Can My Lender Sue Me After a Short Sale?

Many homeowners considering a short sale wondering whether a lender can comes after them in court for the loan balance after a short sale. This will depend, in part, on whether the short sale property is in a judicial or a non-judicial foreclosure state.

In non-judicial foreclosure, also called a mortgage walk-away trustee sale, when a lender forecloses on your property or agrees to a short sale of the home, the lender cannot later come after you personally for their financial losses, with exceptions in some states for borrowers who have significant other assets.

In judicial foreclosure states, lenders go to court and argue to a judge why they should be allowed to foreclose on the property. The lender files a complaint and a notice called a Lis Pendens, which details how much the debt is for and why the lender should be allowed to foreclose and take the property given as security for the loan.

If the court agrees with the lender and grants the judicial foreclosure, it will issue a judgment against the borrower for the total amount owed on the mortgage, including the costs of going through the judicial foreclosure process.

Some states permit lenders to choose whether they want to proceed with judicial or non-judicial foreclosure proceedings.

However, many states limit the rights of lenders to foreclose on a property and seek a personal judgment against the borrower through what are commonly called “One Action Rules.” The rules mean creditors may take only one action for the recovery of debt and may not both foreclose on a property and hold the borrower personally responsible for losses incurred in a foreclosure or short sale.

In states with One Action Rules for foreclosure and short sale proceedings, the rules work in conjunction with state deficiency-judgment statutes to bar or limit a creditor’s rights to recover the balance of proceeds from the sale of real property where the funds paid were insufficient to cover the total debt.

Why Would a Lender Agree to a Short Sale?

Banks and other lenders generally agree to short sales in order to avoid having to foreclose on a property and take it into their inventory. Most lenders would rather cut their losses and avoid a long and expensive foreclosure process by letting the property go in a short sale for a discounted price.

By agreeing to a short sale, a bank or other lender avoids attorney’s fees, property taxes, and other costs associated with the foreclosure process. Also, a short sale generally is a faster and cheaper way for lenders to get rid of delinquent properties compared to a foreclosure.

Will My Lender Accept the Short Sale as Payment in Full for My Loan?

Maybe. Your lender is not required to accept the short sale payment to satisfy your loan amount. The company may decide that you and your property do not qualify for a short sale and deny your request. In that event, you may be forced to explore other options, including trying to sell your house in a traditional sale, requesting a loan modification or a refinance of your home, or declaring for bankruptcy.

Working with a real estate attorney or other professional who has experience filing applications for short sales can increase your chances of being approved by your lender.

If a lender agrees to a short sale, will I owe tax on the deficiency?

Typically, if you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable.  However, Congress enacted the Mortgage Debt Relief Act of 2007, which allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

The Mortgage Debt Relief Act applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

Depending on your state tax laws, however, there may or may not be tax due at the state level on debt forgiven pursuant to a short sale. 

The information on this page is meant to provide a general overview of the law. The laws in your state and/or city may deviate significantly from those described here. If you have specific questions related to your situation you should speak with a local attorney.

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