Owners Face Tough Decision: Is This Home Worth Saving?

Homeowners in the San Fernando Valley and Ventura County are facing tough decisions on whether to rebuild quake-damaged homes, or walk away from their mortgage and allow property foreclosure.

They may also face a maze of complexities and pitfalls.

One complication is whether the loan is the original mortgage used for home purchase or a refinanced mortgage.

Most borrowers don’t realize that this makes a difference. However, California law provides special protection for borrowers with their original home-purchase loans, as opposed to a refinancing.

If they still have the original loan, the law states that should the borrower owe more money to a lender than the value of the property at the time of foreclosure, the lender does not have any recourse to seek funds from the borrower to make up the deficiency. However, borrowers who refinanced could face serious additional woes if they default.

“The greatest aftershock of all is that you could lose your home and still owe money to the lender,” Los Angeles attorney Jerry L. Bergman warned.

When funds are borrowed to buy a home, it is considered a “purchase-money” loan. That makes it a non-recourse loan under California law, Bergman explained. For example, if a borrower owes $200,000 on a home that’s now worth only $150,000, the most that the lender can do is take over the home; the lender cannot sue to get the difference from the borrower.

Not all loans are non-recourse. Because of the drop in mortgage rates in the past year, many homeowners refinanced. Most refis are recourse loans, meaning that the lender has the right to seek a deficiency judgment in court against a borrower if the foreclosed-on property is worth less than the debt still owed by the borrower.

Bergman has clients in Reseda facing just such a possibility. These clients owe $180,000 to the bank, but now the quake-damaged property is worth only $100,000. The lender could judicially foreclose on the house and seek an additional $80,000 deficiency judgment from the homeowners. This method, however, has rarely been employed by lenders because it can take more than a year.

The more common route is what’s known as non-judicial foreclosure, where a lender does not go to court, but directs a trustee to foreclose according to the lender’s rights under the loan note and the deed of trust.

However, Bergman said, because a non-judicial foreclosure prevents a lender from seeking a later deficiency judgment, some lenders may now seriously consider judicial foreclosures and deficiency judgments--especially if the borrower has other assets.

In other words, if your lender wants you to make up the difference in a foreclosure, the lender can only do it by taking you to court.

As if this wasn’t mind-boggling enough, tax implications can make the situation even more complicated.

Suppose a lender goes through the trustee to foreclose on a non-recourse loan. The Internal Revenue Service then treats the foreclosure like a sale of property for the debt. There is tax to be paid if the tax basis of the property is lower than the deemed “sales price,” explained Steven M. Friedman, a Sherman Oaks resident and west region director of real estate advisory services at accounting firm Ernst & Young.

You could owe the IRS money even if your home is worth less than the property’s mortgage, if previously you owned another home and sold that at a profit but deferred that tax by purchasing another home.

When a loan is recourse debt--that is a refinanced loan--the IRS will seek its share of any cancellation of indebtedness. This tax can be avoided, however, if the debtor is insolvent or in bankruptcy. Commercial property owners can also defer cancellation of indebtedness “income” if they own another depreciable property, Friedman said.

“Whatever you plan to do, it really pays to line up your ducks,” Friedman said. Before walking away from a mortgage, he said, it is important to talk with the lender about what type of foreclosure may be initiated and to talk with a tax accountant about the potential tax bill.

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“Borrowers think they are protected from a deficiency judgment, but they’re not if they have a refi loan,” said Alan Kheel, a partner at the law firm of Reznik & Reznik in Sherman Oaks.

Ever since the January earthquake, Kheel said, he has been dealing daily with the problems of borrowers facing the decision of whether to rebuild their homes or walk away. One client in Sherman Oaks has a $650,000 refi loan on a home that has turned to rubble. The land is worth maybe $200,000 today, Kheel said, so if the borrower walks away, he could still face a whopping $450,000 deficiency judgment.

“It’s an absolutely terrible situation,” Kheel said. “The lender will probably threaten a judicial foreclosure so that it can get a deficiency judgment,” he predicted. Kheel doesn’t expect the lender to follow through on such a threat, however, because of the time involved.

Not only does a judicial foreclosure take much longer than a non-judicial foreclosure, but according to the law, the borrower also gets what’s known as a right of redemption. That means that the borrower has a year to return to the lender with the money to buy back the home. This effectively makes the home unsalable for a full year because the title is clouded, Kheel said.

In contrast, a non-judicial foreclosing on a deed of trust takes much less time. Deeds of trust are basically three-party legal instruments created to secure real estate loans. In California, when a property owner (called the trustor) borrows money from a lender, he or she does so by signing a promissory note to repay the debt. The borrower also signs a trust deed giving a neutral third party (called the trustee) the power to foreclose and sell the property if the borrower doesn’t make good on his or her loan obligation.

After two missed payments, most lenders generally report a default to credit bureaus. If nothing is done to correct the situation within about 75 days, lenders will usually begin the foreclosure process by notifying the trustee to file an official notice of default.

Once a notice of default has been filed, any of the above strategies can still be employed, but the borrowers must act quickly.

There’s a 90-day period between the notice of default and recording of a notice of trustee’s sale. The borrower has up to five business days before the date of sale to reinstate the loan. The trustee generally schedules the sale 21 days after recording a notice of sale. The sale can be delayed, however.

If the sale brings in more than the amount owed on the note, this money is transferred from the trustee to the trustor (borrower). If there’s a deficiency, California law basically prohibits the lender in a non-judicial foreclosure from going after the borrower for the balance.

A bankruptcy filing can stay the notice of default or trustee’s sale. This topic, however, could easily fill another column.