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Foreclosure Crisis – Where We Are Headed

We have discussed where the foreclosure crisis has been.  This brings us to the questions of where are we now and where is the crisis headed?  One major issue for borrowers involves the expiration of the Mortgage Debt Relief Act (MDRA).  Passed during the infancy of the crisis in 2007, this federal law in essence protected primary homeowners in foreclosure from tax liability flowing from forgiven mortgage debt.  In the view of the IRS, when a lender forgives all or part of the borrower’s debt, this is a taxable event creating phantom income for which the borrower needs to pay taxes at their ordinary income rate.  The law conferred a great protection by preventing a big tax bill.

The MDRA has been extended numerous times, most recently in January 2013 retroactive to 2012.  As of the date of this writing, another extension is mired in Congress and does not seem likely.  What this means is that a great many borrowers receiving a “1099-C” debt forgiveness form will be hit with a large tax bill.  This is a situation requiring a consultation with a knowledgeable CPA to discuss some potential exemptions or other available damage-control options.

This tax liability is often confused with deficiency actions described more fully below but they are distinct and separate threats.  For years, players in the foreclosure world have been expecting deficiency collection actions to hit foreclosed borrowers.  It appears to finally be happening and this may be a major issue for some time to come.

Simply put, a deficiency is the difference between the fair market value of a property in foreclosure and the final debt owed the lender.  For more recent cases, the 2013 law provided clarity in terms of the statute of limitations for lenders to pursue a deficiency claim, now two years.  For older cases, the allowable time to sue for deficiency is more of a legal grey area but it’s unlikely that motivated lenders will let too much time pass before suing.  Now we’re seeing a wave of deficiency claims representing the biggest new threat to distressed homeowners in the foreclosure aftermath.

I have long urged clients seeking an exit strategy to consider a short sale instead of simply allowing the lender to steamroll them through an undefended foreclosure.  Though short sales carry many virtues for homeowners not interested in keeping the home and the mortgage debt, a major benefit is the opportunity to negotiate a deficiency waiver.

For the overwhelming majority of our firm’s short-sellers, the lenders have agreed to waive the right to pursue a deficiency action as a condition of the deal.  For many “strategic defaulters” lacking great hardship, lenders have granted deficiency waivers in exchange for a borrower’s cash contribution or taking back a much smaller unsecured promissory note to put some “skin in the game.”  When a borrower allows the foreclosure process to take title to the home, there are no promises regarding the deficiency and the lender is free to seek that relief.

Who is at risk for a deficiency action?  The answer is borrowers who have lost their homes through foreclosure or have reached some kind of settlement, such as a short sale or deed in lieu of foreclosure, without the benefit of a deficiency waiver as part of the deal.  Practically speaking, however, lenders are much more likely to pursue a deficiency claim against borrowers they know or suspect to have significant assets to seize.  The old cliché, “blood from a stone” comes to mind and it certainly makes sense for lenders to set their sights on targets with the best potential for recovery.

The next question involves what borrowers can do to defend themselves against deficiency claims.  Though such legal actions may seem a slam-dunk, there are some steps borrowers can take to contain the damage and fight back.

One defense may come from “standing” issues.  This relates to the fundamental legal question of who has the right to sue.  In defending foreclosures over the years, the standing issue has presented the most common defense.  This is because originating lenders sold off the rights to mortgages so frequently (and often illegally, in violation of the terms of mortgage-backed security agreements) that they failed to properly convey the rights to another party attempting to sue.  In many cases, the foreclosing lender will file a deficiency action.  In other cases, they will “sell the paper” to collection company sharks buying for pennies on the dollar with an enormous cushion to reap a profit.  If such rights are not properly and legally assigned, there will likely be holes in the case.

Additionally, the borrower can dispute certain facts in a deficiency action that may not kill the case, but may contain the damage.  For example, the issue of the market value of the property is a benchmark in the case from which the amount of damages is measured.  Successfully challenging that benchmark can significantly reduce the amount owed.

Also, a borrower may engage in asset protection strategies to shield assets from deficiency claims.  This is an ethical and legal minefield that should only be considered very carefully.  There is a legal concept known as “fraudulent conveyance” that refers to a debtor moving assets to avoid or hinder creditor claims.

Generally, there is a spectrum of time under which a borrower may transfer or dispose of assets that would be under judicial scrutiny.  On one end of that spectrum, moves made before a debt is even delinquent and there is no claim against the debtor are more likely to be upheld.  On that other end, moving around assets closer in time to the deficiency claim would more likely be held invalid as a fraudulent conversion.  The surrounding circumstances rule when there isn’t much direct evidence of the debtor’s intent regarding these moves.  A successful fraudulent conveyance claim would allow the lender to overturn asset transfers to get their paws on some money.  Debtors should proceed with extreme caution and seek advice before playing this game.

Deficiency actions may push many borrowers toward bankruptcy protection.  This option may work well, either as a liquidation of debt through a Chapter 7 or reorganization through Chapter 13 of the Bankruptcy Code.  The pros and cons of filing bankruptcy as well as who may qualify for various forms of relief may be complicated and borrowers facing a deficiency claim should consider all the consequences.

It is worth noting that a deficiency action shouldn’t be considered a zero-sum game with a clear winner and loser.  Frequently, fighting back and asserting one’s legal rights will lead to a negotiated settlement that can get the plaintiff some money while containing the damage for the defendant to regroup and start rebuilding one’s financial life.

Though we have come a long way in this long, strange trip, the foreclosure crisis remains far from being over.  Stay tuned for more reports from the frontlines.