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When your bills and mortgage have you financially underwater, letting go of your home may be the only way to avoid a looming foreclosure or bankruptcy. But selling a home when you’re in debt isn’t always easy. If your home is currently worth less than you owe on the property, a short sale may be the answer.
What is a Short Sale?
A short sale is when your lender agrees to let you sell your home for less than you owe on your mortgage.
Let’s say your mortgage balance totals $350,000, but the current market only values your house at $300,000. In a short sale, your lender agrees to let you sell at $300,000—which is $50,000 short of what you owe.
Of course, there’s no guarantee that your lender will to agree to a short sale. You’ll need to prove your case that you’re financially unable to pay by showing that your income is lower than your bills and by providing a hardship letter (more on this later). When the alternatives are a foreclosure or a deed in lieu of foreclosure, your lender is more likely to agree to a short sale.
After the short sale is completed, this doesn’t necessarily mean that you’re free from your mortgage. You’ll still have a remaining balance on your loan that your lender can either forgive or attempt to collect.
If the lender agrees to accept the lesser amount as payment in full for your mortgage, they’ll issue you a 1099-C Cancelation of Debt form—freeing you from any obligation to repay the outstanding $50,000. That forgiven debt is reported to the IRS by your lender (via the 1099-C) and is considered taxable income in most cases.
Thanks to the Mortgage Forgiveness Debt Relief Act in 2007, you may be able to avoid paying taxes on that forgiven debt. However, as of now Congress allowed this act to expire in 2016. If you began your short sale proceedings in 2016 or earlier, you may still be eligible to avoid paying taxes even if the debt didn’t clear until 2017. If you’re only starting your short sale process now, you’ll need to consult a CPA and a short sale expert to determine if there are any ways to avoid paying taxes on the forgiven debt.
If your lender refuses to forgive the $50,000 deficit, then they’ll issue what’s called a deficiency judgment. A lender may then attempt to collect the debt by arranging a payment plan that can include liens on any personal property you still own or by garnishing your wages.
For homeowners on the hook for a large debt after a short sale, there are options. Since you’ve already made your mortgage company aware of your financial difficulties, they may be open to accepting a settlement offer—such as paying back only $10,000 of the $50,000 you still owe to settle the debt.
Although bankruptcy isn’t a good idea if you just want to eliminate the deficiency judgment, it may be a smart alternative if you also have other loans and debts that you cannot repay.
Depending upon where you live, you might also wait it out and hope that your lender never tries to collect. In many states, lenders have a limited window in which they can attempt to collect on the deficiency judgment—and in a handful of states, deficiency judgments are restricted or not permitted at all.
While the deficiency judgment or 1099-C Cancelation of Debt come at the end of your short sale, they need to be addressed up front. You’re in your strongest position to negotiate for a 1099-C at the beginning of the proceedings when the terms of the short sale agreement are still being decided.
And this is just the beginning of the short sale journey.
The Short Sale’s Long Road
The “short” in short sale refers to money (the fact that you are selling your home for an amount that’s short of the debt you owe), not time. When it comes to time, a short sale is anything but short.
The process could take months or years. According to short sale expert Brad Wallace, who ranks in the top 9% of 8,627 agents in the Philadelphia area, “They call it a short sale, but it’s the furthest thing from a short sale. The quickest short sale I had was probably about four months, and I’ve had short sales that lasted over two years.”
The reason a short sale takes so long is because there are more parties involved, additional legal guidelines that must be met and extra steps that must be taken to complete the transaction that traditional home sales don’t have.
The first step is to enlist the help of a real estate agent with short sale experience and get a team of short sale experts (including an attorney or professional negotiator) in place. Once you give them the authorization to negotiate on your behalf, they’ll work to get the 1099-C as part of your initial contract.
Before they can do that, you’ll need to provide them with all of your records and documentation that prove your financial instability. This may include pay stubs, W-2s, collection letters, utility bills, student loans and a hardship letter explaining your long-term financial difficulties. As Wallace advises, “You’ve got to be able to qualify for a short sale. It’s all numbers. You’d better show that your bills outweigh your assets or they will turn you down. If the bank turns you down, then you can’t do a short sale.”
