Foreclosure Deficiency Judgment Compared to Deed In Lieu and Short Sale Scenarios

Basic Primer - the Mechanics of a Mortgage Foreclosure Deficiency Judgment Compared to Deed In Lieu and Short Sale Scenarios-

We get so many questions about having a "deficiency judgment" entered and how it differs from other possibilities in a deed in lieu of foreclosure or short sale, that a refresher article seems appropriate for Activerain.  If you are unsure of what a Short Sale is, then first read the Back to Basics - a Review on Short Sales .

This article is written based on Florida law, but most state laws are similar.  Be sure to contact your own attorney for your state laws, and always consult your own attorney on any legal decision you need to make.  This article is for information purposes and is not specific advice to any one reader.

The Law of a Mortgage Foreclosure:

A mortgage foreclosure (some incorrectly call it a "Lis Pendens") is filed by the lender when the Promissory Note that is secured with a Mortgage on some real estate (usually the home) has not been paid on time (the "default"). 

Let me clarify an important issue that will have meaning later.  A "Mortgage" is NOT the obligation to pay the bank.  The obligation to pay the bank back the money it loaned along with interest is called the "Promissory Note".  The bank makes two types of loans.  Secured loans are when the bank wants the Promissory Note to be collateralized with something of value.  In real estate that "something of value" is usually a "Mortgage" and it collateralizes or secures the Promissory Note with the house or other real estate.  So when we say only the word "Mortgage", technically you are referring only to the security document and not the Promissory Note.  Likewise when we say the words "Promissory Note", we are referring only to the obligation to repay the bank.

If there was only an "unsecured" Promissory Note and there was no Mortgage, the suit would demand payment of the Promissory Note and then the judge after hearing the evidence, would likely issue a Final Judgment against the borrower and in favor of the bank for the amount of the unpaid Promissory Note along with accrued interest, late fees and court costs and attorney fees.  The Final Judgment would also be entitled to interest (in Florida that rate is now 11% a year) until the Final Judgment is paid in full.

A mortgage foreclosure is actually a four step process.

The first step is to file suit (called the "Complaint") on the non-payment of the Promissory Note. (Yes, there are other reasons for a foreclosure suit to be filed, like an unauthorized transfer of the real estate, or non-payment of the real estate taxes, but we are going to focus on not paying the Promissory Note). An action (the suit) is filed at the courthouse and it consists of 3 documents.  The first is a Summons, which directs you to answer the Complaint.  The second is the Complaint, which describes why the bank is entitled to the relief it is asking for - the payment on the Promissory Note.  The third is the Lis Pendens, which puts the public at large on notice (since the lis pendens is filed in the public records where the property is located) that anyone dealing with the property should know that a claim has been made against the property in the Mortgage.  (Lis Pendens literally means "pending litigation" and is one of those fancy Latin words that we lawyers banter about).

Step One:  The Complaint will describe that there was a Promissory Note signed by the borrower to evidence that it was to repay the bank the money, and that to induce the bank to make the loan the borrower also signed a Mortgage on some real estate that promised that if the Promissory Note was not paid, the real estate could be sold and the proceeds would be used to pay the Promissory Note.  It will also say how much is unpaid and what additional money the bank may want for the non-payment of real estate taxes, for example.  It will finally make a "demand", which will ask that if the borrower does not make payment on the Promissory Note to the bank, then the real estate should be sold under court supervision at a public auction, and if there is insufficient money bid for the real estate, the court should give to the bank a judgment for the shortfall (the "Deficiency Judgment")

Step Two:  After statutory time periods have run (for example, 20 days to answer the Complaint, the bank can more for a final judgment.  This is usually accomplished (in Florida) with a Motion for Summary Judgment, or similar name.  Another 20 days must elapse before this hearing can take place, once the motion is filed.  In reality (at least in Palm Beach County right now) that time period can be several months before a court date on the Motion for Summary Judgment can take place.

