by Dan Kloberdanz of Berens, Kozub & Kloberdanz, PLC
Real estate agents representing a seller of a short sale home need to have a basic understanding of the scope of Arizona’s anti-deficiency laws. Otherwise, as we continue to see, agents are allowing their clients to put themselves in worse position by concluding short sale transactions. Also, agents should know the basic potential tax implications which homeowners should contemplate in relation to the short sale of their home, or at least refer their clients to consult a professional in that area of law.
I. Real Estate Broker’s Duty to Give Competent Legal Advice
Under the Arizona Constitution, real estate brokers and salespersons are granted the right to essentially practice law in relation to drafting documents incident to the sale or lease of real property. Along with such rights, however, is the broker’s obligation to give competent legal advice to his or her client. Likewise, Arizona common law imposes a fiduciary duty on real estate agents as does Commissioner Rule R4-28-1101(A).
If an agent is representing a seller in a short sale, the agent owes a duty to know whether or not the short sale is actually in the client’s best interests, especially because typically the client is netting no money out of the transaction.
II. Types of Short Sale Letters or Agreements.
Each lender has developed its own short sale procedures and are using their own unique forms of short sale agreements, which are usually in letter format. We can break down the general types of short sale agreements into the following categories:
(1) The lender agrees to release its lien to allow the short sale and the lender expressly agrees in the short sale agreement to release the borrower from any further liability on the loan;
(2) The lender agrees to release its lien to allow the short sale and the agreement states the borrower agrees or will sign documentation agreeing that a portion of the debt is still owed after the short sale (often, this is accomplished with a new promissory note for the unpaid difference);
(3) The lender agrees to release its lien to allow the short sale but the agreement states the lender reserves its rights to a deficiency if such a right exists under applicable law; and
(4) The lender agrees to release its lien to allow the short sale but the agreement does not address whether or not the borrower remains liable for the remainder of the debt which is unpaid as a result of the short sale.
As a starting point, it should be noted that a lender’s agreement to release its lien is not necessarily the same as the lender’s agreement to release the debt. A typical homeowner may not understand this important distinction.
Too often we see a borrower (i.e. the short sale seller) agree to sell their home through the short sale process and agree to be liable for the remainder of the debt, even though that lender had no legal right to sue the borrower in the first place (as is generally the case with a “purchase money” loan on a single family or two family residence, as explained below). We also see situations where the borrower agrees to be liable for a deficiency where that borrower would not have even been legally liable for a deficiency had that certain lender completed a trustee’s sale on the home (as is generally the case with lenders of both purchase and non-purchase money deeds of trust on a single or two family residence).
A real estate agent representing the borrower (i.e. the listing agent) may incur liability for negligence or breach of fiduciary duty if he or she fails to advise his or her client that the client should have either (1) refused to do the short sale and hope the lender performs a trustee’s sale, if that was a possibility, or (2) should have agreed to complete the short sale only on the condition the lender expressly agrees to release the borrower from the debt, again, if that was a possibility under the circumstances.
III. Arizona’s “Anti-Deficiency” Statutes.
Since 1971, Arizona has had in effect two “anti-deficiency” statutes which prohibit lenders from seeking deficiency judgments under certain types of residential loans. A.R.S. §33-729(A) (“purchase money” mortgages on homes) and A.R.S. §33-814(G) (deeds of trust on homes). These anti-deficiency statutes apply only where the secured real property does not exceed two and one-half acres, and the secured property is “utilized as” and “limited to” either a single one-family or single two-family dwelling (and therefore the statutes do not protect borrowers of commercial properties, raw land, and residential property with more than two units). Likewise, the statutes do not protect an owner where the home has never been utilized for a dwelling, and this must include homes under construction which were never completed.
IV. The “Purchase Money” Requirement Under the Statutes and Baker v. Gardner.
For whatever reason, when the Arizona legislature passed the anti-deficiency laws in 1971, it limited the anti-deficiency protections for mortgages to “purchase money” mortgages but did not place the same “purchase money” limitation on loans secured by a deed of trust. A purchase money mortgage is a loan given concurrently with the transfer of real property between the seller and the buyer (a carryback), or a loan used to pay all or part of the purchase price of the home.
Over twenty years ago, the Arizona Supreme Court made the landmark ruling in Baker v. Gardner, 160 Ariz. 98, 770 P.2d 766 (1989), and held our anti-deficiency statutes completely bar a secured lender from suing a borrower on the promissory note if the loan was used to purchase the home. The court held the anti-deficiency statutes “abolish” any personal liability of homeowners with respect to “purchase money” loans secured by a single family or two family dwelling.
The most important part of the Baker decision is contained in the court’s supplemental opinion which held the prohibition against suing on the promissory note applies only to “purchase money” lenders. Therefore, lenders for home equity loans and lines of credit can waive their security and sue directly on the note, even if the loan is secured by a mortgage or deed of trust against a single family residence.
Although the Baker supplemental opinion affirms the lender’s right to sue directly on the note on a non-purchase money loan, the statute itself (A.R.S. §33-814) provides that any lender (both purchase money and non-purchase money) who actually completes a non-judicial trustee’s sale on a home is prohibited from seeking a deficiency judgment. A non-purchase money lender who desires to seek a deficiency judgment after a foreclosure of a residence must bring a judicial foreclosure, which is cost-prohibitive in most situations. Therefore, a borrower will often be better off allowing a second position home equity lender to complete a trustee’s sale rather than doing a short sale, unless that lender expressly agrees to waive any deficiency.
V. Gray Areas – Refinanced Purchase Money Loans and Construction Loans.
There continue to be gray areas in the anti-deficiency laws which have not yet been addressed by the appellate courts in this state. For example, the law is not clear whether a new refinancing of an existing purchase money loan is subject to the same anti-deficiency protections applicable to the original loan. The law is also unclear to what extent will a construction loan be considered a “purchase money” loan if the home is actually completed and used as a residence prior to the lender’s foreclosure or suit on the promissory note.
VI. Tax issues and the Mortgage Forgiveness Debt Relief Act of 2007.
As a general rule, the amount of “debt forgiveness” resulting from a foreclosure or a short sale is taxable as ordinary income to the borrower. To alleviate this tax burden, the Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007. Under the Act, owners of a principal residence whose purchase money mortgage debt was partly or entirely forgiven may claim special tax relief by filing IRS Form 982 with their federal income tax return. Prior to this Act, debt forgiveness on one’s principal residence (i.e., a loan which is not a business loan) would result in taxable income. Fortunately for homeowners, this tax exclusion also applies to the refinancing of an existing purchase money loan to the extent the new refinancing loan does not exceed the amount of the original purchase money indebtedness.
Under the applicable IRS regulations for cancellation of debt, if the debt is cancelled in a bankruptcy, it is generally not included as gross income. This same exclusion may apply when the taxpayer is insolvent, up to the amount by which the taxpayer is insolvent. If, however, the homeowner incurs the tax liability prior to filing bankruptcy or insolvency, the debt may be taxable to the homeowner. Therefore, a distressed homeowner facing tax liability should consider the strategic timing of when to file a bankruptcy, and it would be wise for any real estate broker to refer his or her client to bankruptcy counsel prior to any foreclosure or short sale, even if the homeowner does not desire to save the home.
Daniel Kloberdanz is a partner in the Scottsdale law firm of Berens, Kozub & Kloberdanz, PLC. Dan’s email address is dkloberdanz@bkl-az.com.
