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A short sale is a sale of a home by a financially distressed homeowner for less than the amount remaining on the mortgage and on which the lender has agreed to forego the remaining debt, allowing the homeowner to give clear title.
A short sale allows the seller to avoid bankruptcy, but the lender may post a negative item on borrower's credit report, which will lower the consumer's credit score, but not as much as foreclosure. Buyers benefit because they can buy property at a lower cost, and, surprisingly, the lender can benefit also; otherwise, the lender would never agree to it. The lender benefits because a foreclosure can cost as much as $50,000 in foreclosure proceedings and marketing costs, and it might be hard to get a better price through foreclosure, after expenses, when real estate prices are falling and there are already many foreclosed properties on the market.
A lender would only agree, however, to a short sale if the lender believes that the homeowner is not going to be able to continue making payments, because it would be more profitable for the lender if the payments were continued. A short sale is also unlikely if there is a 2nd mortgage on the house, since it would require that the junior lender forgive all or part of the loan, which is unlikely.
The disadvantage to buyers is that the short sale could take a very long time. If you want to buy a property through a short sale, and you think the property was overpriced when purchased, or if home values are falling rapidly, show the lender an appraisal of the property as well as recent prices on comparable property. If the remaining mortgage is greater than its current value, the lender will have difficulty selling the property through a foreclosure, and so, it may benefit the lender to agree to a short sale.
If you are a homeowner that seriously needs to consider a short sale, then you should gather all the documents together to verify your situation and explain it to your lender. Explain in a letter the reason for your financial stress, and that it is unlikely to change soon. You should also provide pay stubs, tax returns, banking statements, and a list of all of your debts to verify your situation.
If the lender approves of a short sale, then you should get it in writing that the remaining debt will be forgiven. You should also ask the lender to report the item as a satisfied debt rather than settled for less than full balance in your credit report.
The other major consideration of a short sale is taxes. The IRS treats forgiven debt as income. The lender may send a 1099 to both you and the IRS listing the amount of the debt that was forgiven. The IRS will treat this as income with taxes due, unless you are insolvent, which simply means that your debt exceeds your income, or the mortgage was a nonrecourse loan. A nonrecourse loan is a loan in which the lender accepts the collateral, in the case, real estate, as the only backing for the loan. It cannot sue the borrower for any additional amount. In most cases of a short sale, however, the homeowner probably doesn't have a nonrecourse loan, since it is very likely that he did not put down at least 20% of the value of the property down, in which case, most lenders would never agree to a nonrecourse loan. However, most people who would need a short sale would probably be insolvent; otherwise, there would be no need for a short sale. More information on the tax considerations of a short sale or foreclosure.
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