Facing a foreclosure? You might have heard that a short sale could be the solution to your problem. In a short sale, you sell your house for an amount that falls "short" of what you owe your mortgage lender. For a short sale to work, your lender (or lenders if you have more than one loan on the home) must agree to receive less than they're entitled to under the terms of the loan you signed.
Short sales sometimes work out well for people, but they're not a good idea for everyone and not appropriate in all situations. While a short sale is one way to avoid a foreclosure, these sales have advantages and disadvantages. On the upside, you might get off the hook for the deficiency and you won't have a foreclosure or bankruptcy on your record. A few of the downsides to short sales include:
If you're hoping to avoid a foreclosure and are exploring various loss mitigation options, consider the following before deciding on a short sale of your home.
Short sales have some upsides when compared to letting the foreclosure happen or filing for bankruptcy.
The main benefit of a short sale is that you might get out from under your mortgage without liability to pay a deficiency judgment (see below). To avoid owing the deficiency, you must either:
Otherwise, the lender could come after you for all or part of the loan amount that's left unpaid.
The general thinking is that your credit won’t suffer as much as it would if you let the foreclosure proceed or file for bankruptcy. Though, in reality, a short sale isn't much better when it comes to your credit.
Short sales also have some drawbacks.
If you sell your house in a short sale, you'll have to leave as soon as escrow closes. But if you let the foreclosure happen and stay in the property until your legal right to live there ends, you can build a nest egg that you can draw on in the future to obtain suitable rental housing.
You could be surprised to learn that a short sale doesn’t automatically cancel your obligation to pay off the remaining debt on your mortgage loan. Many homeowners who complete a short sale will face a deficiency judgment.
In a short sale, the difference between the total debt and the sale price is the “deficiency.” For example, say your lender permits you to sell your property for $350,000, but you owe $400,000. The deficiency is $50,000. In many states, the lender can seek a personal judgment against you (a "deficiency judgment") after the short sale to recover the deficiency amount.
Here's why you might still face a deficiency judgment even after selling the home: The two documents used in a typical home loan transaction are a promissory note and a mortgage (or deed of trust). The promissory note consists of your promise to repay the lender. The mortgage (or deed of trust) creates 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 agrees to remove or release the lien from the property. But is the lender also agreeing to cancel the borrower's obligation to repay the loan in full? Not necessarily.
Some lenders even ask borrowers to sign new, unsecured promissory notes before approving short sales. Other lenders, without asking for a new promissory note, reserve their right to collect the deficiency as part of a short sale agreement. After the short sale closes, the lender starts collection proceedings. Other lenders assign the debts to collection agencies, which then go after the borrowers for repayment after short sales.
To be sure that you won’t be on the hook to pay any more money after your short sale closes, ask your lender to waive the deficiency and get it in writing. If your lender refuses to forgive the deficiency, consider talking to an attorney to see if any state laws prohibit your lender from collecting the deficiency. Again, in a couple of states, you can't be sued for a deficiency after a short sale.
Preserving your credit score might be the most touted reason for choosing a short sale of your home rather than letting it go through a foreclosure sale. But the reality is that a short sale isn't much better for your credit score than a foreclosure. Short sales, foreclosures, and deeds in lieu of foreclosure are all about the same for purposes of your credit score. Only bankruptcy is worse for your credit.
Exactly how much your score will drop depends primarily on what information the servicer reports about the short sale and your credit history. If you have a high credit score before a short sale, which is unlikely if you're behind in mortgage payments, you’ll lose more points than someone with a low credit score. And if you avoid owing a deficiency, your credit score might not take as big of a hit. Overall, though, the difference in how much a short sale or foreclosure affects your credit is pretty minimal.
A short sale might generate an unwelcome surprise if the lender forgives all or part of the deficiency: taxable income. Although the concept isn't intuitive, the IRS treats forgiven debt as taxable income, subject to regular income tax. Thanks to the Mortgage Forgiveness Debt Relief Act of 2007, though, most homeowners who have had mortgage debt forgiven before January 1, 2021, won't owe taxes on it. The exclusion created by this law applies to debts forgiven as the result of a written agreement entered into before January 1, 2021, even if the actual discharge happens later. (I.R.C. § 108(a)(1)(E)).
To qualify for the exclusion, the forgiven debt must have been incurred to purchase, build, or make significant renovations to your principal residence. But if you borrowed against your principal residence and used the money for any purpose other than acquiring or improving that property, you might owe taxes on the forgiven amount. For example, if you used the loan to buy a second house, to pay college tuition for a child, or to take a vacation, and you end up not paying it back in full, the amount your lender writes off (typically whatever amount wasn’t paid back) is considered forgiven debt.
If you face this situation and can prove you were legally insolvent at the time of the short sale, you won’t have to pay the tax. Insolvency is when your total debts are more than the value of your total equity in your real estate and personal property. You can also get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy if you file before escrow closes. Of course, if you're going to file for bankruptcy anyway, there isn’t much point in doing a short sale because the bankruptcy will negate any benefit the short sale has on your credit rating.
Still can't decide if a short sale is right for you? Here's some more food for thought.
A short sale can take a long time and a lot of work, with no guarantee that it’ll close in the end. Before embarking on a short sale, you might want to contact your servicer about other ways you might avoid a foreclosure, like by modifying your loan or getting a deed in lieu of foreclosure. Like short sales, these alternatives have drawbacks and benefits to consider before proceeding.
An approved agreement for a short sale transaction might include a marketing or listing period during which the borrower may market the property, and the lender won't foreclose. If you don't have an approved short sale transaction by the end of the marketing or listing period, the lender can generally go forward with the foreclosure.
Is there a second loan on your home? Do other creditors hold liens on your property? You’ll most likely need the approval of all parties with an interest in your property to close the short sale. The time and effort needed to close a short sale increases exponentially with each additional interested party. It’s very difficult to accomplish a short sale if you don’t get started as soon as you learn about the pending foreclosure, especially if you have to deal with several mortgage holders.
If you decide to proceed with a short sale, you should identify all parties with an interest in your property and contact them early in the process. Needless to say, if you don’t complete the short sale before the foreclosure sale, you’ll have nothing to sell.
To learn more about how short sales and other foreclosure avoidance options work, consider talking to a HUD-approved housing counselor. If you want to learn about foreclosure procedures in your state or fight a foreclosure in court, consider talking to a foreclosure attorney. If you want to learn the pros and cons of filing bankruptcy, talk to a bankruptcy attorney.