In a short sale, the lender agrees to settle the debt owed on the property for less than the full amount. “Settled” means that the lender is writing off the debt and that they are not going to go after you for the money they lost by filing a deficiency judgment in the future.
The majority of our clients are approved for a short sale because we know how to submit the short sale package in such a way that the lenders will approve them and we have a tremendous amount of experience with short sales and negotiating with the lenders. The primary reason for the bank approving a short sale is financial hardship. The current owner of the property can no longer manage the payments on the mortgage(s).
A short sale is recorded on your credit report as “debt settled for less than the amount owed”. This typically will result in a relatively minor hit on your credit compared to a foreclosure or late payments on your mortgage. Typically, the hit on your credit ranges anywhere from 80-110 points.
The reason you often hear and read that a short sale will drop your credit 100 points or more, is that, many people, when they do a short sale, stop making their mortgage payments. If you stop making your mortgage payments for 4 months, regardless of whether you do a short sale or not, 4 months of missed mortgage payments will have a significant negative impact on your credit. In other words, it is the missed mortgage payments that have the big impact on your credit, not the short sale itself.
If you are current on your payments and can stay current throughout the short sale process, you will save your credit to a large extent.
There are several different scenarios with regard to whether or not you will owe federal income taxes on the loss the lender takes in a short sale.
When you do a short sale, your lender is agreeing to settle the debt on the property for less than the amount they are owed. The IRS therefore allows them to write off this loss, which is why your lender will send you a 1099-C after the short sale.
The IRS considers “debt relief” to be income for tax purposes. In other words, if your lender writes off $50,000 on your short sale, they will send you a 1099-C for that amount, and you would include that when you file your income taxes. The “C” stands for “Cancellation of Debt” and the law says canceled debt is taxable as income.
There are however a few exceptions that most people who do a short sale qualify for that exclude them from having to pay taxes on their short sale. It is highly recommended that you speak with your tax financial adviser when you have any questions about your tax liabilities.
Fortunately for the Mortgage Tax Debt Relief Act that George W. Bush signed into law in January of 2008, homeowners who do a short sale on their primary residence, and have a purchase money loan (in other words, they have not pulled cash out of their home with a cash-out refinance) pay no taxes on the loss that their lender incurs in a short sale.
All other short sale scenarios – if you pulled cash out on your primary residence but spent it something other than upgrading your home or if you are doing a short sale on a second home or investment property – result in a taxable event unless you qualify for the “Insolvency” exclusion. Again it is important for you to talk with your tax professional.
The Mortgage Tax Debt Relief Act was originally only slated to go until the end of 2008, however it has now been extended to the end of 2012.
California has passed its own version of the federal Mortgage Tax Debt Relief Act. It is Senate Bill 1055, which conforms to the federal law described in detail above, but applies to California state income taxes on a short sale.
There are differences between the state and federal law. For example, the term of the California law is currently only until the end of 2008, however the state is widely expected to extend it to 2012 to conform to the federal law.
In general, a purchase money loan is considered to be a “non recourse” loan, while a “cash out” loan is considered to be a “recourse” loan.
The difference between these two loans is that in a “recourse loan” the lender technically has recourse to go after the borrower for the money they lose in a foreclosure. I say “technically” because, for this to happen, the lender has to file a judicial foreclosure, which is rarely done in California.
The overwhelming majority of foreclosures in California are “non-judicial” foreclosures, where the property is sold at a trustee sale.
It will be stated clearly on the bank’s short sale approval. Your lender will state in plain English (though in different verbiage depending on the lender) that they are “releasing the lien”, “accepting a short payoff to satisfy the lien”, “reporting the sale as a settled debt to the reporting agencies”, “issuing a full satisfaction of the mortgage”, “not pursuing a deficiency judgment”, or some other variation that states they are settling the debt for less than what they were owed.
The primary advantage to doing a short sale vs. walking away and letting your home go to foreclosure is that in a short sale the debt is settled and you no longer owe the bank any money. If your home goes to foreclosure, you may still be liable for the deficiency in the event that the bank files a judicial foreclosure. You can look for foreclosures in your area and possibly view your own home using our foreclosure search. This will give you a quick idea what stage of foreclosure it is in.
A secondary (but still very important) advantage is that in a short sale, your credit takes much less of a hit compared to a foreclosure. The impact on your credit will vary depending on how established your credit is at the time of the short sale or foreclosure.
Finally, Fannie Mae & Freddie Mac revised their guidelines in August of 2008 with regard to how they view borrowers who have filed bankruptcy, gone through foreclosure or done a short sale. Through these new guidelines, they are in effect severely penalizing those who go the route of foreclosure or bankruptcy, and rewarding or encouraging those who do short sales, which they view as the borrower doing the responsible thing in light of the circumstances.
Per recent Fannie Mae / Freddie Mac guidelines, borrowers who file bankruptcy or go through foreclosure have to wait up to 7 years to buy another home.
By contrast, the new guidelines stipulate only a 24 month waiting period after a short sale, so borrowers who do a short sale can buy again in just 2 years.
I have yet to hear a coherent argument for letting your home go to foreclosure vs. doing a successful short sale. Depending on whether you have a recourse or non-recourse loan, when you let your home go to foreclosure you either run the risk of being liable for the deficiency amount or liable for the income taxes on that loss.