At the Motion for Summary Judgment hearing the bank must prove that there is a valid Mortgage securing a valid Promissory Note and that it is unpaid.  The judge will then issue a Final Judgment of Foreclosure that says (1) if the borrower does not pay the bank the amount the bank proved is due to the bank within usually 30 days, the real estate is ordered to be sold by the clerk of the court to the highest bidder, and if the highest bidder bids less than the amount due to the bank then the bank can come back to court and request a Deficiency Judgment.  It is important to note that the Final Judgment of Foreclosure is NOT a money judgment against the borrower!  However, depending on step three below the bank can move to obtain a money judgment later on.

Step Three:  Assuming that the borrower has not paid the bank to the bank's satisfaction during that 30 day period, the public sale (the "foreclosure sale") will occur.  It is conducted by the Clerk of the Court and it usually occurs "on the courthouse steps", but more usually in a courtroom or meeting hall or even in a large hallway in some courthouses.  The property is announced and bidding starts at $100 and goes up from there.  The bank is able to bid for the property and it will do so to "protect" the collateral up to the amount (and usually beyond) the bank has determined the property is worth.  Usually the bank will bid up the amount of the judgment it received from the judge. (This is great news for the borrower, but that is another article I need to write).  More often than not the property gets sold to the bank for a mere $100 and there are no other bidders at the foreclosure sale.

Step Four:   I am now again making as assumption.  The assumption is that the bank ended up with the property at the foreclosure sale by bidding one hundred dollars.  In that event the borrower still owes the bank money to satisfy the promissory note.  The amount of the remaining balance is what is in question.

To figure get the balance of the monies the bank must go back to court to ask the court to award it a "Deficiency Judgment".  The amount is what is in question and the amount is measured using various rules.  In our example the bank bid $100.  The court is not going to say that the house was worth $100 and $324,900 is still owed.  For our assumption and as an example we will say that the property is worth $200,000 and the foreclosure judgment is for $325,000.  That means the court will ask for an appraisal of the property as of the day of the foreclosure sale and the judge will likely give it that value.  So it will be the appraisal value less the judgment amount which will equal the Deficiency Judgment.  If the appraisal is $250,000, the Deficiency Judgment would be $75,000.   Now if there was real bidding at the foreclosure sale the judge could consider that bidding and instead adopt the selling price under the competitive bidding process that occurred at the foreclosure sale.  Then the Deficiency Judgment would be the difference from the foreclosure judgment and the winning bid amount. If the competitive bid was $240,000, then the Deficiency Judgment would be $85,000.

A little issue that comes up is how long the bank has to get the deficiency judgment.  The Florida Statute of Limitations (time to enforce) the Promissory Note is 5 years from the time it went into default. 

There is also a rule on how long a plaintiff can keep open a lawsuit that has no activity.  That rule says after 1 year of inactivity, the lawsuit can be dismissed by the court.  The rule is referred to the "Failure to Prosecute Within One Year" rule.  IF the court dismisses the lawsuit after one year and before the bank asks for a deficiency judgment, it could be argued that the bank cannot again seek to enforce the promissory note. This concept is untested in the courts of Florida, but see the next paragraph.

Florida courts have noted that a claim for deficiency in a foreclosure action does not accrue until the foreclosure sale has occurred.  Thus the five year period starts at the time of the foreclosure sale (not the time of the default).  The courts have not addressed the one year "failure to prosecute" issue, but it is likely that a decision on it would consider that a deficiency action is separate and could be filed as new action based on the accrual of the event at the time of the foreclosure sale that resulted in the deficiency. (See Chrestensen v. Erogest, Inc., 906 So. 2d 343 (Fla 4th DCA 2005). So notwithstanding that the court could dismiss the case after one year, that dismissal would not bar the re-filing of the claim during the 5 years after it accrued. [UPDATE; Florida case law now says that the time to file a claim or for a deficiency judgment or new suit for amount of balance of note has a starting date as of the foreclosure sale date.]

Almost every client I meet with first starts out wondering if they should "just give the property back to the bank".  I tell them first off that, "it ain't so easy." 

A Deed In Lieu has many prerequisites.  The first is that the property cannot reasonable expect to be able to be sold within a reasonable period of time.  The second is that the bank to receive the Deed In Lieu must be the only lienor.  This means there can be no second mortgage and the borrower must be clean of any claims or judgments from other creditors.  In other words the title to the property must be "clean" except for the bank's mortgage.  (Note that if the bank with the first mortgage also has the second mortgage or HELOC, the Deed In Lieu is still a possibility.) 

