Short Sales

A short sale is a sale of real estate in which the proceeds from the sale fall short of the balance owed on a loan secured by the property sold.

In a short sale, the bank or mortgage lender agrees to discount a loan balance due to an economic or financial hardship on the part of the mortgagor. This negotiation is all done through communication with a bank’s loss mitigation or workout department. The homeowner/debtor sells the mortgaged property for less than the outstanding balance of the loan, and turns over the proceeds of the sale to the lender, sometimes (but not always) in full satisfaction of the debt. In such instances, the lender would have the right to approve or disapprove of a proposed sale. Extenuating circumstances influence whether or not banks will discount a loan balance. These circumstances are usually related to the current real estate market and the borrower’s financial situation.

A short sale typically is executed to prevent a home foreclosure, but the decision to proceed with a short sale is predicated on the most economic way for the bank to recover the amount owed on the property. Often a bank will allow a short sale if they believe that it will result in a smaller financial loss than foreclosing as there are carrying costs that are associated with a foreclosure. A bank will typically determine the amount of equity (or lack of), by determining the probable selling price from a Broker Price Opinion BPO (also known as a Broker Opinion of Value (BOV)) or through a valuation of an appraisal. For the homeowner, advantages include avoidance of a foreclosure on their credit history and partial control of the monetary deficiency. A short sale is typically faster and less expensive than a foreclosure. In short, a short sale is nothing more than negotiating with lienholders a payoff for less than what they are owed, or rather a sale of a debt, generally on a piece of real estate, short of the full debt amount. It does not extinguish the remaining balance unless settlement is clearly indicated on the acceptance of offer.

Short sales are common in standard business transactions in recognition that creditors are not doing debtors a favor but, rather, engaging in a business transaction when extending credit. When it makes no business sense or is economically not feasible to retain an asset, businesses default on their loans (called bonds). It is not uncommon for business bonds to trade on the after-market for a small fraction of their face value in realization of the likelihood of these future defaults. For owners who can no longer afford to keep mortgage payments current, a “short sale” may be a viable option. This is why short sales have become a significant factor in overall real estate sales throughout the country.

When lenders agree to do a short sale in real estate, it means the lender is accepting less than the total amount due. Not all lenders will accept short sales or discounted payoffs, especially if it would make more financial sense to foreclose; moreover, not all sellers nor all properties qualify for short sales.

If you are considering buying a short sale, there could be drawbacks. For your protection, you should always consult a competent real estate lawyer and an accountant to discuss short sale tax ramifications.

Except for certain conditions pursuant to the Mortgage Forgiveness Debt Relief Act of 2007, the IRS could consider debt forgiveness as income, and there is no guarantee that a lender who accepts a short sale will not legally pursue a borrower for the difference between the amount owed and the amount paid. In some states, this amount is known as a deficiency. A lawyer can determine whether your loan qualifies for a deficiency judgment or claim.

Although all lenders have varying requirements and may demand that a borrower submit a wide array of documentation, the following steps will give you a pretty good idea of what to expect.

Now, if everything goes well, the lender will approve your short sale. As part of the negotiation, you might ask that the lender not report adverse credit to the credit reporting agencies, but realize that the lender is under no obligation to accommodate this request. Federal enabling laws, first enacted by Congress and authorized regulations passed by the Bush Administration and extended by the Obama Administration may significantly impact what your bank may do for you. The Mortgage Forgiveness Debt Relief Act was introduced in Congress on September 25, 2007, and became law on December 20, 2007. This act offered relief to homeowners who would formerly owe taxes on forgiven mortgage debt after facing foreclosure. The act extends such relief for three years, applying to debts discharged in calendar years 2007 through 2009. (With the Emergency Economic Stabilization Act of 2008, this tax relief was extended another three years, covering debts discharged through calendar year 2012.)

Normally in U.S. law when a lender decides to forgive all or a portion of a borrower’s debt and accept less, the forgiven amount is considered as income for the borrower and is liable to be taxed. However, after the signing of the Mortgage Forgiveness Act, amendments have been made to remove such tax liability and allow the borrower and lender to work freely together to find a common solution that is beneficial to both parties. This protection is limited to primary residences. Rental properties are ineligible for relief, so consultation with a tax advisor is necessary to ensure that a borrower qualifies. The amount of forgiven mortgage debt allowed to be excluded from income tax is limited to $2 million per year.

