What is Deficiency?
Deficiency is simply the difference between what is owed and what the lender nets on a shortsale. How a lender reacts to a deficiency is determined by who the investor is, state laws and the lien status. Deficiency’s are settled by lenders with the seller in one of the following ways:
1) providing a Waiver of Deficiency, in which case a 1099-C is provided to seller or 2) pursuing a Deficiency Judgment.
This is why it is so important for the seller to have sought competent legal counsel and/or taxadvice. Agents should not be presenting or explaining approval letters to a seller. The language on an approval is basically a contract, and that can determine the seller’s liability. In a perfect case, the settlement of the deficiency is clearly spelled out on the approval letter. In many cases, however, the language can be vague or misleading.
This opens up the concern: tax liability. This is different from a deficiency. To make it simple, the deficiency is what you owe the lender, and the tax liability is what you owe the IRS. Generally, if a lender issues you a 1099, it waives the right to collect the deficiency so they can write off the loss against their revenue. In other words they cannot double dip.
The safest course of action is to urge the seller to speak with an Attorney or CPA regarding tax liability.
Lien Position Makes a Difference
When there is a second lien, depending on the type, deficiency is more common. Purchase money seconds are more apt to release deficiency but Home Equity Lines of Credit (HELOCs) almost never do. What many don’t realize is that a HELOC is not really a mortgage.
Yes, it is secured by property, but a HELOC is treated like consumer debt, and it is not extinguished in a foreclosure. In a foreclosure, the lien position of the second is wiped out, but not the debt and they will pursue collection activity in most cases. The only option in many cases is a cash or promissory note settlement of some kind.
Perhaps the most insidious of investors is the mortgage insurance companies, or MI/PMI.
Mortgage Insurance investors almost always demand deficiency. PMI, is Private Mortgage Insurance, and is usually clearly stated on the mortgage statement as Borrower Paid. Mortgage Insurance, or MI, is sometimes Lender Paid. Basically, this is secret insurance taken out and paid for by the lender or investor without the knowledge of the buyer. Regardless of insurance type, PMI/MI can be difficult to predict and deal with, and they almost always demand a cash contribution or promissory note to release their lien and approve the short sale.
Deficiency Settlement Techniques
There are three main techniques to settle deficiency. It is important to realize that in some cases, no amount of negotiation can settle a deficiency, and that is part of the risk of doing a short sale.
Sellers should be honestly apprised of these risks before the property is listed, especially when there are several liens. A seller who refuses the possibility of deficiency should raise a red flag and the agent should seriously consider not taking the listing. There can be no guarantee that deficiency will be waived in a short sale.
This is the most powerful technique. Agents should anticipate this need especially if it is known that there is a HELOC, MI/PMI involved, HOA or certain 2nd or 3rd lien holders (Green Tree, GMAC). You need to know at the time of listing the “attitude” and “ability to contribute” of your seller when there are liens.
Most HELOCs will settle at anywhere between 5 – 20% of outstanding balance. Most 1st lien holders will only contribute between 6 to 10% of the loan value to the 2nd or more junior lien holders. Usually the junior lien holder investors will come right out and demand a “seller contribution” or a promissory note if their “net” is not being satisfied by the contribution from the 1st lien holder.
A Promissory Note is a written promise to pay. It is a legal contract and should always be reviewed by an attorney. However, it is unsecured debt. Basically, a promissory note can be used as a tool to get the deal done. Generally, a note can be negotiated at a fraction of the deficiency amount, and is usually at 0% interest and terms are generally from 60-120 months.
While you cannot guarantee that a seller will have no deficiency in a short sale, by understanding what deficiency is we can many times find a way to eliminate or reduce deficiency. Always have the sellers seek legal counsel to make a final decision regarding deficiency.