The issue becomes what becomes of the disposition of the Promissory Note?  There is documentation in a Deed In Lieu that is very important to the borrower.  This documentation can be an agreement in conjunction with a deed to the bank, or it can be written right into the deed to the bank from the borrower for the subject property.  In any event the document(s) must provide that as part of the consideration for the giving the property to the bank the Promissory Note is satisfied in full.  If this language is included, then there is no further liability of the borrower to the bank and no lawsuit to enforce the Promissory Note can occur.  Most of all, banks don't like to have to sell your property so they don't like taking property to have to manage and sell.  It is expensive to take in your property and unless your property is worth more than the amount the bank loaned to you, the bank is likely to only loose more money than if you sold it for them.  That is why the do short sales and deeds in lieu.

Short Sale Negotiation:

A short sale by its nature does not encompass a law suit to foreclose the Mortgage or a lawsuit to enforce the Promissory Note and that is one of the primary advantages of this method of loan workout.  On the other hand, there is often a Mortgage Foreclosure Suit already in progress when a short sale is attempted to be negotiated.  [It is important to realize that a short sale "attempt" does NOT stop a Mortgage Foreclosure Suit.  The bank may instruct its attorneys to delay acting on certain aspects of the suit - usually getting the Foreclosure Judgment or if one is issued, then delaying the actual conducting of the Foreclosure Sale].

The short sale does often times result in a "Release" of the lien of the Mortgage but not a "Cancellation" or "Satisfaction" of the Promissory Note.  It is this remaining financial obligation that is the crux of so much discussion about "1099's" and forgiveness of debt.  Sellers Always Have Income is a comprehensive article on the subject and also deals with recent legislation on how income does not have to be recognized.

Unless a release or satisfaction of the entire Promissory Note or in the case of a property with more than one loan, then each Promissory Note is obtained, there remains the ability of the bank or banks to sue the borrower for the balance of the unpaid promissory note.  In the case of a 2^nd Mortgage, this might be the entire amount of that loan if the 2^nd Mortgage bank took nothing so the short sale could succeed. 

The documentation regarding a short sale is very important.  The borrower needs to know what further obligations could be in the future as a result of the short sale.  Like the Deficiency Judgment statute of limitations, the balance of the Promissory Note must be enforced within 5 years of the default or the demand for payment by the bank.  The rule about the one year dismissal for lack of prosecution does not apply to the short sale scenario.

If the unpaid balance of the Promissory Note is enforced by the bank, then it can file a lawsuit against the borrower (if done within that 5 year period) and the result will likely be a Judgment for the payment of money in the amount of the unpaid portion of the Promissory Note.  Many persons that short sell and do not get a release of the Promissory Note utilize an offer to pay back all or a portion of the Promissory Note balance with a new unsecured promissory note.  This new promissory note replaces the old Promissory Note.  The new promissory note can also be enforced by the bank in the same way as the old Promissory Note, but the time to enforce it will be based on whatever new default might occur if the terms of the new promissory note are not followed by the borrower.

The Second Bite from the Apple

An interesting twist is being used by the banks.  They take the now unsecured remaining balance of the promissory note, or the new negotiated promissory note, and sell it to investors for 5 to 10 cents on the dollar.  Then the new investor tries to collect on the promissory note.  This is mentioned in my article on Negotiated Paybacks.  Obviously this represents an opportunity to negotiate the remaining balance a borrower may have on the old loan - sort of a second bite at the apple.

Opportunity abounds for finding solutions for those that need a short sale or find themselves in a foreclosure action.  No solution is a panacea for the borrower's troubles, but the solutions present an ability for a borrower to make a bad situation a little less bad, and it gives some control to the borrower over what is otherwise a nightmarish situation.

Be sure to contact your own attorney for your state laws, and always consult your own attorney on any legal decision you need to make.  This article is for information purposes and is not specific advice to any one reader.

Copyright 2008 Richard P. Zaretsky, Esq.