What Is Foreclosure?
Foreclosure is the process by which a bank or lender takes possession of collateral used to secure a loan. Put another way, foreclosure happens to a homeowner when he or she doesn’t pay their mortgage.
Foreclosure is not always a court action. There are two types of foreclosure: judicial foreclosure and trustee’s sale (non-judicial) foreclosure. Some states use one or the other, and some states (like California), use both. Judicial foreclosure is just like it sounds: it is a lawsuit by a bank against a lender to secure a judgment of foreclosure. This means paperwork, court proceedings, motions, orders, appraisals, and a formal auction. As such, judicial foreclosure is more expensive for a bank, and takes longer.
A trustee’s sale is a walk in the park for a bank: The trustee names in the deed of trust (mortgage) simply needs to record a public notice of default to initiate a non-judicial foreclosure against the owner. No court intervention is required. If the owner doesn’t pay in a certain amount of time, the trustee can schedule a public sale of the property.
If you are sued for a debt that is not related to your home, you may enjoy homestead protection–a large amount of the equity in your home may not be reachable by outside creditors–but homestead protection does not protect you from the amount that you owe to lenders who have mortgages against your property. We discuss homestead protection in this article: Homestead Exemption.
Deficiency Judgments are legal judgments available (in only some states) to banks and lenders if the foreclosed property does not yield enough money at a foreclosure sale to satisfy the entire mortgage loan. That’s a mouthful, so the following explanation should make it clearer. Say you buy a property with $20,000 down, and you borrow $80,000 from First Bank. You fall behind, and First Bank forecloses on the property and the property yields $70,000 at a foreclosure sale. Well, the bank is still out $10,000. That “deficiency” may be the subject of a deficiency judgment if the bank wants to pursue it. That said, banks don’t always have the right to pursue deficiency judgments, and even when they do, they don’t always seek deficiency judgments. We discuss deficiency judgments at length generally, and with respect to California read Deficiency Judgement, Anti-Deficiency Laws, California and Elsewhere.
Why Foreclosed Homeowners Receive 1099s for Cancelled Debt First, the basics: if you owe a debt to someone else, and that debt is forgiven, the IRS Code treats that forgiven debt as income to you. Does it make sense? Sure, because you have just received something that you did not have before. And so, when a homeowner loses a property in foreclosure, banks will typically charge off (forget about) the mortgage loan and simply issue to the former borrower a 1099 for the amount of the loan that the bank forgave. For example, if you bought a house with a $100,000 loan, and the bank received $80,000 in a foreclosure proceeding, that leaves $20,000 to collect from you, the borrower. Now, the bank might sue you for the $20,000, or the bank might simply forgive the debt. If the bank forgives this debt, the bank will issue you a 1099 for the amount of $20,000–what they do depends on state law (more on this below) and the circumstances of your individual case. This example is over-simplified, actually, the bank may also include in the 1099 expenses, fees, late fees, and whatever other fees originally appeared in your loan contract.
More Information on Foreclosure and Anti-Deficiency
For more information, see our full article on 1099s and cancelled debt entitled 1099 After Foreclosure – Cancellation of Debt & Anti-Deficiency.