NON-JUDICIAL FORECLOSURE IN CALIFORNIA

Introduction

Consider the typical situation when a person wishes to purchase a home. The purchaser typically puts a certain amount of money down, say 10% of the purchase price, and finances the remaining 90% through a loan from a bank or other mortgage lender. The purchaser then signs a promissory note in favor of the lender and executes a trust deed or mortgage on the property to secure the lender. The trust deed on a mortgage provides the lender with security in the event the purchaser fails to make required payments on the loan. Typically, the loan would be paid off over a 30-year or 15-year fixed period, or when the property is sold and transferred to a new purchaser.

However, in some instances, the purchaser is unable to continue making monthly mortgage payments, and he defaults on the loan. In that instance, the lender will “foreclose,” and seek to recover the remaining balance on the loan. There are two ways for the lender to proceed. One way is for the lender to bring a judicial foreclosure action, which is a legal proceeding in court. The other, more common method of foreclosure in California, is for the lender to institute a non-judicial foreclosure, also known as a “private sale.”

Since a judicial foreclosure proceeding is an action in court, it may take a year or more to resolve, and will be subject to the all of the defenses a borrower may have in a breach of contract action, including the statutes of limitation applicable to such actions. In the case of a judicial foreclosure action, the four-year statute of limitations for breach of a written contract would apply. Since this type of foreclosure requires full court proceedings, the lender would typically need to hire an attorney to prosecute the action.

Non-Judicial Foreclosures

A non-judicial foreclosure action, on the other hand, is not an action filed in court and, therefore, is not subject to a statute of limitations defense. Moreover, a non-judicial foreclosure may result in a foreclosure sale, with proceeds paid to the lender, in a much shorter period of time than would be the case in a judicial foreclosure action.  That period of time may be as short as 110 days from the time the lender provides the purchaser with notice of default. Nonjudicial foreclosure proceedings are also less expensive than judicial foreclosure proceedings, since the lender may not require the assistance of an attorney.

Since non-judicial foreclosure proceedings are quicker and less expensive than judicial foreclosure proceedings, the question arises, why would a lender proceed judicially? The answer is that, in some cases, a lender may be able to obtain not only the amount for which the property is sold, but also the difference between the sale price and the full amount the lender is owed (i.e., the “deficiency”), in the event the sale proceeds are less than what the lender is owed.  In that instance, the lender will be made whole through a judicial foreclosure proceeding.  In contrast, in a non-judicial “private sale,” the lender may not recover any deficiency.

California Anti-Deficiency Statutes

However, a judicial foreclosure proceeding is not available in many, if not most instances in California. Consider the typical scenario mentioned above: a purchaser obtains a loan in order to purchase a home in which he intends to live. In that situation, the “anti-deficiency” statutes apply. The anti-deficiency statutes provide that a lender may not obtain a deficiency judgment under a deed of trust or mortgage given to the lender to secure repayment of a loan that was in fact used to pay all or part of the purchase price of the dwelling, if the dwelling is occupied entirely or in part by the purchaser. In the case of such a “purchase money loan,” no deficiency may be collected by the lender.

One Form of Action Rule

Also relevant in the typical scenario referred to above is California’s “one-form-of-action rule.” This rule provides that foreclosure is the only form of action that may be pursued by a lender to recover any debt or enforce any right secured by a trust deed or mortgage. Under the one-form-of-action rule, if the purchaser/borrower defaults on the loan secured by a deed of trust or mortgage given to the bank or other mortgage lender, the lender must look to recover what the lender is owed first — and perhaps only — from the security, that is, the property subject to the trust deed or mortgage. Moreover, in the “purchase money loan” scenario described above, the lender will not be able to seek or obtain a “deficiency” and, therefore, must proceed by way of non-judicial foreclosure, rather than a judicial foreclosure action.

In the event the property is sold in a non-judicial foreclosure proceeding, the lender will be paid first out of the proceeds of sale. If the lender is paid in full, any remaining funds will be paid to the purchaser/borrower if there are no other lenders with security interests in the property, or to any such secured lenders subordinate to the bank or other mortgage lender which provided the original loan enabling the purchaser/borrower to purchase the subject property. Of course, typically the proceeds of sale will not be sufficient to pay the original lender, so there will be nothing left after partial payment of the loan is made to the original lender out of the proceeds of sale.

Junior Liens

It is not uncommon for a producer/borrower to obtain a home equity line of credit (HELOC) or other form of second loan, giving the second lender a trust deed or mortgage on the same property. In that instance, the second lender, or “junior lienor,” will have security in the property for repayment of the loan, but that security will be subordinate to the original lender who holds a first trust deed or mortgage on the property.

In that situation, in what position does the second trust deed holder find himself if the original purchaser/borrower defaults on the loan he obtained from the original lender? In a typical situation, the original lender will institute a non-judicial foreclosure proceeding. If there are insufficient funds from the sale of the property to fully pay off the first trust deed holder, there will be nothing left to pay off the second trust deed holder. In that event, the second trust deed holder, also referred to as a “sold-out junior lienor,” will not benefit from a foreclosure proceeding, either judicial or non-judicial, because his security for the property will have been wiped out. Since he no longer has a security interest in the property, he is not constrained by the one-form-of-action rule, and may seek a personal judgment against the borrower.

