Having trouble paying your mortgage? You may have heard that a short sale is the answer to your problems. A short sale is a sale of a property where the proceeds of the sale are less than the balance owed on the mortgage covering the property. A short sale may be right for many people, but is it the best option for you? Consider the following before deciding on a short sale of your home.
A Short Sale Won't Save Your Credit Score
Saving your credit score may be the most touted reason for choosing to short sale your home rather than letting it be sold at a foreclosure sale, but the reality is that a short sale is not much better for your credit score than a foreclosure. According to myFICO, the consumer division of Fair Isaac (the company that invented the FICO score), short sales, foreclosures, and deeds-in-lieu of foreclosure are all "not paid as agreed" accounts and are considered the same for purposes of your FICO score. For additional information on short sales, see Nolo's article Short Sales and Deeds in Lieu of Foreclosure.
Short Sales Don't Always Cancel the Remaining Debt on the Mortgage
You may be surprised to learn that a short sale does not automatically cancel your obligation to pay off the remaining debt on your mortgage. There are two parts to your mortgage. The first part consists of your promise to repay the lender. The second part secures the loan, creating a lien on your property -- in other words, if you break your promise to repay, the lender has the right to have the property sold to pay off the loan.
So, when a lender approves a short sale, what is the lender agreeing to do? At the very least, the lender is agreeing to remove or release the lien on the property. A seller would have a near impossible task in selling a property without this lien release.
Is the lender also agreeing to cancel the seller's obligation to repay the loan in full? Not necessarily. Some lenders ask sellers to sign new, unsecured promissory notes before approving the short sale. Other lenders, without asking for new promissory notes, reserve their right to collect the deficiency -- the remaining balance of the debt -- within the fine print of their short sale approval documents (which you might not even see until the property sale is nearly due to close). After the short sale closes, the lenders start collections proceedings against the borrowers. Other lenders assign the debts to collection agencies, which then go after the sellers for repayment after the short sale closes. But in some states, first mortgages are non-recourse loans, meaning that you can't be sued for a mortgage deficiency after a short sale.
To be certain that you will not be on the hook to make any more mortgage payments after your short sale closes, ask your lender and get their answer in writing. If your lender refuses to give you a straight answer, contact an attorney to see if there are any state laws prohibiting your lender from collecting the deficiency -- and whether your lender has a history of complying with that law. (Some major lenders have been known to simply reinterpret the law in their own interests.)
You May Owe Taxes on the Deficiency
If your lender forgives you for a deficiency after a short sale, you may owe taxes on the forgiven amount. That's because it's considered income by the IRS, upon which you may owe federal and state income tax. Under the federal Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude from your income all or a portion of the amount of forgiven debt in a short sale, but only if all of the following requirements are met:
- The forgiven debt was used to buy, build, or substantially improve your home or to refinance debt incurred for those purposes.
- The debt was forgiven between 2007 and 2013. (Congress is considering a bill, the Tax Extenders Act of 2013 [S. 1859], that would extend the Act through 2014.)
- The discharge was directly related to a decline in your home's value or your financial condition.
To learn more about this federal tax break, read Nolo's article Canceled Mortgage Debt: What Happens at Tax Time? Some states -- including California, Michigan, New York, and Illinois -- have statutes conforming to the federal Mortgage Forgiveness Debt Relief Act. Contact a tax professional or attorney in your area to find out whether you will owe any taxes as a result of your short sale. (To find an attorney in your area, visit Nolo's Lawyer Directory.)
Short Sales: More Things to Think About
Still can't decide if a short sale is right for you? Here's some more food for thought.
You have other options. Short sales can take a long time and a lot of work, with no guarantee that they will close in the end. Before embarking on a short sale, you may want to contact your lender about other foreclosure alternatives, such as refinancing your mortgage, modifying your loan, or negotiating the terms of a deed-in-lieu of foreclosure. Like short sales, each of these other options has its own set of drawbacks and benefits to consider before proceeding.
Is time on your side? Make sure you have enough time to sell your home. As mentioned above, short sales can take a long time, usually months, to close. Will you have enough time to market the property, find a buyer, and negotiate with your lender for approval before your house is foreclosed on? Short sale negotiations with your lender, or even your lender's approval of a short sale, will not automatically stop that lender's foreclosure process. Contact your lender and the trustee managing the foreclosure process about postponing any scheduled foreclosure sale to give your short sale enough time to close. The flip side of the time question is that, while most short sales take months to close, yours may be the exception and close quickly. Like any home sale, once the short sale closes, you will have to move. If your primary goal is to stay in your home for as long as possible, letting the home be sold at a foreclosure sale may be a better option for you.
You'll need approval before you close. Is there a second loan on your home? Is your mortgage covered by insurance? Do other creditors hold liens on your property? You most likely will need the approval of all parties with an interest in your property to close the short sale. This is bad news because the time and effort needed to close a short sale increases exponentially with each additional interested party. In this situation, you should identify all parties with an interest in your property and contact them early in the short sale process.
Short sale fraud. The increase in the number of short sales taking place is leading to a rise in incidents of short sale fraud. To learn how to avoid becoming a victim of short sale fraud, see Nolo's article Short Sale Fraud: Three Scams to Avoid.
To learn more about short sales, including whether or not a short sale is right for you, get Nolo's bestselling Foreclosure Survival Guide, now available online at no charge. It is written by practicing attorney Stephen R. Elias, president of the National Bankruptcy Law Project.