In a short sale, you sell your house for an amount that falls short of what you owe your mortgage lender before the property is auctioned off at a foreclosure sale. 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 are entitled to under the terms of the loans you signed. Why would they do that? They aren’t in the business of owning homes, and generally do a poor job of it. Also, foreclosures are expensive for lenders (who might not get all they’re owed anyway) and often take a long time.
If you're hoping to avoid a foreclosure and are exploring various loss mitigation (foreclosure avoidance) options, read on to learn the pros and cons of completing a short sale.
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).
In order for this to work, however, you must either live in a state that doesn't allow deficiency judgments after a short sale or get the lender to agree to waive the deficiency. Otherwise the lender could come after you for all or part of the amount of the loan that's left unpaid.
The general thinking is that your credit won’t suffer as much as it would were you to let the foreclosure proceed or file for bankruptcy. Though, in reality, a short sale isn't much better when it comes to your credit. (Learn more in Which Is Worse for Your FICO Score: Bankruptcy, Foreclosure, Short Sale, or Loan Modification?)
Short sales also have some drawbacks.
If you sell your house, you will be expected to leave as soon as escrow closes. But if you let the foreclosure happen and stay in the house until your legal right to live there ends, you can build a nest egg that you can draw on in the future to obtain good rental housing. (See our article on how foreclosure can help you save money.)
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. Needless to say, if you don’t complete the short sale before the foreclosure sale, you’ll have nothing to sell.
Many homeowners who complete a short sale will face a deficiency judgment.
What is a deficiency? Because 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 your lender gives you permission to sell your property for $200,000, but you owe $250,000. 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. In a few states, though, the lender can't get a deficiency judgment after a short sale.
A short sale might generate an unwelcome surprise if the lender forgives the deficiency: taxable income based on the amount the sale proceeds are short of what you owe. Although the concept is not at all 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 through 2017 (as well as debt discharged in 2018 if there was a written agreement entered into in 2017) don't owe income tax on that forgiven debt come tax time.
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. (To learn more, see Canceled Mortgage Debt: What Happens at Tax Time?)
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 are going to file for bankruptcy anyway, there isn’t much point in doing the short sale, because any benefit to your credit rating caused by the short sale will be negated by the bankruptcy.
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 the 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.