Written by attorney Perry B. Thompson

Debts For The Unpaid Mortgage Balance After Short Sale Or Foreclosure

A question that I have heard a lot recently is, "Can lenders collect deficiencies after a short sale or foreclosure in Michigan?" This simple answer is, yes. Of course, nothing in this area of law is ever that simple.

Looking at short sales first, these are completely negotiated arrangements. If the bank agrees to waive the deficiency, it is waived. If they do not agree to waive it, then the borrower still owes it. They might even agree to waive part of the deficiency but reserve the right to collect the rest. Sometimes the deficiency is specifically documented in a new unsecured promissory note signed by the borrower. But, even if this note is not signed, the borrower will remain responsible for the amount of the loan that is not covered by the sale.

Again, this is a completely negotiated agreement. So, the borrower is free to refuse to go through with the short sale if the bank will not waive the deficiency. The key is to examine the total financial situation and decide if it is better to go through with the sale and deal with the deficiency later or to stay in the house through the foreclosure process and then possibly deal with the deficiency that will definitely occur after that with a bankruptcy. It is also important to remember that if the bank does waive any of the debt, this forgiven debt is taxable income that may be offset with a tax deduction if the borrower meets the requirements.

Deficiencies in a foreclosure are not things that you can negotiate. They are governed by state law and the court cases that have interpreted it. The first thing to understand about these rules is that the amount bid at the sheriff's sale is the important amount, not the amount for which the bank eventually sells the property to a third party. If the bank bids the full amount of the loan, the debt is extinguished and there is no deficiency. If the bank bids significantly less than the fair market value of the property, the statute provides that this low bid is a defense to the later attempt to collect the deficiency. If the bid is less than the full amount, but not significantly less than fair market value, then the bid amount will offset the amount of the deficiency. But, the borrower will still owe the balance of the loan. The amount of the loan that is offset by the bid is not forgiven debt, so this will not be taxable as discussed above.

A final point about waiver of deficiencies is that a waiver is not always in the borrower's best interest. If the debt is not going to qualify for the income tax deduction to offset the reported income, a huge tax liability could result. Deficiencies are dischargeable in bankruptcy. Tax debts generally are not. So, if the buyer is going to be unable to pay the taxes on the forgiven debt, they may actually want to avoid having the debt forgiven so that they can discharge the deficiency with a bankruptcy filing rather than being stuck with an IRS problem that they cannot get rid of other than by paying money they do not have

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