Short Sale Risks

Short sales come with risks for both buyers and sellers. Learn about those risks here.

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If you are a homeowner facing foreclosure, a short sale might sound like the perfect solution to avoid foreclosure. For buyers, short sales often appear to be a fantastic way to purchase a property for a great price. However, there are certain risks associated with short sales for both sellers and buyers. Read on to learn more about these risks.

(You can learn how short sales work in Nolo's Short Sales & Deeds in Lieu of Foreclosure section.)

What is a Short Sale?

A short sale is when a homeowner sells his or her home for less than the total debt balance remaining on the mortgage and the lender agrees to accept the proceeds from the sale in exchange for releasing the lien on the property. Short sales are one way for borrowers to avoid foreclosure.

Short Sale Risks for Sellers

If you are considering short selling your home, make sure you understand some of the risks that go along with short sales.

You Might Be Liable for a Deficiency Judgment

The biggest risk for homeowners seeking to complete a short sale is the possibility of having a deficiency judgment against them.

What is a deficiency? Since the sale price is “short” of the full debt amount in a short sale, the difference between the total debt and the sale price is the “deficiency.”

Example. Say you are approved by your lender to sell your property for $200,000, but you owe $250,000. The difference ($50,000) is the deficiency. In many states, the lender can seek a personal judgment against you after the short sale to recover the deficiency amount.

Anti-deficiency laws. While many states have enacted legislation that prohibits a deficiency judgment following a foreclosure, most states do not have a corresponding law that would prevent a deficiency judgment following a short sale. California is an example of a state that does have specific legislation prohibiting a deficiency judgment following a short sale, however most states have no such prohibition.

How can I avoid a deficiency judgment? To ensure that the lender cannot obtain a deficiency judgment against you following a short sale, the short sale agreement must expressly state that the transaction is in full satisfaction of the debt and that the lender waives its right to the deficiency.

Frustrating Application and Approval Processes

Frequently short sale deals fall through because the lender takes a long time to decide whether or not to accept the deal.

The short sale process. To be approved for a short sale, the seller must submit a short sale application to the lender and the lender’s loss mitigation department must approve the short sale before the transaction can be completed. This process can take weeks or months. Moreover, the lender will probably reject the first offer, especially if the offer is lower than the listing price or is substantially below fair market value. Sellers and buyers often get frustrated and choose to give up on the deal before the sale is approved.

Streamlined short sales. Fortunately for some borrowers, the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) have streamlined their short sale processes so that homeowners can be more quickly and easily approved for a short sale.

As of June 2012, loan servicers must abide by strict timelines when considering a short sale offer pertaining to loans backed by FNMA and FHLMC. The loan servicer must:

  • Review and respond to the short sale request within 30 calendar days from receipt of the complete short sale application

  • Provide the borrower with weekly updates if the short sale application is still under review after 30 days; and

  • Make a final decision to accept or deny the short sale, and notify the borrower of such decision, within 60 calendar days after receipt of the complete loss mitigation package.

The new guidelines apply only to loans backed by FNMA and FHLMC. To find out if your loan is owned by either of these entities, you may go to www.knowyouroptions.com/loanlookup or www.freddiemac.com/mymortgage/.

To learn more about these new procedures, see Short Sales for Fannie Mae and Freddie Mac Loans.

The Second Mortgage Holder Must Agree to the Short Sale

Another issue that sellers face in short sales is second mortgages. If there is more than one mortgage on the property, both mortgage holders must consent to the short sale. The first mortgage holder will offer a certain amount from the short sale proceeds to second mortgage holder to release their lien, but the second mortgage holder can refuse to accept the amount and kill the deal.

You May Be on the Hook for Taxes

After a short sale, the lender may choose to forgive the deficiency amount and issue the borrower a 1099-C (“Cancellation of Debt”) form to the seller. Usually, the forgiven amount would be considered taxable income, however you may be able to exclude it under the Mortgage Forgiveness Debt Relief Act of 2007.

 This Act, effective through 2013, allows taxpayers to exclude income from the discharge of debt so long as the forgiven debt was used to buy, build or substantially improve a principal residence, or to refinance debt incurred for those purposes.

(To learn more, see Will You Owe Taxes on Forgiven Deficiency Debt?)

Negative Impact on Your Credit Score and the Ability to Obtain a Subsequent Mortgage

Though not as bad as a foreclosure, a short sale negatively impacts a seller’s credit score to a great extent. Moreover, if you complete a short sale under FNMA and FHLMC’s streamlined process, you will not be eligible for a new mortgage backed by either for at least two years after the short sale.

Short Sale Risks for Buyers

If you are thinking of buying a home through a short sale, here are some risks that you should be aware of:

Ridiculously Low Home Prices that Waste Your Time

In many cases, the listing price for a short sale property is set very low simply to attract offers. To obtain a short sale approval from a lender, the seller needs an actual offer to get the process started and, in many cases, the seller's real estate agent (rather the lender) will have set the listing price. As a result, the lender will very likely come back with a significantly higher counteroffer and buyers may find they are wasting their time pursuing properties that are not actually within their price range.

Poor Property Condition

Short sale homes are sold “as is” which means the seller typically will not pay for any repairs to the home. Short sale homes frequently need significant maintenance since the seller may not be financially able (or motivated) to provide upkeep for the property.

(Find more articles on buying a home.)

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