California Law Protects Some Homeowners in Foreclosure or Short Sales

August 26, 2010

California has been among the states hardest hit by declining real estate values. Many homeowners now find themselves "underwater," or owing more on their home than it is worth. According to a recent report from research firm First American Home CoreLogic, 37.4 percent of California home mortgages are underwater. In such cases, if homeowners cannot make their payments and the home is foreclosed, or if they are forced into a "short sale" whereby they sell the home for significantly less than the amount of their mortgage, many wonder how they can possibly pay back the bank. Fortunately, California's laws have long protected homeowners in these situations.

Since 1933, California has had anti-deficiency statutes, which keep creditors (banks) from over-valuing properties and protect landowners in times of decreasing property values. Here's how they work: If the purchase of a property is financed with a mortgage for $300,000 and the property is later foreclosed or sold at a value of $200,000, the difference of $100,000 is called a deficiency. Although the lender would like to require the property owner to pay back the $100,000 deficiency, in many cases the owner isn't required to do so.

When is a property owner protected? That depends on how the bank proceeds. Generally, the bank has three options. The first is judicial foreclosure, under which the property owner may be responsible for the deficiency if the loan does not contain purchase money. Fortunately for California homeowners though, judicial foreclosure often takes years, making it an unattractive option for banks. Additionally, under judicial foreclosure, the original property owner has the right to buy back the property following the sale (this is called the right of redemption). For these reasons, banks will often not pursue judicial foreclosure.

The second option a bank might pursue is non-judicial foreclosure, also known as a trustee's sale. In this process, the bank issues a Notice of Default, waits 90 days, issues a Notice of Sale, waits 21 days, and can then sell the home. Because the process is much faster, banks tend to favor it over judicial foreclosure. But the good news for homeowners is that under non-judicial foreclosure, California's anti-deficiency statutes protect them from being forced to pay the difference if the home sells for less than the amount of the existing mortgage with the entity conducting the foreclosure sale. In addition, this protection applies when the mortgage is for a "non-purchase money" loan- in other words, typically when the homeowner has refinanced their mortgage.

The third option a bank might select is to agree to a short sale. Under a short sale, the homeowner sells the property with the bank's agreement that the resulting sale will satisfy the mortgage, even though it may be for less than the original amount of the loan. Although banks have traditionally been reluctant to agree to short sales, in the wake of the real estate market collapse short sales have helped banks get troubled loans off their books and spurred the housing market.

Some banks have sent letters to homeowners asserting that if they have the rights to pursue the homeowner for funds above that obtained in a short sale, they are not waiving those rights. Naturally, homeowners considering a short sale are concerned that they're going to be responsible for the difference between the short sale and the original loan.

But here again, California's anti-deficiency legislation may provide some relief. Although the language of the statute expressly limits anti-deficiency protection to use in a purchase money or non-judicial foreclosure setting, there may be some equitable arguments to prevent lenders from pursuing homeowners for deficiency balances following a short sale.

California's Supreme Court has stated that the statute is to be interpreted in light of its legislative purpose, which is to "discourage land sales that are unsound because the land is overvalued and, in the event of a depression in land values, to prevent the aggravation of the downturn that would result if defaulting purchasers lost the land and were burdened with personal liability." Given the current real estate climate and the reliance on short sales to spur the depressed housing market, homeowners may increasingly look to the anti-deficiency statute for equitable relief following a short sale, as well.

Although California law limits lenders to "one action" to recover its debt, a bank looking to preserve its options might commence proceedings for both judicial foreclosure and non-judicial foreclosure, while at the same time discuss authorizing the homeowner to conduct a short sale. Because of the complex issues involved, homeowners should talk to a seasoned California real estate attorney who understands the issues and can make sure their rights are protected.

Article provided by The Mellor Law Firm
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