Short sales and deficiency states v. non-recourse states

Short sales and deficiency states v. non-recourse states

In today’s roller coaster of a housing market, more homeowners are turning to short sales as an alternative to avoiding foreclosure. A common misconception though among some homeowners is that they might not be as free and clear from further financial liability as they think they are after their short sale is completed. In reality, they could still be liable for thousands of dollars owed on the deficiency balance equal to the total principal balance of the homeowners existing loan minus the net proceeds paid to the lender at the closing of their home. News stories about shocked homeowners who receive demand letters from lenders that are seeking additional amounts from homeowners after they have completed a short sale are certainly on the rise. One of the main reasons for confusion among homeowners regarding their liability is the difference among state laws on short sales. 

What is a short sale An alternative to foreclosure, a short sale is when you sell your home to pay off the remaining balance on your mortgage. However, if the amount received for the home is less than the remaining balance, the homeowner may still owe the mortgage lender. Say for example, a home sells for $150,000, but the remaining balance on the mortgage is $200,000. After paying realtor fees and other closing costs, the net proceeds from the sale that are paid to lender are roughly $136,000.  The seller is left with a loan balance of $64,000.  This balance is what we refer to as a deficiency.  The obvious issue then becomes whether a homeowner is still on the hook for that amount.

Pros and cons of a short sale Some lenders recommend a short sale for a few reasons. Perhaps the biggest reason is that a short sale is a way to eliminate a large chunk of mortgage debt while avoiding the process and emotional impact of foreclosure. With a short sale, some homeowners can take a measure of pride in the fact that they themselves sold their home. Certain banks also claim that a short sale will have less of a negative impact on your credit score compared to going through foreclosure, but this is contingent on the homeowner’s short sale agreement with its bank and whether the bank pursues the deficiency.

Short sales are not without their drawbacks though. One of the primary disadvantages is that unlike loan modifications or mortgage refinances, the homeowner does not get to keep the home. Further, if a lender does actually agree not to pursue a deficiency, the lender still may be liable to the IRS and may have to report the forgiven deficiency amount as taxable income. Also, as touched on above, if lenders do not expressly agree to doing so, they can report the short sale as a mortgage account “not paid as agreed,” which can negatively impact your credit score just as much as foreclosure. Another drawback is that short sales can take months to complete and can make for an extremely long and slow process because most buyer offers are contingent on lender approval.

Difference in state laws Perhaps one of the biggest potential disadvantages of a short sale lies in the state in which you reside. Some states, called deficiency judgment states, allow lenders to pursue the full deficiency amount after a short sale has been completed. Referencing the example above, a lender in a deficiency judgment state can sue a homeowner for the $64,000 deficiency remaining after the short sale.

Ohio law Ohio is a deficiency judgment state. Not only are lenders here allowed to sue for the deficiency, but they can also sue for costs associated with pursuing the deficiency. The only way in Ohio to avoid being sued for a deficiency is to get your bank to waive its right to pursue the deficiency judgment or agree in writing not to pursue it. Never assume in a deficiency judgment state that a short sale releases you from the mortgage balance; you must get your lender to specifically agree to release you from the deficiency judgment.

Non-recourse states In contract though to deficiency judgment states, certain states called non-recourse states have laws that expressly prohibit lenders and banks from pursuing a deficiency judgment. Returning to the example above, if the homeowner lived in California or Arizona, if a bank forecloses, and once the process is complete, the homeowner would not be liable for the deficiency following a sheriff's sale. Currently, there are 12 non-resources states, with the others (in addition to California and Arizona) being Alaska, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington.

Just how popular are short sales in non-recourse states? According to the Office of Mortgage Settlement Oversight, from March 1, 2012 to June 30, 2012, there were $8.669 billion in short sales. This number does not reflect the sale amount of a home but is actually the total for all the remaining deficiencies for every short sale completed during this time period. California accounted for the most in deficiency amounts forgiven, coming in at $3.9 billion alone. Arizona is second with $522 million. Ohio had about $47 million in short sale deficiencies forgiven.


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