Secondly, your credit will drop up to 400 points and you will not be able to buy a home or get any decent credit for up to 7 years.
Compare this with a short sale, in which the lender agrees to SETTLE the debt for less than the amount owed. If you have recourse loan, you may be liable for income taxes on the lender’s loss (just as in a foreclosure) but you will not be liable for the deficiency (and if you qualify for the “Insolvency” exclusion, you will avoid the income taxes as well).
Further, the loss that the lender takes in a short sale will be MUCH LESS than the loss the lender takes at the end of the foreclosure process. The foreclosure process takes months & months, at the end of which the lender has to process the property through its overwhelmed system (another 3 -5 months) and then put the property back on the market, all while the market continues to drop.
Finally, the impact on your credit from a short sale will be significantly less than with a foreclosure and you will be able to buy again within 2 years, compared to up to a 7 year waiting period to buy a home after a foreclosure.
A short sale costs the seller nothing – the lender pays all closing costs, escrow fees, commissions etc. The lender may also pay any outstanding property taxes.
The short sale process typically takes about 4 months, start to finish. It can take longer depending on how backlogged the lender is. You can live in the property for the entire duration of the short sale or you can move out whenever you wish.
No. This is a common misconception. You do not need to be behind on your payments or have been late on a payment to do a short sale although the lenders are more motivated to do the short sale if you are not making payments.
It is our belief that you will be best represented in a short sale by a competent, experienced real estate agent who works every day in the real estate business, will market your property aggressively in order to attract buyers, and who is experienced at doing short sales and negotiating with lenders. In our view, an “experienced short sale agent” is one who has done at least 50 successful short sales in this downturn cycle (i.e. since 2006).
If you have questions about the tax implications of a short sale, we recommend you seek the advice of a qualified CPA or tax accountant.
If you want to explore filing bankruptcy, we recommend you seek the advice of a competent bankruptcy attorney. Call our office – we can recommend several.
With this said, a word of caution. Many attorneys seem to be preying on the fear and desperation of people facing foreclosure. Their websites use scare tactics to make people think that they would be crazy to do a short sale without first hiring an attorney, that attorneys are the only ones qualified to interpret a short sale approval, and that hiring an attorney is a normal and accepted part of doing a short sale, like hiring an attorney for divorce proceedings.
The bottom line is that this is just not the case. The overwhelming majority of short sales are conducted by real estate brokers who are experienced at negotiating with the lenders and charge NO UPFRONT FEES for their services.
Finally, many of these attorneys do not even negotiate the short sales themselves, and instead subcontract out all of the short sale negotiations. In our opinion, these short sale negotiation companies (known in the industry as “short sale mills”) are absolutely the wrong entities to entrust with the negotiation of your short sale.
Real estate agents & bankruptcy attorneys are solicited on a daily basis by the many “short sale negotiation” companies that have sprung up on the web over the past couple of years. For the agents or attorneys that use these companies, it’s a very attractive set up: they just take the listing and refer the file out to the negotiation company, and wait to see what happens.
The agent has invested almost no time or effort into the deal, so if it closes, great, they pay a referral fee to the negotiator and keep the rest of the commission. If the negotiator tells them they couldn’t get an approval, or that the bank wants an unreasonable amount of money for the property, or the bank wants the seller to sign a promissory note, well, the agent has invested almost no time or money into the deal, so…who’s next?
There are 2 types of bankruptcy commonly used by individuals – Chapter 7 (“Fresh Start”) and Chapter 13 (“Wage Earner”). Chapter 7 can enable individual filers to wipe away debts such as credit card and medical bills so they can continue to make their mortgage payments.
Chapter 13 involves setting up a 3-5 year repayment plan to repay your debts. Chapter 13 requires that you are earning a steady income, as you will be repaying all of your debt. Both have a very negative impact on your credit and remain on your credit report for 10 years.
Because of the new 2005 bankruptcy law, which raised the bar for people to qualify for Chapter 7 “fresh start” bankruptcy proceedings, fewer and fewer people pass the “means” test to qualify for Chapter 7 and for this reason can only qualify for Chapter 13 bankruptcy (a 3-5 year repayment plan).
While both Chapter 7 and Chapter 13 can temporarily delay foreclosure proceedings, neither will allow you to keep your home unless you can bring your mortgage current.
If you would like more information on whether a bankruptcy is right for you, we recommend you consult a competent bankruptcy attorney, as we are not attorneys and do not dispense legal advice. Call our office – we can recommend several.
Short Sale Tax Implications
When going through a short sale you need to know about your possible tax issues. Many people overlook the potential tax issues. The short sale procedure is controlled by the Mortgage Forgiveness Debt Relief Act of 2007 and Emergency Economic Stabilization Act of 2008. With this law, if you short sale your home, you have to fill a 1099-C form for the deficit amount. The deficit amount usually is equal to the amount of your lenders loss and is considered loan forgiveness by the IRS. If your short sale ends up with a lower amount than the actual amount you owe, you are required to report it as forgiven debt. Forgiven debt is the amount that you owe to the lender after foreclosure or property repossession.
If the forgiven debt amounts to $600 or more then you will receive a Form 1099-C from your lender to file your tax return. You need to submit this IRS and report the forgiven amount as your income.