Legal Issues When Rental Property You Own is in Foreclosure

The process of foreclosing on a rental property and a homeowner’s primary residence are similar, but there are key differences in the help that may be available and the outcome.

If you’re the owner of rental property that is in danger of foreclosure, you may be wondering if there are any issues unique to rental property that you should be aware of. While the process of foreclosing on a rental property and a homeowner’s primary residence will generally be the same, there are important differences in the help that may be available and the outcome.

Foreclosure Alternatives

There are many programs under the federal government’s Making Home Affordable umbrella geared to help homeowners avoid foreclosure. Unfortunately, most of the Making Home Affordable programs, including the two most popular programs, the Home Affordable Modification Program (HAMP) and the Home Affordable Refinance Program (HARP), have traditionally only been available to help borrowers with mortgages secured by their primary residence. (For more information about the federal government’s foreclosure avoidance programs, see Nolo's section on The Making Home Affordable Program.) Fortunately, changes to HAMP and the Home Affordable Unemployment Program (UP) have expanded eligibility to include owners of rental properties.

If you’re a borrower with a rental property and you don’t qualify for any of the federal foreclosure prevention programs, this doesn’t mean you can’t modify or refinance your mortgage. You are just limited to the modification, refinance, and other loss mitigation solutions that your lender offers in-house.

Deficiency Judgments

When a property is sold in foreclosure for less than the outstanding amount due on a mortgage, that difference is called a deficiency. In many states, lenders may sue borrowers to recover the deficiency. If the court finds for the lender, the court will grant the lender a deficiency judgment. With a deficiency judgment in hand, the lender can pursue a number of methods to collect the deficiency from the borrower, including garnishing the borrower’s wages, freezing the borrower’s bank accounts, and placing liens on the borrower’s other property. (For more information, see our article on Foreclosure & Deficiency Judgments.)

In some states, such as California, Iowa, Nevada, North Dakota, and Oregon, lenders are prohibited from pursuing a deficiency judgment after the foreclosure of a mortgage secured by the borrower’s primary residence so long as certain conditions are met. These protections of course would not apply to the foreclosure of a mortgage secured by a rental property. (For a summary of each state’s laws covering deficiency judgments, see our page on State Anti-Deficiency Laws.)

Tax Implications of Forgiven Debt

If your lender, rather than sue you for the deficiency, decides to forgive the debt, you may have to include the amount of debt forgiven in your taxable income. Under the Mortgage Forgiveness Debt Relief Act of 2007, borrowers have been allowed to exclude forgiven debt (up to $2 million) from taxable income, but only if the debt was secured by the borrower’s principal residence and used to buy or improve the borrower’s principal residence. Debt secured by a borrower’s rental property does not qualify for this exclusion. (The Mortgage Forgiveness Debt Relief Act of 2007 expired on December 31, 2013, but Congress is considering a bill that would extend the Act through 2014.)

However, you may still be able to exclude all or a portion of the forgiven debt from your taxable income if you are able to prove to the IRS that your liabilities exceeded your assets at the time the deficiency debt was forgiven. The amount of the forgiven debt that you will be able to exclude is capped by the extent to which your liabilities exceeded the value of your assets. For more details, see our article Income Tax Liability for Deficiencies.

Tenants in Foreclosed Properties

The foreclosure of rental property is complicated by the fact that in addition to the borrower and the lender, there is also a tenant that will be affected by the foreclosure. A landlord needs to be aware of the following rights and obligations of tenants living in properties in foreclosure.

The Protecting Tenants at Foreclosure Act

Under the Protecting Tenants at Foreclosure Act of 2009, tenants living in foreclosed properties no longer have to worry about the termination of their leases upon foreclosure. This federal law allows tenants to stay in their homes until the end of their lease terms and gives month-to-month tenants the right to receive 90-days’ notice before having to vacate.

This doesn’t mean that you can quickly execute a lease renting the property out to yourself or your family before the foreclosure is finalized. There are two exceptions to the Protecting Tenants at Foreclosure Act: If the buyer of the foreclosed property intends to occupy the property, a lease may be terminated with 90-days’ notice. Also, only bona fide leases are protected under the act. A bona fide lease is a lease in which the tenant is not the borrower or the borrower’s spouse, parent, or child; that was the result of an arm’s-length transaction; and in which the rent is not substantially lower than the fair market rent.

Assignment of Rents

Even before your property is sold at a foreclosure auction, you may lose the right to collect rent from your tenants. When you signed your mortgage loan documents, you probably signed a standard document called a 1-4 Family Rider (Assignment of Rents). This document gives your lender the right (except in Michigan) to collect rent directly from your tenant after giving you a written notice of default and notifying your tenant in writing.

Liability to Tenants

Tenants whose leases are terminated prematurely due to a foreclosure sale may decide to sue you to recover the cost of having to move and pay any increase in rent. Their lawsuits may be filed under two different theories. First, when you signed the lease with your tenant, you basically promised to the tenant that you would deliver the property for a certain period of time (this is called the covenant of quiet enjoyment). By defaulting on your mortgage and allowing your property to be sold in foreclosure, you reneged on this promise, giving your tenant the right to sue you for any damages suffered. Second, if you knew that your property would be lost in a foreclosure and rented out to the tenant anyway, your tenant may sue you for fraud.

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