Real Estate Law | October 2011
The Short Side of Short Sales
Short sales are good for lenders and can be great for buyers. But for many homeowners, a short sale is not the cure-all they were expecting.
consult with homeowners who are in the difficult position of
negotiating with their lender about the status of their home loan.
If you are unable to make your house payments, it is very likely
that you will have to confront the loss of your home.
The three most common ways of relinquishing
distressed property are foreclosure, deed in lieu of foreclosure,
and short sale. The last of those three options is the focus of this
In a typical short sale, you find a buyer
for the property, at a price that is less than your loan balance.
The lender agrees to accept the buyer and remove the portion of the
lien that exceeds the sales price.
For most lenders, a short sale is the
preferred method of dealing with a defaulted loan, since the lender
gets a new buyer, and the house never goes vacant. Meanwhile, you
get the benefit of avoiding a foreclosure on your credit rating.
(The value of that benefit is subject to debate, as is discussed
later in this article.)
Unfortunately, for many borrowers a short
sale is not the cure-all for which they had hoped. While the lender
and new buyer are undoubtedly better off, you (as the former
homeowner/borrower) can get burned if the transaction is not handled
correctly. Your financial exposure after a short sale can come from
two directions: (1) a loan deficiency lawsuit filed by your lender,
and (2) federal income tax on the unpaid portion of your loan.
First, consider the status of the
“deficiency” that resulted from the short sale. Suppose you sold
your home for $250,000, and your loan balance was $400,000. Do you
have to pay the remaining $150,000?
In Arizona, “anti-deficiency statutes”
prevent lenders from foreclosing on a property and then suing the
borrower for the unpaid loan balance. These are powerful and
effective consumer laws that, during our severe recession, have
saved thousands of homeowners from bankruptcy.
However, a short sale is not the same thing
as a foreclosure. Some lenders take the position that, after a short
sale, you still owe the deficiency, and they can try to collect from
you for the next six years. Would they win? The courts have not
decided this one yet, but you do not want to finance a lawsuit
against a bank in order to get the answer.
The solution: Before agreeing to anything
else in a short sale, be sure that the lender agrees – in writing –
to give you a full release from liability for the unpaid loan. Then
have an experienced real estate attorney review the documents. If
the lender refuses to give you a written release, stop the process
then and there; all they can do is foreclose, and the
anti-deficiency statutes will protect you from post-foreclosure
(It is important to understand that
Arizona’s anti-deficiency statutes do not apply to foreclosures on
all loans that are secured by your home. If the loan was used to
purchase your home, you are probably safe. But if the loan was for
other purposes, such as a home equity line of credit, the lender can
sue – but only if it waives its right to foreclose).
In addition to deficiency issues, beware of
tax on “phantom” income. When a lender lets you off the hook from a
portion of your mortgage, the IRS can, under certain circumstances,
treat the “forgiveness of debt” to be ordinary income. That means
that, continuing with our example above, in the year in which your
debt was forgiven, your taxable income may increase by $150,000 even
though you did not see a dime of it.
Thanks to current federal law (which is
scheduled to expire at the end of 2012), a foreclosure of your
principal residence will not result in taxable income. Also, debt
that is “non-recourse” does not result in income when it is forgiven
(because it was not a personal obligation anyway).
However, once again, short sales are not
foreclosures; thus, the tax liability protection contained in
federal law may or may not apply to debt forgiveness stemming from a
short sale. And, since the anti-deficiency statutes might not apply
to short sales, there is an argument that you have been released
from “recourse” debt, even when the lender does give a full release.
Some lenders are reporting canceled debt to the IRS, via a Form
1099, showing as income the amount of debt forgiven in conjunction
with a short sale. The result: The IRS has been told you have
received income – perhaps lots of it. Whether you would actually
have to pay tax on that amount is uncertain, but you don’t want to
sue the IRS in order to find out.
If your motivation in pursuing a short sale
(instead of submitting to foreclosure) is to protect your credit
rating, consider this: We have been advised (in legal seminars, by
speakers who should know) that a foreclosure will hit your credit
rating to the tune of about 227 points, while a short sale is worth
about 215 points. For most people, that small difference does not
warrant the risks inherent in a short sale.
Again, short sales are good for lenders, and
they are great for buyers. But for homeowners who don’t get legal
guidance in assessing their situation, a short sale can leave them
on the short end of the transaction.