans do not apply to these loans.   Fortunately for borrowers, the government rarely sues for personal liability.  

The Government can take your income tax refund to offset a bad loan.   Thus you must be careful to structure your withholding carefully (and properly) so that you either break even or owe a slight amount of money at year-end for quite a few years into the future.  

Protecting Your Assets

As mentioned in the above paragraph, you have to carefully arrange your tax withholding to avoid letting the government scoop up your refund if you had a government loan.  Other than that, a lender cannot attack your assets unless it first gets a judgment against you.  Then it has to find your assets are located.

This first means filing a lawsuit and ultimately winning it.   In most recourse-loan states, the lender forecloses through the courts and can get a judgment for personal liability against you right away.  In other states, the lender must take separate independent steps to get such a judgment, including filing a second lawsuit at times. 

In purchase money states, lenders usually foreclose by Trustee's sale, thereby giving up their right to collect a personal liability judgment.  If a lender forecloses through the court, it must first get a judgment before it can go after any of your assets.  This does not prevent eager agents in lender collection departments from making absurd statements to try to intimidate you. Don't allow it! Under the Fair Debt Collection Practices Act  the collector can be held personally liable for violating said act, and for stating the following:

        "If you don't pay, we'll

                1.     Garnishee  your wages next week,
                2.     Put a lien on another property you own,
                3.     Take your car for collateral,
                4.     Send the Sheriff out on Tuesday to (various threats)
                5.     Make a report to the police."

The first three can only happen after the lender (a) files the lawsuit and (b) goes to court and wins.  The first can be done easily, but the second is never guaranteed (remember that the only two guarantees in life are death and taxes). In between the two is a lot of effort and expense on the part of the lender, which is why lenders are generally open to negotiation.

Items four and five in the above list simply don't happen.   There is no such thing as Debtor's prison any more. 

If you own another home you are living in, you can protect up to $100,000 of the equity in California by filing a Homestead Declaration.   As long as this gets recorded before the lender is able to record the judgement it gets in court, this much equity is protected.

            Example 8:  A second trust deed lender (or anyone for anything, for that matter) sues you in court and gets a judgment on July 1.  The lender records a copy of the judgment on July 2.  You and your spouse own a home with $75,000 equity.  When you find out that you lose at trial, you record a homestead declaration that same day, July 1.  Your $75,000 is protected.  The lender can put a lien against your home, but if you were to sell it immediately, you could get your $75,000 out.  If you don't put it into another home, six months later, the lender could attach the money - if it could find it. 

While the lender has ways of finding it, it isn't easy.  Also, you have ways of staying one step (or many more) ahead of the creditor who got the judgment.

Same facts as example 7 except that your equity is $130,000.   Theoretically, the creditor could force the sale of your home.  You could keep the first $100,000 and the creditor would get the balance of $30,000.  In California, however, the steps to accomplish this are very technical.  Also, there is a State policy against selling a person's home out from beneath him.  These facts together mean that such a sale is seldom attempted.  

Avoiding Harrassment by the Lender

A handful of lenders are compassionate and understand that risks they undertake in lending often materialize.  Most lenders will engage in a fforceful campaign to get you to continue making payments.  This can include threats as discussed above, calling you at all hours of the day and night, calling you at work, and knocking on your door demanding payment.  The federal Fair Debt Collection Practices Act limits what collectors can do. 

If the collector is approaching you as an agent for someone else (which is the case 98%of the time), he must stop contact with you if either,

            1.     You tell him you are not going to pay and ask him to stop his collection efforts.  You should send a letter to this effect, although this does not always stop or even slow down attempted collection in many cases. 

        Collection agents are not supposed to call you at work to collect.  But they will. 

Negotiating with the Lender

Most lenders would prefer to negotiate some sort of settlement rather than go to court.  All who actually file suit would prefer to settle rather than go to trial.  A lender would rather not risk losing everything because the borrower filed bankruptcy.  You may have neither inclination nor a situation which lends itself to filing bankruptcy.  The lender can not always be sure that your situation and/or inclination will not change, however. 

A final negotiation usually means some cash down, though not always, and a promissory note signed by you for the balance of the negotiated amount.   The negotiated amount  depends on a great variety of factors including: your financial position as the lender sees it, the lender's actual loss, how many bad loans the lender has in its portfolio already, and so forth. 

            Example 9:  On a second of $30,000 the lender agrees to settle for $20,000 with you paying $3,000 now, and making payments on the balance.  Generally there is no interest.  The payments could be from $300 to $700 a month.  If during the payment period you can manage to pay the remaining balance in one lump sum, you can usually negotiate a further small discount.  For instance, if you paid the balance down to $10,000 and then could come up with a lump sum, you might be able to settle for $8,500 or $9,000.  Again, this would depend on a variety of factors.

Whether you are negotiating with a lender for a short sale, or after a foreclosure, you should always attempt to include removal of any negatives on your credit report as part of the settlement.  Sometimes the lender will agree to this; most of the time it will not. 

Tel: (877) 255-1074 - Fax: (800) 291-4555