At various times during the Great Recession and its aftermath, different economists have estimated that approximately 25% of American households with mortgages are “upside down.” That is, for approximately 25% of American households with mortgage debt, the debt exceeds the property’s fair market value. While these percentages vary from place to place, the 25% figure likely understates the issue, even in a relatively prosperous state like Colorado, because the statistic does not consider the typical transaction costs (i.e. brokerage commissions and title insurance) associated with the sale of a home. Personal representatives and their attorneys must often address the strategic choices surrounding ownership of upside down real estate. This article specifically focuses on considerations for addressing upside down homes in insolvent estates, where estate liabilities exceed assets.
Generally there are six options for any owner to consider in dealing with an upside down property. We have found it helpful to at least briefly mention all six generic options, even if some of these options are not practical for a particular owner. Most of the practical options for insolvent estates owning underwater property require the personal representative to default on the mortgage(s) against the property. Personal representatives typically do not make this choice easily, particularly in light of their various fiduciary responsibilities. Personal representatives receive some peace of mind knowing that they have at least briefly considered all possible options. This article identifies the six options to address upside down properties, focusing on the practicality of each option where the estate is insolvent.
A. The Impractical Choices for an Insolvent Estate
This section identifies the impractical options when addressing upside down property in an insolvent estate and describes why each of the options is not realistic for the personal representative administering an estate where debts exceed assets.
- Hanging on. Although a property may be upside down, an owner may still have the ability to service its debt, through their own contributions, from rent proceeds received from tenants, or through some combination of the two. Living owners who earn good incomes sometimes face the dilemma of hanging on to upside down property to avoid the negative consequences of the last three options discussed in section B, below. Insolvent estates do not face this dilemma, as they have no resources with which to service the property’s debt. This article will not further discuss the “hanging on” option, as it is generally moot for insolvent estates. Personal representatives and estate beneficiaries should take caution before contributing funds to the estate to service the debt on an upside down property, as the insolvent nature of the estate may preclude the contributor from ever being reimbursed for the advance.
- Bringing cash to close. Some owners have the option of contributing funds at the closing of the sale of the property to cover the difference between net proceeds from the sale and the amount owed to the lenders holding liens against the property. Consider, for example, a property worth $200,000.00 that has $250,000.00 of mortgage debt against it. After subtracting an estimated $15,000.00 in transaction costs (seller closing costs and costs such as real estate broker commissions) from the sale price of $200,000.00, the proceeds due the seller, net of transaction costs but not net of the mortgage debt, total $185,000. Some sellers have the capability to contribute the $65,000.00 difference between the amount owed and net proceeds from sale at closing to facilitate closing on the sale of the property. However, by its nature, an insolvent estate does not have the resources to bring cash to closing, thereby mooting this option for estates where assets exceed liabilities.
- Loan Modification. Living owners of an upside down property who have verifiable steady income should also consider modifying the loan as a means to hang onto upside down property. Generally, residential loan modifications involve altering the terms of the loan to reduce the loan’s monthly payments. Typical loan modifications involve one or some combination of reducing the interest rate, extending the period over which the debt is amortized, converting the note to an interest only payment, or moving any accrued delinquent amounts to the back end of the mortgage.
As of the publication of this article, some lenders are experimenting with programs that modify loans by also reducing the principal balance of the debt, sometimes in consideration for the owner allowing the lender to benefit from some percentage of post-modification appreciation, upon the sale of the property. These “principal reduction” loan modifications, however, seem very much the exception, and not the rule, particularly in recourse states like Colorado. Lenders have greater incentive to reduce principal balances of loans in non-recourse states, where the lender’s only recourse is to the property, but not the borrower individually.(E1)
An insolvent estate does not have the means to service the debt against the property while waiting for the property to appreciate. Lenders tend not to offer loan modifications unless the borrower/owner has some predictable and verifiable source of income with which to service the post-loan modification debt. For these reasons, obtaining a loan modification tends not to be a practical option for a personal representative administering an insolvent estate.
