If your property is underwater, not only did you probably reach out for help and examine your options, but you probably also received a lot of unsolicited offers from real estate agents and other “foreclosure consultants” who want to “help” you.

When they talk up all the benefits of a short-sale, they probably mention all these things:

Myth 1: You will be able to avoid personal liability for deficiency (roughly the amount you owe minus what the lender will receive for your house), that you would have if you just walk away and allow the lender to foreclose.

Myth 2: The person helping you with the short sale knows what he/she is doing and will protect you.

Myth 3: If you go through a foreclosure or bankruptcy, you will never be able to buy a house again.
Until recently, I naively believed that while short sales mostly benefited the real estate agent receiving commission, in most cases they didn’t “hurt” the seller (underwater homeowner). I believed that short sales were a waste of time for most, and better options were available, but that they didn’t make the situation worse. I was wrong!

True story:

A couple walks into my office with a horribly botched short sale. If the short sale was a haircut, it would be the equivalent of the horrid short haircut plus bangs I got in high school which looked awful with my insanely curly hair and round face. I cried for months…ok, back to what I was saying, when I heard this couple’s story, I couldn’t believe what I was hearing.

They had one deed of trust (mortgage) on their residence. The home was underwater. They were talked into a short sale. The real estate agent that handled this couple’s short sale failed to obtain release of personal liability. A few months after the couple thought this nightmare was behind them, they began receiving collection calls for the deficiency amount of the loan.

The short sale put this couple in a worse position than they would have been if they just moved out and allowed the foreclosure to proceed. They would not be liable for the deficiency if the lender just chose to foreclose.

A little real estate law background to explain why: Traditionally, when people speak about the “mortgage,” they are referring to a loan which is a combination of two things: a promissory note (“Note”) outlining the personal contractual obligations of the borrower and a deed of trust that secures the lender’s interest by attaching as a lien to the property.

In CA, most foreclosures proceed as “non-judicial” foreclosures. The power to sell is in the Deed of Trust. As such, foreclosures don’t go through the court. Because this leaves the borrowers less protected than a “judicial” foreclosure (where a judge would review the foreclosure), the borrowers get certain protections.

CA Code of Civil Procedure 580b provides that no deficiency judgment will apply if the loan was a “purchase money” loan for a “dwelling” (residence) occupied by the purchaser.

In addition, CA Code of Civil Procedure 580d provides that no deficiency judgment will apply when a lender forecloses non-judicially. Because it is likely that the first deed of trust holder will do the foreclosing, it is a section that doesn’t really apply to second mortgage/deed of trust holders. However, in some ways this section is wider in application, because it applies to all real property, not just the borrower’s “dwelling.” In other words, this section covers investment properties and commercial properties.

In this couple’s case, they only had one loan, but it was a refinance of their original purchase money loan (a loan borrowed to pay for the purchase of the home), and therefore there would be no deficiency, despite the fact that the home would be sold for a lower price at a foreclosure, because of 580d! That is if the home was foreclosed upon instead of sold in a short sale.

What happened to the couple and Myth 2:

In this couple’s case, because the lender didn’t proceed through a “non-judicial” foreclosure, but rather agreed to a short sale, there is potential personal liability for the deficiency. Section 580d no longer applies. While the deficiency issue could have been avoided if the real estate agent who negotiated this short sale for the couple made sure that the lender released both the lien interest as well as the underlying personal liability of the buyer, the real estate agent didn’t obtain those terms and the bank only agreed to “release its lien interest.” The real estate agent that botched this short sale proceeded to collect a commission of approximately $10,000, while the couple went on to have numerous sleepless nights thinking about what will happen with these collection calls they were now enduring.

I would argue that the borrower didn’t receive any “benefit of the bargain” from the short sale and that if no money was taken out during a refinance, it was in essence a “purchase money” loan entitled to protection under 580b. However, while I think these are valid arguments, it is frustrating to think that this couple would not be in this situation if they never proceeded with the short sale or if the real estate agent was not negligent in negotiating this short sale.

SB 931 and real estate agents everywhere are celebrating: Recently CA legislature passed SB 931 (codified as CA Code of Civil Procedure 580e) and it provides that if the lender in first position approves a short sale in writing, that lender may not pursue a deficiency against the seller/borrower. Note, this law is not retroactive and will apply to short sales after January 1, 2011. This section will also not protect borrowers/sellers where fraud is an issue. This applies to the initial purchase money loan as well as a first position refinance loan.

Frankly, I am a little surprised that this SB 931 was necessary at all. I do not understand what any borrower/seller would get from agreeing to a short sale if personal liability on the first position loan is not extinguished. In essence, the seller/borrower could walk away from the house and the house would be sold in a “non-judicial” foreclosure, after which the lender in first position would not be able to collect a deficiency because of 580d. However, if prior to SB 931, a short seller didn’t get release of personal liability as part of the short sale agreement, the person with a refinanced first loan (arguably “non-purchase money” loan, though this is a topic in itself) would potentially be opened up to deficiency liability, because the lender would not be exercising “non-judicial” foreclosure rights, but rather contractually agreeing to a sale.

It is my position that SB 931 came about as a result of negligent practice by “short sale” agents that fail to protect the borrower/seller and push people into short sales in order to receive commission. Now these agents are celebrating something that should never have been an issue to begin with.

As for Myth 3 – please see a previous blog I posted: about financing a house after bankruptcy.

In conclusion, do be careful before agreeing to do a short sale and make sure it is the right thing for YOU, not just the real estate agent and the lender.