2nd Lien Holder's Can No Longer Pursue Deficiency in CA

Effective July 15, 2011, California has prohibited Junior Lenders (2nds, HELOCs, etc) from having any deficiency recourse claims against the borrower if the lender agrees to take part in a short sale. Gov. Jerry Brown signed SB 458 (Corbett) into law and it took effect immediately. In January, 2011, SB 931 (2010) was put into effect requiring that any First lender that agrees to a short sale must accept the agreed upon short sale payment as payment in full of the outstanding balance of all loans. But unfortunately, the rule did not apply to junior lien holders. SB 458 extends the protections of SB 931 to junior liens. Both laws only apply to one to four unit residential properties.

Whether this is a victory for sellers and the real estate industry remains to be seen.

California Association of Realtors President Beth L. Peerce stated: “SB 458 brings closure and certainty to the short sale process and ensures that once a lender has agreed to accept a short sale payment on a property, all lienholders – those in first position and in junior positions – will consider the outstanding balance as paid in full and the homeowner will not be held responsible for any additional payments on the property.”

But the real question is whether this will in fact make short sales harder to get done. For any lender being asked to take the loss of the deficiency in a short sale, their only obligation is to determine whether a short sale will get more money back for their investors than a foreclosure. For first lenders on one to four unit residential properties, short sales are almost always better because: 1) Buyers pay more at a short sale than at a foreclosure sale; and 2) almost all foreclosures of these type of properties in California are done using a Trustee Sale from which there is no deficiency recourse. So for the foreclosing first lender, the short sale will generally bring them more money than a foreclosure. That is not necessarily the case with junior lenders.

Junior lenders would wait until the 1st lien foreclosed then they were free to pursue a deficiency judgement to get back the balance owed (unless the seller filed Bankruptcy). Now the 2nd lien does not have this option. So, it will be interesting to see how well they cooperate with short-sales. Still, the upside for a short-sale for a 2nd lien is at least they get "some" money from the short-sale proceeds from the 1st lien holder. Something is always better than nothing.

I am still not clear on whether or not the 2nd lien holder can send out a 1099 to the Seller/Borrower after they agree to a short-sale. Prior to SB 458 being passed a lender would either write off the balance owed to them via a 1099 to the Borrower or reserve the right to pursue deficiency. If they write off the balance as a loss and send the Borrower a 1099 that shows as ordinary income for that year for the borrower. It was my understanding that if they send out a 1099 they could not also pursue deficiency because they wrote the deficiency off as a loss.

As with anything else...only time will tell how this all plays out.

Note: I am not an attorney or accountant. This is for informational purposes only. Please contact your own attorney or accountant for advice regarding your specific situation.