I recently had an interesting email exchange with a couple of fellow bankruptcy attorneys on the subject of foreclosure.  The specific question we discussed was whether a second mortgage holder’s claim is extinguished after the holder of the first mortgage conducts a foreclosure sale.

The question is complicated by the fact that there are three relevant statutes at work, and they don’t have the same foci.

I.          The “One-Action” Rule

The first statute is Cal. Civ. Proc. Code § 726, which states in relevant part:

There can be but one form of action for the recovery of any debt or the enforcement of any right secured by mortgage upon real property or an estate for years therein, which action shall be in accordance with the provisions of this chapter.

This means that if a creditor holds a mortgage on a piece of property, it has one bite at the apple:  it can either foreclose on the property, or sue the borrower to collect on the debt, but not both.  Thus, if the lender conducts a foreclosure sale and comes up short, it cannot sue the borrower to collect the post-resale deficiency.  The shortfall has to be cancelled, which is why the (former) homeowner can face a nasty tax bill after losing the home.
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When the foreclosure sale looms large, filing for bankruptcy protection prior to the sale date is probably the only smart move. It avoids the unpleasant post-foreclosure sale tax hit, and frees you from owing the bank anything.

Those of you who have followed these posts for a while know that I have predicted a new wave of residential and commercial foreclosures. I stand by that prediction, the residential portion of which has just been bolstered by a recent article by Don Lee in the Los Angeles Times:
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I.          The Basic Idea:  Cancellation Of Debt Income

Let’s first understand the basic idea with a simple non-real estate example.  Suppose you owed me $100,000.  I’m such a nice guy that I forgive the debt.  It turns out that this becomes a mixed blessing because now the IRS and the Franchise Tax Board (FTB) both