And you’ll need to keep this documentation current throughout the process. Any changes to your financial situation may alter the terms of your short sale agreement. Wallace says, “With your financials, you want to have as much information as possible and keep it up to date. Every time that you get a bank statement or mortgage statement or a pay stub, you want to send them in.”
Failure to keep your financial records up-to-date with your lender may force the deal to fall through when it comes time to close.
Once you’ve got your short sale agreement in place, it’s time to get your home on the market. Brad notes that, “You market it initially at fair market value, and then you don’t wait around on a short sale. You continue to reduce, reduce, reduce, reduce, until it sells.”
Starting out at fair market value shows your lender that you’re making a good-faith effort to sell your home for as much as it’s currently worth. The problem is, the fact that yours is a short sale listing goes into the MLS—which can deter many buyers.
The short sale process isn’t just difficult for the seller—it’s lengthy and unpredictable for the buyer as well. Since regulations and negotiations make the short sale process more complex than a traditional sale, there’s no way to predict the closing date.
And even if both the buyer and the seller do everything right to make the short sale go smoothly, the deal can still fall through.
Short sale buyers are taking a risk when they make an offer on a short sale property—so they’ll make lowball offers that your lender may not be willing to accept even if they’ve agreed to a short sale.
The Lowdown on Lender Negotiations
Getting your mortgage company to agree to a short sale is just the first ‘yes’ you need to get. When it comes to accepting an offer, it’s the lender—not the seller—who is in control.
Once an offer is on the table, your agent negotiates with the lender, the buyer’s agent and you, the seller, to come to an agreement. This process can take months because the lender will need time to review the offer, the original short sale terms and any changes in the seller’s financial status.
If any one of these parties disagrees with any of the terms of the contract, the short sale will fall through. This exact situation happened to Wallace:
“I had a short sale where we had a buyer in place with an offer on the table for $113,900. But the lender wanted a $6,000 contribution from the seller. Now my short sale clients didn’t have the $6,000, but the buyer was willing to come up with it, so the bank would’ve gotten $119,900 for the property. We went back to the bank asked, ‘Is it all right if we get the $6,000 from the buyer?’ The bank said, ‘No, it has to come from the seller.’ Since the bank would not allow that, the deal fell through. Eight months later the bank sold it for $94,000.”
The negotiations get even trickier and take longer if there are multiple mortgages on the property. The more lenders that are involved, the more complex the process becomes because your agent will need to get each lender to agree to take less than they’re owed from the short sale.
Life After a Short Sale
Closing on your short sale doesn’t completely put it behind you. The negative impact of the short sale will lower your credit score by 85 to 160 points. Completely rebuilding your credit takes anywhere from three to seven years depending upon how good your credit was before the short sale.
The better your credit before the short sale, the bigger the hit it will take—which means more years rebuilding it (link to my Short Sale Credit article). In this way, a short sale does almost as much damage to your financial situation as a foreclosure.
But the news isn’t all bad. Wallace says, “Generally from a short sale, if you continue to pay your other bills and you keep everything on time, you can generally get your credit back up in a couple of years.”
The news gets even better when you look to buying another home down the road. According to the Federal Trade Commission, “While borrowers who go through a foreclosure may have to wait seven years before they’re eligible for a new mortgage, short sellers may qualify in two years.”
Should I Try for a Short Sale?
Now that you know the ins and outs of a short sale, how do you decide if this is the right option for you? First you need to look at why you’re considering one.
If you’re expecting your short sale to net you money to pay down other debt—don’t. Wallace advises, “The seller takes nothing from the short sale. They’re just trying to get out in the best shape that they can.”
If you’re only considering a short sale in order to avoid a pending foreclosure, you may have better options available to you. The U.S. Department of Housing and Urban Development has a number of resources available to help struggling homeowners avoid foreclosure.
You may be able to refinance, reduce your principle, put your mortgage into forbearance, or temporarily reduce your monthly payments while you get back on your feet financially.
For those that don’t qualify for any of the assistance programs, or those that simply want to be free of their upside-down mortgage a short sale may be the right way to go. Just make sure that you get a top-notch short sale agent on your side as soon as possible. The right agent will guide you through the complex process and ensure that you come out of the short sale in the best financial shape you can be.
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