A deficiency balance is remaining debt after an asset is seized and sold to repay a loan. If the selling price of an asset is lower than the outstanding balance on the loan, the debtor may be liable for the remainder. The law regarding a deficiency balance depends on the region, as well as the specific terms of the debt. People with concerns about this possibility may want to review loan terms and discuss the situation with an attorney to learn more about their potential obligations.
The classic example of a situation where a deficiency balance may arise is that of a short sale. In this case, a debtor negotiates with a lender to sell a home for less than the value of the outstanding loan. Lenders may agree to this when a borrower clearly cannot repay the loan. With a non-recourse loan, once the sale goes through, the debt may be considered settled, and the lender cannot pursue the balance.
In recourse loans, lenders can demand they be paid the amount left over after the proceeds of the sale are applied to the loan. Lenders can potentially sue to recover the funds, although this may not be practical. Often in this situation, the debtor may not have money available to cover the judgment. An analyst can determine whether it would be possible to recover more money from the debtor, and whether the effort would be worth it, given the amount owed and how much the lender could reasonably expect.
An alternative may be for the lender to forgive the deficiency balance. The lender then writes off the remainder of the debt, classifying it as discharged. This can create some problems for borrowers, which they should consider when deciding how to deal with the situation. The first problem can be a hit to their credit score, which may take several years to recover. Additionally, it creates tax liability, as the government considers the write-down a form of income for the borrower, who will owe taxes.
Borrowers preparing to negotiate on a loan who think a deficiency balance may arise can discuss the situation with attorneys and their lenders. It may be possible to work out a repayment plan to address the issue, or to negotiate loan forgiveness. Attorneys and financial advisers can help their clients plan for the increased tax liability, so they won’t end up in trouble with the tax authorities.