Co-signors

One final note: the one-form-of-action rule in the anti-deficiency statutes does not apply to in the event the lender has obtained a guarantee of the loan from a third-party. In that event, if the purchaser/borrower has defaulted on the loan, the lender may file a legal action against the guarantor on the guarantee, and may collect the full amount of the unpaid loan from the guarantor.

For further information, contact our team of trusted attorneys at Gehres Law Group.

Applicable statutes include: CA Civil Code §2924; CA Civ. Proc. §580d; CA Civil Code §2932-33; CA Civ. Proc. §580b; CA Civ. Proc. §726(a).

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2019 – A Vintage Year for Irrevocable Living Trusts

Although California produces stellar wine vintages year after year, there has been relatively little production of anything new or positive for California non-grantor trusts. But the landscape has changed, the conditions are ideal, and the time is ripe. A recent crop of legislation and cases, including California’s new Uniform Trust Decanting Act and the Paula Trust case, might make 2019 a vintage year for updating irrevocable trusts, overhauling estate/gifting plans, and potentially reducing California tax exposure.

CA Decanting

The California Uniform Trust Decanting Act (“CUTDA”), which took effect January 1, 2019, has significantly eased restrictions and limitations on trust fiduciaries when it comes to “updating” irrevocable trusts in California. “Decanting” an old trust, similar to decanting an old wine, is literally the act of pouring the assets and provisions from an outdated irrevocable trust into a brand-new irrevocable trust. The crucial difference is that wine decanting involves pouring the same wine into a different container. Trust decanting, on the other hand, allows fiduciaries the ability to modify the trust’s terms and provisions, resulting in a substantially different and improved container.

Before passage of the CUTDA, a fiduciary’s ability to modify the terms and provisions of an irrevocable trust in California, with certain exceptions, was limited, time consuming and expensive. In most cases, the fiduciary was required to obtain the consent of all the trust’s beneficiaries, and a court hearing was needed to make any proposed changes. And even if the fiduciary was able to overcome these obstacles, their power to make substantive modifications to the original trust instrument was severely restricted.

Under the CUTDA, a fiduciary now has the power to decant and modify an irrevocable trust without the consent of the settlor, beneficiaries, or the court.  The fiduciary must still provide notice to all of the interested parties above (as well as the California Attorney General if the trust has charitable components), but their approval and consent is no longer required.

Fiduciaries can use decanting to make administrative changes and, depending upon the authority granted to them by the original trust, they may also have the power to make significant substantive changes. Fiduciaries with “expanded distributive discretion” can alter both administrative and dispositive provisions, including modifications to distributions, beneficiaries, appointments and trust duration.  Decanting power does not mean unlimited power and unfettered discretion – the decanted trust’s “juice” can be modified and fortified, but it can’t be replaced with an entirely different product. Fiduciaries are still restricted when it comes to modifying their own powers, liabilities and compensation. In addition, they are barred from making any changes that alter the trust’s charitable components and/or negatively affect its tax status.

Fiduciaries are free, however, to make changes that positively affect the trust’s tax status. The Paula Trust case, coupled with the new decanting powers under CUTDA, could very well provide trustees with a perfect window to make that happen.

The Paula Trust Case

In general, the income of a non-grantor trust is subject to taxation in California if that trust’s fiduciary or beneficiary is a resident of California.^[1] The California Franchise Tax Board (“FTB”) has generally taken the position that all California-source income is subject to taxation and all other trust income is eligible for apportionment according to a formula involving the trust’s fiduciaries and beneficiaries.^[2]

The Paula Trust v. FTB ^[3] decision rejected the FTB’s historic position and held that all of the Paula Trust’s income, including all of its California-source income, was eligible for apportionment. A 2007 sale of the Paula Trust’s property resulted in a $2.8M capital gain in California, and the Paula Trust successfully argued that the same tax structure should be applicable to both California-source and non-California-source income. By applying the apportionment formula, the Paula Trust was able to defer California taxes on roughly $1.4M of the gain. The Paula Trust decision is being appealed by the FTB, but it’s currently the law of California.

Dust Off Your California Irrevocable Trust and Pop the Cork

There are additional compelling factors making 2019 an opportune time to evaluate and overhaul existing estate and gifting strategies, including the potential sunsetting of the high federal basic exclusion amount at the end of 2025, CA Senate Bill 378 which could establish a separate and punitive estate tax regime in California, and the availability of new insurance products that can help mitigate tax burdens.

An effective estate plan, like a vintage Napa cabernet or First Growth Bordeaux, is a precious and enduring gift that needs to be preserved and protected for future generations to enjoy and cherish.  If you are a trustee or fiduciary of a non-grantor California trust that is past its prime, the Decanting Statute and Paula Trust decision may empower you to make substantive changes that better serve the evolving needs of the trust’s beneficiaries while significantly reducing (and possibly eliminating altogether) California tax exposure. The attorneys at Gehres Law Group can help guide you through the options and find the right fit that integrates your business and personal goals, mitigates risk and uncertainty, and maximizes potential benefits for your family and loved ones regardless of what the future may hold.

[1] Cal. Rev. & Tax Code §17742(a)

[2] Cal. Code Regs. tit. 18, §17743

[3] Paula Trust v. Cal. Franchise Tax Bd., 2018 Cal. Super. LEXIS 644 (currently under appeal by FTB)

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