For insolvent estates, the options of hanging on to a property, contributing cash at closing, or modifying the terms of the loan to allow an estate to hold on to a property are generally not practical solutions. This leaves the personal representative of the insolvent estate to consider the other three of the six possible alternatives for upside down estate property. In each of these options, title to the property changes hands. The remainder of this article discusses these conveyance options in greater detail.
B. Conveyance Options For Handling Upside Down Property in Insolvent Estates
The options discussed thus far tend to be impractical solutions for dealing with upside down property in insolvent estates. This section discusses more practical solutions, although personal representatives are likely to have greater success selling the property via short sale or letting the property go to foreclosure than conveying the property back to the lender via deed-in-lieu of foreclosure.
- Deed-in-lieu of Foreclosure. In a deed-in-lieu of foreclosure, the owner deeds the property back to the lender holding the mortgage debt against that property and the lender agrees to accept the deed, in lieu of the lender incurring the delay and expense of foreclosing. In the echo of the Great Recession, a deed-in-lieu of foreclosure tends not to be a practical option for most upside down owners of residential property, including insolvent estates, for one or more of the following reasons:
- Second Mortgages. Approximately two-thirds of the upside down households in the United States have second mortgage against the property. Unlike a foreclosure, which eliminates liens junior to the foreclosed upon deed of trust, a deed-in-lieu of foreclosure does not convey title to the grantee free and clear of liens junior to the first mortgage. A deed-in-lieu of foreclosure tends not to be a realistic option for properties encumbered by second mortgages because senior lenders (the lender that would conduct foreclosure proceedings) require the property to be conveyed free and clear of any junior encumbrances, meaning the second mortgage against the property needs to be released. Even if an upside down property has no second mortgage against it, homeowners’ associations commonly encumber upside down properties with liens for delinquent assessments, thereby preventing owners from conveying the property back to the senior lender free and clear of junior encumbrances. Junior lenders can of course voluntarily choose to release their liens, but unless they are offered cash to do so, they have no self-interest in even considering whether to release the lien, not even reaching the point of considering whether the estate is insolvent or the property is upside down. Unlike a short sale (discussed below) there is no “new money” coming in from a short sale buyer with which to pay junior lien holders to release their liens.
- Lender Preference Against REO(E2) Option. Lenders generally prefer options by which they do not acquire title to property. Unlike a short sale, in which the property is sold to a third party buyer, a deed-in-lieu of foreclosure requires the lender to take title to the property, adding another property to the lender’s inventory and burdening the lender with the risks arising from holding and reselling the property. These risks include the property not being worth as much as the lender estimated, the condition of the property deteriorating after its acquisition by the lender, the market depreciating after acquisition, and the financial and administrative burdens of holding and maintaining the property until it sells.
- Setting Bad Precedent. Lenders generally disfavor deeds in lieu of foreclosure because of the concern that they set bad precedent. If lenders began mass acceptance of properties that owners no longer wished to keep, one can imagine a large number of owners wishing to convey their properties back to their lender. As lenders have a preference against holding and liquidating REO properties, lenders prefer to encourage owners who no longer wish to own their property to pursue other disposal options, particularly short sales.
2. Short Sale. The personal representative in an insolvent estate may allow an upside down property to go through the foreclosure process with few detrimental consequences to the estate or the decedents’ successors. Yet the foreclosure process typically unfolds over many months, and sometimes takes many years. All other things equal, stakeholders in the estate seek closure and to have the probate estate closed out sooner rather than later. Family members of the decedent also often take pride in avoiding a foreclosure. For these reasons, personal representatives may consider short sales as a realistic alternative to letting the property go to foreclosure.
A “short pay-off” or “short sale” is a transaction in which a lender or lenders agrees to accept less than it is owed on its promissory note in order to facilitate the sale of the property that secures its loan to a third party buyer.(E3) HUD calls these sales “Pre-Foreclosure Sales.”
