A short sale is when you sell your home for less than what is owed. For example you owe $700,000 on your mortgage but your home has depreciated so that you can only get $600,000 for it. This would be a short sale since you are short $100,000.
After the short sale you may owe the lender the amount by which you were short (in this example $100,000). This about is called the "deficiency". The bank may (or may not) agree to excuse the deficiency.
The effect on the bank is that they pretty much get the same result as in a foreclosure without the hassle and expense of going through the foreclosure process. Studies have shown that the bank loses more money if the property is foreclosed than if the property is subject to a short sale. In exchange, for the fact that the bank doesn=t have to go through the foreclosure process the bank is sometimes willing to reduce all or part of the deficiency.
You would think it would be a "no brainer" for the lender. You would think that the lender would always prefer to do a short sale rather than foreclose. But for some reason there is often a reluctance on the part of the banks to agree to a short sale. Perhaps one reason is that the foreclosure by the holder of the first wipes out all junior liens (except for tax liens). In other words, by foreclosing the holder of the first may get a "cleaner" title than if there is a short sale.
If you do a short sale don't assume that the lender is accepting the payment in the short sale as full and final payment. I have seen short sales where my client made this assumption but when I reviewed the papers I saw that the lender was not waiving the deficiency. Let me give you an example. Let's say the balance due on the loan is $800,000. The sales price in the short sale is $500,000. If the bank waives the deficiency, after the short sale, the seller doesn't owe the bank any money. If the bank does not waive the deficiency then the bank can sue the seller for $300,000.
As you can see, a short sale may possibly result in a benefit to the debtor if he doesn=t owe as much to the bank after the short sale as he would after a foreclosure. The benefit to the bank is that the bank avoids the hassle and expense of the foreclosure process. Of course, if there is a broker handling the short sale, there will be a commission paid to the broker.
Another possible benefit to the homeowner in a short sale is that the homeowner’s credit rating may be less severely harmed if he does a short sale as opposed to a foreclosure.
An alternative to a short sale is for the homeowner to deed the property to the lender instead of forcing the lender to foreclose. This is called a “deed in lieu of foreclosure”. Ordinarily when a borrower pays off a loan the borrower pays the loan off with money. In the “deed in lieu” scenario the lender is receiving the property in payment of the loan instead of money. The loan is being paid off to the extent of the fair market value of the property that the lender is receiving.
As in the case of a short sale, the question arises as to whether the receipt of the property by the bank constitutes full payment of the loan. It may or may not depending on what the borrower and the lender have negotiated.
Since a short sale and a deed in lieu of foreclosure accomplish the same thing then why do we hear so much more about short sales than deeds in lieu of foreclosure? Probably the reason is that real estate brokers receive a commission in short sales but not in a deed in lieu of foreclosure. Therefore short sales are heavily marketed by real estate brokers. But no one markets the deed in lieu process.
Another alternative to the short sale and the deed in lieu of foreclosure is for the property owner to stop paying the mortgage, continue to occupy the property and to let the foreclosure process run its course. This will often allow the property owner to retain the property for many months while waiting for the eviction after foreclosure.
If the property in question is the debtor’s residence the debtor will be able to live rent free for many months or more. If the property in question is the debtor’s rental property the debtor will be able to collect rent during this time period. If the property owner has lost his job this may be the only way the debtor can financially survive.
If the property owner is going to declare bankruptcy anyway doesn’t it make sense for the property owner to get the benefit of retaining the property payment-free for many months? After all the, if the property owner is declaring bankruptcy, his credit will already be damaged. He might as well take advantage of payment-free ownership for as long as possible?
I suppose the question is as follows: In the case of a property owner, who will be declaring bankruptcy, is it better for the property owner’s credit rating to do a short sale (or deed in lieu) than to let the property go though foreclosure?
There is no clear-cut answer to this question. You should consult with me and your lender about this issue. But keep in mind that once you declare bankrutpcy the lender can not subsequently make a negative report to a credit reporting agency that you have allowed your property to be foreclosed.
The general rule is that debt relief is taxed. In fact, the bank must issue you a 1099 for the amount of the debt relief.
Fortunately, there are exceptions to the general rule that the forgiveness of the loan is income.
1. Bankruptcy exception. If you discharge the deficiency in bankruptcy then the amount of the discharged debt will not be considered income.
2. Insolvency exception. You may not have to include the forgiven amount to the extent you can prove that you were insolvent at the time of the transaction.
3. Mortgage Forgiveness Debt Relief Act. Congress passed The Mortgage Forgiveness Debt Relief Act of 2007 (see 26 U.S.C. 108) This law exempts some debt relief from taxation.
The Mortgage Forgiveness Debt Relief Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. Debt used to refinance your home qualifies for this exclusion, but only up to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified.
You can read what the IRS has to say about this subject at: