Real Estate Short Sales
A short sale is a sale of a home by a financially distressed homeowner to a buyer looking for a bargain, where both the sale price and the property value are less than the amount remaining on the mortgage. Only if the property value is less than the mortgage amount will the lender agree to forgo the remaining debt. Otherwise, the property could be sold for the full amount of the mortgage or more, thus allowing the lender to recoup most or all its potential losses. For properties worth less than their mortgage amount, a short sale makes sense for the lender, because, otherwise, the property would eventually have to be repossessed, then sold through an auction or by listing it. However, since the property value is less than the mortgage amount, the lender is unlikely to recoup any losses on the property. Indeed, the losses could be greater, since the lender must pay holding costs, such as insurance and real estate taxes, on the property and will incur the opportunity cost of holding the property until sold. When the lender agrees to the short sale, then the homeowner can give clear title. The buyer benefits not only because a rental property is bought at a bargain price, but the property can usually be immediately rented to the former homeowner. The buyer must pay cash to the lender, since most lenders will not lend money for a short sale.
A short sale allows the seller to avoid bankruptcy, but the lender may post a negative item on the borrower's credit report, lowering the borrower's credit score, but not as much as a 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.
However, a lender would only agree to a short sale if the lender believes that the homeowner will be unable to continue 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, since the 2nd lender will not receive any of the sale proceeds. A buyer will have a better chance of convincing the lender that a short sale is its best option by providing the following information:
- hardship letter from borrower that he will be unable to continue the payments
- copies of the borrower's income tax returns
- information on the current condition of the property and the estimated cost of repairs
- estimated value of the property
- the buyer's offer for the property
The lender will probably verify the estimated home value by obtaining a Broker's Price Opinion for the property.
The disadvantage to buyers is that the short sale could take a very long time: 6 months or more. However, the time may be shortened if the homeowner stops paying the mortgage, since the lender's costs will increase with time of nonpayment. 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 properties. If the remaining mortgage exceeds its current value, the lender will not get a higher price for the property through a foreclosure or even a trustee sale (in those states where property loans are secured by a deed of trust rather than a mortgage), so the short sale may be more agreeable to the lender.
If you are a homeowner that seriously needs to consider a short sale, then 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. 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 get it in writing that the remaining debt will be forgiven. 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 Form 1099-C, Cancellation of Debt 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 this case, real estate, as the only backing for the loan. It cannot sue the borrower for any additional amount. However, the homeowner needing a short sale probably doesn't have a nonrecourse loan, since the downpayment was probably less than 20% of the property value. Without sufficient equity in the collateral, most lenders would never agree to a nonrecourse loan. However, most people needing a short sale can probably avoid taxes on the canceled debt since they would probably be insolvent; otherwise, a short sale would not be needed.
A temporary tax provision — the Mortgage Foregiveness Act of 2007, later extended by American Taxpayer Relief Act of 2012 — allows a homeowner to exclude canceled debt of up to $2,000,000 on a principal residence from gross income. (For more info, see Taxation of Canceled Debt, Including Foreclosures and Short Sales.) However, the taxpayer must fill out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness to inform the IRS about the exclusion.