In a typical short sale, a lender agrees to accept the net proceeds from the closing (the sales price, minus the cost of closing the transaction, including the real estate broker’s commission), perhaps with some additional consideration from the seller (such as a cash contribution or promissory note), in exchange for releasing its lien against the property. When properties are encumbered by multiple loans, the lenders must negotiate the allocation of net proceeds from the sale among themselves. Lenders do not agree to short sales to be generous. In negotiating the short pay-off, the lender needs to be convinced that it will come out better than it would by foreclosing on the property and/or otherwise pursuing the seller/borrower for its losses. Though short pay-off procedures vary somewhat from lender to lender, most short sales require the following:
- Default. Most lenders do not consider approving a short sale unless the lender’s loan is in default.
- Purchase Contract. Most lenders will not consider a potential short sale without having a specific purchase contract to consider. The buyer and seller’s ability to close on a short sale is not entirely within their control; approval by any lender not being paid off in full is required. The estate’s short sale contract must condition the estate’s obligation to close upon the mortgage lender(s) agreeing to a short sale, on terms that are acceptable to the estate. The Short Sale Addendum (SSA38-8-10) promulgated by the Colorado Real Estate Commission should be used when listing any property that will require lender short sale approval.
- Market Value Offer. The lender must perceive that the sales price under the proposed contract is equal to or higher than the amount for which the lender would be able to sell the property after a foreclosure. The lender will often conduct a market analysis to evaluate the proposed sales price by asking its own sources, such as an appraiser or the real estate agents who handle its REO sales, to opine about the property’s market value.
- Reasonable Broker Commissions. The lender must believe that the commissions to be paid to real estate brokers under the proposed transaction are equal to or less than the market rate for commissions. The lender will want to know as precisely as possible the amount of proceeds it can expect to receive from the sale. The more precise the estimate, the better.
- Explanation of Circumstances. The lender will want an explanation of the circumstances which created the need for the short pay-off transaction. The death of the last surviving insolvent homeowner of an upside down property should suffice.
- Description of Hardship. The lender must believe that the estate does not have the money to make up the shortfall between amount owed and net sales proceeds. To verify the financial condition of the seller/borrower, the lender typically requires a living short sale seller to provide: financial statements showing the seller’s assets, liabilities, income, and expenses; bank statements; the seller’s tax returns for the previous two years; and the seller’s paycheck stubs for the most recent pay periods. Personal representatives can demonstrate the insolvent nature of the estate by providing the lender the estate inventory. If the inventory shows a net positive value, but the estate has become insolvent as a result of incurring expenses of administration with priority for payment under the Probate Code, the lender may also require a current accounting to be provided.
- Patient Buyer. Short sales require a patient buyer. Working through the bureaucracy of the loan servicer, the mortgage investor, and the private or public mortgage insurance company takes time and causes uncertainty for all parties until lender approval is issued. Closing dates may need to be extended. It is important to work with buyers who have flexible closing needs and flexible dispositions.
- Pursuit of Liability Release. The goal of avoiding post-short sale liability typically drives the estate’s motivation to pursue a short sale (pride in avoiding foreclosure also motivates estates to pursue short sales). Whether a lender agrees to release a borrower from liability for a short sale deficiency will be reflected in the lender’s short sale acceptance letter. It is not uncommon for the lender’s written approval to perhaps not entirely reflect the understanding among the real estate broker, seller, and lender’s negotiator during the course of telephone negotiations. It is therefore imperative to make certain that the lender’s release of liability is obtained in writing.
- Consideration of Tax Consequences. Short pay-off transactions may involve the forgiveness of debt, which may create detrimental tax consequences to the seller. While residential short pays rarely create capital gains problems for their sellers, forgiveness of indebtedness income may be reflected on the lender’s issuance of an IRS form 1099-C. While the Mortgage Forgiveness Debt Relief Act of 2007 and IRS insolvency exclusion allow many sellers of residential properties to exclude 1099-C income from taxation, sellers should consult their tax advisors if a short sale contemplates forgiveness of debt.
