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Short Sellers Beware

Real Estate short sale legal issues

A front-page article in the Arizona Republic ("Not all sellers are off the hook after short sales") appears calculated to create a false impression of confusion regarding the continuing liability of short-sale sellers. In fact, with a few exceptions, the rules are very straightforward, if not always favorable to the unwary seller.

There are really three rules to keep in mind on deficiencies:

First, if a residential property (defined as a property of 2 ½ acres or less used for a single one- or two-family residence) is sold at a trustee's sale, the borrower cannot be sued for a deficiency balance on the loan that was foreclosed. (The exception to this rule is that the borrower can be held responsible for waste to the property).  Significantly, this rule applies in foreclosure situations, but not to short sales.

Second, if the proceeds of a loan are used to pay all or part of the purchase price of a residential property and are secured by a mortgage or deed of trust on that property, the borrower cannot be sued for a deficiency, regardless whether a foreclosure sale occurs, and cannot be sued directly on the loan.  This type of loan, referred to as a "purchase money loan," is encountered in some, but not all short sale transaction.

Third, where a loan, such as a home equity line of credit, is secured by a mortgage or deed of trust on a residential property but the proceeds are used for purposes other than the purchase price, the borrower can be sued directly on the loan and is liable for any deficiency following a judicial foreclosure (but not a trustee's sale). It is this type of loan that needs to be identified and dealt with in a short sale.

Purchase-Money vs. Non-Purchase Money

The problem that arises in applying these rules is that it is not always clear whether a loan is properly classified as purchase-money or non-purchase money.  In a 1997 case, the Arizona Court of Appeals found, on particular facts, that a loan used in part to refinance an existing purchase money loan and in part to purchase airline stock was a purchase money loan, and accordingly dismissed a lawsuit brought against the borrower.  In reaching its conclusion, the Court noted (1) that the lender had abandoned its argument that the loan could be separated into two components (purchase and non-purchase money) and (2) that the new note was secured by the same deed of trust as the original purchase note.  Because of the limitations of the decision, a number of open questions exist. For example, if the proceeds of a loan are used solely to pay off an existing loan, but the lender requires a new deed of trust, does the new loan lose its purchase money status? And if only part of the proceeds are used to pay off a prior purchase note, can the lender sue for the non-purchase money portion of the loan? While it is always advisable for a short seller to have the sale documents reviewed by a knowledgeable attorney, the need for legal review is particularly acute where any of these issues might be present.

The Republic article, in addition to suggesting that professionals are in disagreement, quotes a local practitioner as saying that the anti-deficiency statutes only apply to trustee's sales and judicial foreclosures.  This is simply incorrect. If a loan is a purchase money loan, there is no deficiency obligation, whether or not a foreclosure has occurred.  Conversely, if a loan is not a purchase money loan, the rule is likewise clear:  Unless the lender has conducted a trustee's sale, the borrower of a non-purchase money loan can be sued directly on the loan and is responsible for a deficiency remaining after a judicial foreclosure sale.

Some lenders have attempted, however, to go around the anti-deficiency statutes either by demanding that the seller/borrower either execute a new promissory note or by inserting into the agreement a provision under which the seller agrees to remain liable for a claimed deficiency.  Again, the potential for this type of provision is a significant reason to have all short sale documents carefully reviewed.

While the rules regarding Arizona's anti-deficiency statutes are complex, their application is generally clear. It is important, however, that a property owner contemplating a short sale seek legal advice, so that there will be no surprises after the sale.


About the author: Roger Cohen is a partner at Jaburg & Wilk PC with over 30 years' experience as a business attorney, representing clients in both litigation and transactions.  He has a deep knowledge and understanding of commercial law and the litigation process and is a forceful and effective advocate for his clients.