The Lender‐Borrower Tangle: Understanding California And Arizona Anti‐Deficiency Legislation

Rising foreclosure rates in the residential real estate market have prompted underwater borrowers to ask about possible foreclosure strategies—most notably, how to avoid deficiency judgments. Often overlooked, however, are the challenges that lenders face, primarily due to borrowers choosing to strategically default on their mortgage when the amount owing on the loan exceeds the value of their home. These challenges are of particular concern for lenders operating in states like Arizona and California that have enacted strict anti‐deficiency laws to mitigate the effects of foreclosure and personal liability. Anti‐deficiency legislation insulates the residential borrower from any personal liability on the outstanding debt. This article examines both Arizona's and California's anti‐deficiency statutes and presents strategies that may affect a lender's decision to foreclose on residential properties.

There are two types of foreclosure in Arizona and California: the first type is "judicial" foreclosure in which a lender files a lawsuit and gets a court order to foreclose on the property, and the second is "non‐judicial" in which the property is sold by a trustee's sale via a power of sale clause in a deed of trust.

When faced with a potential foreclosure, the threshold questions to be asked by a lender in either state are:

(i) does the state's anti‐deficiency legislation restrict the lender's ability to seek a deficiency judgment for the difference between the outstanding loan balance and the proceeds received by the lender at the sale (or the fair market value of the property), and (ii) is the underlying loan secured by a mortgage or a deed of trust, and is the debt secured by the loan purchase money or nonpurchase money.

If the property does not qualify for anti‐deficiency protection, no further discussion is necessary, since the lender can choose under which foreclosure statute it wishes to proceed. In turn, if the property does qualify, the next step is to determine which statute allows the lender to maximize its recovery.

In both Arizona and California, if the property is foreclosed by a trustee's sale, under no circumstances can the foreclosing lender collect a deficiency. On the other hand, if the lender elects to judicially foreclosure on the property, a deficiency may be pursued, and the lender may be entitled to recover the difference between the loan amount and the actual sale price of the property (or its fair market value). Although...