3. Foreclosure. Personal representatives in insolvent estates should also consider the option of stopping payment on the mortgage(s) and letting the property go through the foreclosure process. Estate liability in the event of a post-foreclosure deficiency depends on whether the lender’s claim was presented in a timely manner, in accordance with the Colorado Probate Code.
a. Foreclosure Process. A lender will file a foreclosure action after the borrower misses some number of mortgage payments. Institutional lenders typically file for foreclosure once payments on a loan become 90 or more days late.
Lenders start foreclosures by filing a Notice of Election and Demand (“NED”) with the Public Trustee of the county where the property is located. The Public Trustee then has ten working days in which to record the NED at the Clerk & Recorder’s office. If the property is non-agricultural, the Public Trustee must schedule the foreclosure sale for 110-125 days after recording the NED; if the property is agricultural, the foreclosure sale will be scheduled for 215-230 days after the NED is recorded. If a borrower has filed a notice of intent to cure not later than 15 days prior to the foreclosure auction, then the borrower has until noon the day before the foreclosure sale to cure monetary defaults.
In a foreclosure sale, the foreclosing lender submits an initial bid, which serves as the floor at which the foreclosure auction bidding begins. The deficiency, or post-sale shortfall, is calculated by subtracting the net proceeds received by the lender from the total amount due on the loan, including missed payments, late fees, and attorney and Public Trustee costs and fees, among others. As a general legal principle, the borrower is liable to the lender for any post-foreclosure sale deficiency.
b. Estate Liability. As a secured creditor, the foreclosing lender is not limited in the amount of time within which they need to foreclose on the property. However, if a lender is to seek recovery of a post-foreclosure deficiency balance from an estate, the lender must comply with the Colorado Probate Code’s claim presentation requirements. Otherwise, the extent of the lender’s recovery will be limited to the property in which the lender holds the security interest.(E4)
Where a liquidated claim – such as a borrower’s obligation on to a promissory note – exists prior to death, the creditor must file a claim against the estate within one year of the decedent’s passing.(E5) Claims against an estate that are not filed within the applicable time period are barred by the terms of the nonclaim statute.(E6)
Since the typical foreclosure process usually takes a minimum of eight to nine months from the time the first mortgage payment is missed until the foreclosure sale takes place, a lender seeking to recover a post-foreclosure deficiency from an estate must file a claim against the estate soon after the foreclosure sale in order to preserve its right to recover. Of course, if the lender was provided actual notice of the need to file a claim prior to one year from the date of the decedent’s death, the lender must comply with those timing requirements, even if the claim filed against the estate is only contingent at the time it is filed. However, if the estate is insolvent, even if a valid claim filed against the estate in a timely manner cannot be paid.
This article examined options for personal representatives and their attorneys to consider where the debt against a property in an estate exceeds the value of the property. In particular, this article focused on realistic options for parties to consider where an insolvent estate holds upside down property. Although some personal representatives of insolvent estates may seek to sell upside down properties via short sale, many will find that simply letting the property go to foreclosure leaves the estate and its beneficiaries no worse off than if the personal representative had expended the considerable time, energy, and resources necessary to attempt to sell the property via short sale.
(E1)These authors have not yet seen an institutional first mortgage lender reduce the principal balance due on a residential first mortgage loan in Colorado to allow property owner to keep it. The one institutionalized principal reduction loan modification program that this author has read about intends to lower the principal balance owned on the first mortgage to 95 percent of the fair market value of the property. After factoring in the cost of selling a property (which typically averages eight to ten percent of the sales price), this program would still leave an owner upside down in a sale that takes place immediately after the closing on the principal reduction loan modification.
(E2)The real estate industry refers to real estate owned by a financial institution as “REO” property, or sometimes OREo.
(E3)Throughout these materials, the term “lender” or “lenders” refers to the collection of institutions aligned on the “lender’s” side, which might include the holder of the note, a loan servicer, and a private mortgage insurance company.
(E4)C.R.S. § 15-12-809.
(E5)In re Estate of Ongaro, 998 P.2d 1097 (Colo. 2000).
(E6)C.R.S. § 15-12-803.