For homeowners having trouble making their monthly mortgage payments, a short sale might sound like the perfect solution to avoid foreclosure. If you're considering this route, you should be aware that you might still be on the hook for any amount that exceeds the short sale price, called a "deficiency."
Most states allow lenders to obtain a deficiency judgment following a short sale, but a couple of states prohibit it. (To learn what to do—and what not do—if you’re facing a foreclosure, see Foreclosure Do's and Don'ts).
In a short sale, the homeowner sells the home for less than the total debt balance remaining on the mortgage. The lender agrees to accept the sale proceeds and release the lien on the property. The proceeds of the sale pay off a portion of the mortgage balance. (Learn more about short sales.)
Short sales are one way borrowers can avoid foreclosure. To learn about the issues you might encounter when doing a short sale, see Common Short Sale Problems and Obstacles.
When you short sell your home, the total debt owed exceeds the sale price. The sale proceeds are "short" of the amount needed to repay the debt. The difference between the sale price and the total debt is called a "deficiency."
Example. Say the total debt owed is $400,000, but the home sells for $350,000 at the short sale. The deficiency is $50,000.
In some states, the lender can seek a personal judgment against the borrower to recover the deficiency. Generally, once a deficiency judgment has been obtained, the lender may collect this amount—in our example, $50,000—from the borrower by doing such things as garnishing wages or levying a bank account. (To learn more about deficiency judgments in the foreclosure context, see Deficiency Judgments: Will You Still Owe Money After the Foreclosure?)
In the vast majority of states, the lender can go after the homeowner for a deficiency judgment after a short sale. But a couple of states—like California and Nevada—have laws that prohibit deficiency judgments following a short sale under certain circumstances. (To learn the law in your state, talk to an attorney.)
If you live in a state that doesn't have a law that prohibits a deficiency judgment following a short sale, you can avoid one by getting the lender to waive the deficiency. The short sale agreement must expressly state that the lender waives its right to the deficiency and that the transaction is in full satisfaction of the debt. Without this waiver, the lender might later file a lawsuit against you to obtain a deficiency judgment after the short sale is completed. (If the lender does eventually get a deficiency judgment, you might be able to eliminate your personal liability by filing for bankruptcy.)
If the lender waives the deficiency and issues you an IRS Form 1099-C (“Cancellation of Debt”), you might have to include the forgiven debt as taxable income. (For more information, see Canceled Debt: What Happens at Tax Time? For specific information about your particular situation, consider talking to a tax attorney.)
If you need help arranging a short sale and otherwise dealing with a foreclosure, consider talking to a foreclosure lawyer. A HUD-approved housing counselor can also provide you with information about different options to avoid a foreclosure, like a short sale.