More recent legislation provides for a specialized type of refinancing option, available for mortgages made after 2006, for owner-occupied homes. Under this program, a debtor provides information similar to that necessary for a short sale but rather than selling the house to a third party, an FHA guaranteed loan at a fixed rate is available if the original lender is willing to write-off all but 85% of the outstanding debtor’s obligations (including principal, interest, late fees, prepayment penalties, and all other fees). FHA-backed refinance packages are available beginning October, 2008, and carry a fee equal to 1.5% of the value of the house. Debtors who exercise this option must sacrifice 50-100% of equity that builds in a house, and may not participate in home equity loan programs. This program is only available to owner-occupied residences. This program requires consent from a lender. Consent is not automatic and may be freely withheld, though withholding consent can result in a foreclosure with adverse financial results.

Negotiation Tips

Lenders have a department (typically called “loss mitigation”) that processes potential short sale transactions. Today, lenders may accept short sale offers or requests for short sales even if a Notice of Default has not been issued or recorded with the locality where the property is located. Given the unprecedented and overwhelming number of losses that mortgage lenders have suffered from the 2009 foreclosure crisis, they are now more willing to accept short sales than ever before. This is great news for borrowers who are “underwater” or in other words, those who owe more on their mortgage than their property is worth and are having trouble selling to avoid foreclosure because of this.

Lenders have a varying tolerance for short sales and mitigated losses. The majority of lenders have pre-determined criteria for such transactions. Other distressed lenders may allow any reasonable offer subject to a loss mitigator’s approval. Multiple levels of approvals and conditions are very common with short sales. Junior liens – such as second mortgages, HELOC lenders, and HOA (special assessment liens) – may need to approve the short sale. Frequent objectors to short sales include tax lienholders (income, estate, or corporate franchise tax – as opposed to real property taxes, which have priority even when unrecorded) and mechanic’s lienholders. It is possible for junior lienholders to prevent the short sale. If the lender required lender’s mortgage insurance/mortgage insurance on the loan, the insurer will likely also be party to negotiations as they may be asked to pay out a claim to offset the lender’s loss in the short sale. The wide array of parties, parameters, and processes involved in a short sale makes it a relatively complex and highly specialized type of real estate transaction, which is why unfortunately short sale deals have a high failure rate and often do not close on time to save homeowners from foreclosure when they are not handled by a knowledgeable and experienced professional. The best sources of knowledge and expertise in short sales are short sale negotiators, loss mitigation specialists, and real estate lawyers who specialize in short sales.

One thing a buyer should know about a short sale is there is no necessary commitment by the bank to sell the house. When the bank completes a short sale, they have to write off the difference between their loan amount and the lesser proceeds from the escrow, something they wish to avoid. You may go through all the paperwork to make an offer on the house, pay for inspections, and put down a deposit to start the sale process. After you have made your offer, the bank may try to convince the seller to refinance their loan and stay in the house, which avoids the bank having to take the write off. Any short sale contract includes a contingency where the bank must approve the sale. If the bank persuades the seller to refinance the house, the bank doesn’t approve the short sale, and the buyer gets their deposit back. In this situation, the bank has tied up several months of the buyer’s time and now the buyer must start the buying process over again. So if you have a fixed time period to get in a specific city or neighborhood you may be better off with a foreclosure (the bank formally took possession of the property) or a situation where the seller has equity. So in a short sale situation, look for clues like has the seller moved out (revealed they have no intention of staying in the property) and/or grill the selling realtor about how much the selling bank has agreed to sell the house for (the price you want to offer).

Credit reporting

A short sale does adversely affect a person’s credit report, though the negative impact is typically less than a foreclosure. Short sales are a type of settlement. Like all entries except for bankruptcy, short sales remain on a credit report for seven years. Depending upon other credit information, it is typically possible to obtain another mortgage one to three years after a short sale. While it is frequent if not common for a lender to forgive the balance of the loan in question, it is unlikely that a lienholder that is not a mortgagee will forgive any of their balance. Further, it is common for a lender to omit updating mortgage balances to zero balance after a short sale. However, willfully misrepresenting information on a credit report can constitute libel in some jurisdictions, and lenders may be sued in civil court for engaging in this behavior.