Legal Question in Real Estate Law in California

Whether the bank can go after other assets depends on the nature of the original loan transaction, and then how you dispose of the property. A short sale in this case may leave you in the worst possible position.

Lenders on residential property are prohibited from collecting the debt from other assets of the borrower in two situations in California. First, there is an anti-deficiency statute that applies to purchase-money loans. That means loans made at the time the property is purchased and used entirely for purchasing the property. (In some cases the lender finances a pay-down of consumer debt and wraps it into the mortgage to help the borrower qualify, or a home equity line of credit is opened at he same time as the purchase but is used for other expenses; those would not qualify as a purchase-money loan). If a lender has made a purchase-money loan, and the borrower defaults, the lender can only foreclose on the property and take what they can get. They cannot go after any other assets of the borrower.

Second is the "one form of action rule." There are two kinds of foreclosure, judicial and non-judicial. Non-judicial, also called a Trustee's Sale, is what most people think of as a foreclosure. The bank turns the matter over to a foreclosure company which records and gives various statutory notices, and when the time expires the company sells the property at a foreclosure auction. If it doesn't sell at the auction, the lender takes the property. A judicial foreclosure involves filing a traditional lawsuit to collect the debt and the property is sold at a sheriff's auction as part of the lawsuit. As you can imagine a non-judicial foreclosure is much faster and less expensive than a judicial foreclosure. There are also other legal advantages to it. In exchange for using this advantageous process, however, the lender is then not allowed to file a lawsuit on the same debt, because that is a "second" form of action. So once the trustee's sale occurs, the lender cannot pursue any shortfall.

So how does this play into a short sale? It gives the lender a way to "end-run" the one form of action rule. Unless the lender agrees to accept the short payment as full satisfaction of the debt, if it is not a purchase-money loan, they can take the money from the short sale and then collect the balance as an unsecured debt. Since it is unlikely that your HELOC is a purchase money loan, they will have the option to go after your insurance proceeds and any other money or assets you have, even after agreeing to the short sale.

The other thing you need to bear in mind about short sales is that if the lenders do write off the balance, either because they have to under the anti-deficiency statutes, or because the make the business decision that the debt will be too hard to collect, they will issue you a 1099-misc. That is a report of taxable income paid out. The IRS will then treat the amount the bank writes-off as taxable income to you. That can result in a major tax hit.