What happens When You Can’t Pay Your Mortgage?

By Robert J. Mintz, J.D., LL.M (taxation)

This article was written at the height of the foreclosure crisis. Many clients were dealing with the impact of a substantial loss of equity in their homes and investment properties. For many, the issue was should they continue to pay the mortgage on an underwater property or simply walk away. The questions concerned the legal and practical consequences of a default. What would a lender do and what was it likely to do under various scenarios.

The worst of the crisis has certainly passed at this point, at least in the residential market. But some clients have been engaged in extended negotiations concerning loan workouts or other modifications which are, only now, reaching their conclusion. For those who have not obtained a satisfactory result in these negotiations or who feel they may still face the possibility of a future default, this article points out some of the key legal issues which should be considered.

It seems like most of our clients were active real estate buyers and investors when times were good.  Now, they’ve been hit hard by the market crash, with property values sinking below the amount of their loans.  The real estate website Zillow.com, recently estimated that 28% of all mortgaged homes had a negative equity.  And that number is substantially higher in the hardest hit regions of California, Florida and the Southwest.

Many of those with negative equity have and will continue to default on their loans out of economic necessity or as a planned “strategic default.”  When a comparable property can be purchased or leased at a substantially lower monthly cost, it’s reasonable to expect that many or most property owners will choose to default on their loans and “walk away.”

The decision to avoid throwing good money after bad, with no end in sight, applies not only to personal residences, but also to investments in commercial property. The toxic combination of falling rents and rising vacancies has caused a collapse of cash flow and value and many investors are faced with the difficult decision of whether to continue to support an “underwater” property with a large monthly negative or whether to throw in the towel and take the consequences. One of the factors making this such a tough decision is that the amount of these commercial loans are often in the millions of dollars and may have been personally guaranteed by a group of partners or  members of a limited liability company which purchased the property. Since each partner or member who guarantees a loan has legal responsibility for the full amount of the loan -not just a proportionate share- the resulting liability can be far beyond the amount that any single investor anticipated or intended.

For example, a client of ours invested $100,000 for a 10 percent share in a limited liability company formed to construct a medical office building in 2006. The LLC borrowed $8 million with each member signing a personal guarantee to the construction lender. By the time the construction was completed in late 2008, the market had plunged and the estimated value was less than $5 million. Because of low rents and vacancies there is a monthly shortfall of nearly $100,000 and our client has been paying his share, at the rate of $10,000 per month.

The decisions he is facing are those now under consideration by millions of others in similar situations. What are the legal consequences if I default on my loan? Does a default put my other assets at risk? Is there any way to protect my other assets from a possible judgment?

Foreclosure and Deficiency Judgments

The legal consequences of a loan default vary by the terms of the loan agreement as well as applicable federal and state laws. In general, we know by now that if you don’t pay your mortgage, at some point, the lender is likely to take back the property through a foreclosure or trustee sale. Although, the number of home foreclosures slowed measurably in the past year, due to litigation over improper foreclosure practices by the banks,  the system is now back in high gear with lenders moving aggressively against borrowers who are behind on their payments.

For commercial loans, lenders are usually more hesitant about a foreclosure. Commercial properties are management intensive and the desire to avoid realizing losses on the loan may weigh heavily in the considerations and the negotiations. Alternatives to foreclosure may be explored, but if the negotiations are not successful then the foreclosure route is generally pursued.

The liability problem here is that, in most cases, the amount by which the loan exceeds the value of the property is known as a deficiency and the borrower will generally be legally responsible for the full amount of this deficiency together with penalty fees, costs of collection and associated legal fees.

Collection Against Other Assets

In some states, a lender is not permitted to pursue your personal assets to satisfy a deficiency on a property. In those cases, the foreclosure is the end of the process and while your credit report may be impaired, there is no threat to future income of assets.

Unfortunately these protections are usually narrowly limited in their scope and application. For example, in California, the lender’s only remedy for loans made to purchase a residence is to foreclose on the property. Whatever it’s worth, that’s all the lender gets. But if the original loan was replaced in a refinancing or the loan was used to buy an investment property, rather than a home, then the lender has full access to all of the borrowers’ available assets to cover any shortfall in the value of the property. These restrictions on collection are known as anti-deficiency statutes and they vary according to the state law which applies.

If you are not protected by an anti-deficiency law, the lender has the right to obtain a court judgment against you and/or any loan guarantors for the amount of the deficiency.  Once the judgment is final it acts as a lien against any property or other assets in the name of any defendant.  Any property or other assets standing in your name at the time of the judgment or any later time, while it is in force, is subject to collection.

Until recently, the banks rarely pursued collection actions against foreclosed homeowners. To some extent, collection is a time consuming and expensive process and at the end of the day, the foreclosed homeowner rarely had much left to make it worthwhile. However, with the sharp rise in “strategic defaults” from borrowers who may have other assets available, currently or in the future, the number of deficiency judgments and collection actions has risen dramatically.

If collection is pursued, the lenders generally rely on your previous financial statements or a legal procedure known as a Debtor’s Examination, to determine the amount and location of your assets. For example, if you live in California and default on a property in Florida, the judgment will initially be entered in Florida and then subsequently in California to attach any assets held there.

The decision making process about “strategic defaults” should take into account whether the anti-deficiency protection is available and what other assets or income you may have which is available in a collection action against you.

Can Assets Be Protected From a Judgment?

Certain types of assets are protected by state law from collection and asset protection planning often involves maximizing the use of these exemptions. For example retirement plans are sometimes partially or fully protected depending on the structure of the plan. Also most states protect some or all of the equity in a home from a collection action.  Again, depending on the state, life insurance policies and annuities may be exempt, as well as interests in a trust or other specified entities.

The key issue in protecting assets from collection is usually that of timing. All states have laws prohibiting many types of transfers that are intended strictly to avoid paying an obligation. If the goal is to shield or insulate assets from a future potential liability risk, sound planning should be undertaken at the earliest time, to provide the widest range of options and the greatest flexibility.

Anyone making a tough decision about a possible loan default should consider the risks associated with a deficiency judgment and the extent of personal assets which are legally exposed in the event of a claim. Certainly, any planning strategy must be discussed with your attorney who is familiar with your particular situation and after a thorough consideration of state and federal laws pertaining to fraudulent transfer rules and exemption laws applicable to your circumstances.

Depending on the outcome of the estate tax legislation proposed in Congress your estate may be subject to significant estate taxes as it is passed to your children or grandchildren. A Dynasty Trust may be useful in reducing or eliminating these taxes as well as preserving family assets from future claims and liabilities. These issues are complicated from a legal and tax perspective however and as always you should discuss your personal situation and the possible benefits and drawbacks of this planning with your professional advisors.

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