In 2014, the Arizona Legislature enacted significant changes to the anti-deficiency statutes, which protect certain residential borrowers from a deficiency judgment following foreclosure. These statutory changes, which apply to mortgages or deeds of trust that originate on or after January 1, 2015, were designed to clear up confusion created by some recent court decisions regarding when the protection applies. Significantly, the new statutes allow for deficiency judgments against residential developers as well as owner-occupiers whose homes are unfinished or have never been lived in. 

Background 

For many years, A.R.S. §§ 33-729(A) and 33-814(G) have protected certain borrowers from a deficiency judgment if the proceeds of a foreclosure sale are lower than the loan balance. The protection applies when the collateral is: (1) a property of two-and-a-half acres or less and (2) “limited to and utilized for either a single one-family or a single two-family dwelling.” In addition, for judicial foreclosures, the protection applies only if the mortgage secures a purchase-money loan.

There is no statutory definition of the “limited to and utilized for” language. This ambiguity forced courts to grapple with how much construction must be complete before the homeowner can assert the anti-deficiency protection. For example, in M & I Marshall & Ilsley Bank v. Mueller, 228 Ariz. 478, 268 P.3d 1135 (App. 2011), the Arizona Court of Appeals held that borrowers whose residence was under construction at the time of foreclosure and who intended to occupy it upon completion would not be subject to a deficiency judgment. That court has since applied the Mueller holding in multiple unpublished cases.

At the other end of the spectrum, though, is BMO Harris Bank N.A. v. Wildwood Creek Ranch, LLC, 234 Ariz. 100, 317 P.3d 641 (App. 2014). In that case, no construction had begun at the time of the foreclosure. Distinguishing Mueller, the court held that a vacant, undeveloped lot could not receive anti-deficiency protection even if the borrower intended to construct and later occupy a residence on the land. Judge Kessler, in a separate concurring opinion, noted that there remained great uncertainty in the anti-deficiency law when improvements have begun but are incomplete. He suggested a “totality of the circumstances [approach] to see if the debtor intended the structure under construction to be utilized as his or her dwelling,” suggesting a fact-intensive inquiry. 

The Arizona Legislature Enacts Prospective Reforms 

The recent court decisions raised two concerns among participants in the lending and home-buying industries. First, the cases may not be consistent with each other. While the Mueller court (and the Wildwood concurrence) gave significant weight to the borrowers’ subjective intentions, the Wildwood majority strictly applied the statutory language. Second, if courts were to apply a fact-intensive inquiry to determine borrower intent, lenders and borrowers may not know at the time they contract with each other whether the anti-deficiency protection will apply if the property is foreclosed before or during construction.

The recently effective legislative changes seek to eliminate that ambiguity. The changes, which are codified in A.R.S. §§ 33-729(C) and 33-814(H), apply to mortgages and deeds of trust originated after December 31, 2014, whether foreclosed judicially or by a trustee’s sale. They explicitly exclude three categories of property from anti-deficiency protection. 

First, property owned by someone who constructs and sells homes in the course of that person’s business (including “spec builders” and builder-vendors) will no longer receive anti-deficiency protection. This is a significant change in the law. Arizona courts have historically declined to draw a distinction between owner-occupiers and other classes of borrowers for anti-deficiency purposes. See, e.g., Mid Kan. Fed. Sav. & Loan Ass’n v. Dynamic Dev. Corp., 167 Ariz. 122, 128–29, 804 P.2d 1310, 1316–17 (1991); N. Ariz Props. v. Pinetop Props. Grp., 151 Ariz. 9, 12, 725 P.2d 501, 504 (App. 1986). The new legislation now draws a line in the sand based on the type of borrower, placing spec builders and other residential developers at risk of deficiency liability. 

Second, anti-deficiency protection will no longer apply to “a dwelling that was never substantially completed.” “Substantial completion” is defined as the completion of the local government’s final inspection, or, if no final inspection is done in that locality, then the dwelling is materially complete according to that jurisdiction’s building codes. This provision was intended to overrule theMueller decision. Going forward, owners of homes that are only partially constructed at the time of foreclosure will not receive anti-deficiency protection.

Third, anti-deficiency protection will no longer apply to “a dwelling that is intended to be utilized as a dwelling but that is never actually utilized as a dwelling.” The likely purpose of this provision was to preclude courts from considering borrower intent. Industry participants favored a more objective approach, where parties to a loan would have more certainty ahead of time whether or not the protection would apply. In theory, this provision would allow a deficiency judgment against someone whose home is “substantially completed” but has never been lived in.

Conclusion 

The new legislation resolves some uncertainties in Arizona foreclosure law. However, because it only applies prospectively, it does not resolve those uncertainties to the extent they arise under existing loans. Such was the compromise necessary among various stakeholder groups to ensure enactment. The Arizona Supreme Court is currently reviewing the Wildwood decision. It remains to be seen whether the Court will resolve any tension between Mueller and Wildwood for loans pre-dating the statutory change.