What’s a Short Sale in Real Estate? This FAQ Sheet Breaks Down the Basics

Every time you open your mailbox, you’ve got stacks of collection notices from every creditor. You’re behind on the mortgage with no way to catch up, and now you’re facing foreclosure. Soon you’ll be out on the street with a big blot on your financial record.

In the midst of these financial straits, there may be a slightly better option: a short sale.

You’ll still have to sell the house and move out, but you’ll have more control over the situation and you’ll also put yourself in a better position to recover faster.

But what is a short sale and is it the right route for you? We’ve broken out the most common questions about short sales to help you make a more informed decision about your next steps.

  1. What is a short sale?
  2. How do I know if I qualify for a short sale?
  3. How does a short sale differ from a foreclosure?
  4. What documents do I need to apply for a short sale?
  5. How is my home’s current value determined during a short sale?
  6. Who pays closing costs in a short sale?
  7. How does a short sale impact my credit?
  8. What are the tax considerations of a short sale?
  9. Can I hire any agent to handle my short sale?
  10. What are the alternatives to a short sale?
  11. Is a short sale right for me?

An office where a real estate short sale takes place.
Source: (Matt Hoffman/ Unsplash)

1. What is a short sale?

“A short sale is a scenario where the mortgage company approves a loan payoff that is short of—or less than—the full loan balance,” explains Misty Soldwisch, an experienced short sale agent in Des Moines, Iowa.

In a short sale, your mortgage lender agrees to let you sell your house for an amount that is less than you owe, and forgives any extra debt remaining after the house sells. This essentially means that they’re giving you money for free, at least on paper.

Note: this only works if your house is currently worth less than you owe on your mortgage. 

2. How do I know if I quality for a short sale?

You must be underwater on your mortgage in order to qualify for a short sale, which means that you have negative equity.

This can happen for a variety of reasons:

  • A real estate market downturn lowered your home’s value below the amount you borrowed to purchase it
  • The debt from a second mortgage or a home equity line of credit (HELOC), combined with your primary loan, now totals more than the house is worth
  • Missed mortgage payments, delinquency fees, interest charges that added up

Negative equity isn’t the only criteria you need to meet in order to qualify for a short sale, though.

“In order for a mortgage company to consider a short sale, the property needs to be in imminent risk of foreclosure. Lenders will not consider a short sale if there is no foreclosure pending,” says Soldwisch.

“The borrowers must also be able to demonstrate a distressed financial situation. The mortgage company will look for hardship factors like, divorce, the loss of a job—which is a loss of income—or devaluation of the home, meaning that the house is currently worth less than the borrowers paid for it, putting them underwater on the property.”

Bottom line: If you’re underwater on your mortgage, if you’ve received pending foreclosure notices, and your can demonstrate financial distress, you may qualify for a short sale—as long as your lender agrees.

A foreclosure notice during a short sale in real estate.
Source: (RAGMA IMAGES/ Shutterstock)

3. How does a short sale differ from a foreclosure?

Short sales and foreclosures are often lumped together because both are rock bottom options for homeowners who are behind on their mortgage payments and in financial hot water.

They aren’t the same, though.

When you’ve reached foreclosure stage, the bank has taken the house from you because you’ve defaulted on your mortgage. In that scenario, your lender cuts their losses and will move to evict you. When your house eventually sells, the bank is the one selling it—you are no longer involved.

However, letting your lender foreclose on your house doesn’t necessarily mean you’re freed from your mortgage debt. Depending on where you live, your lender can sue you to recoup some of what you owe.

None of this happens with a short sale. When you arrange for a short sale, your lender is agreeing to forgive any extra debt after the house is sold for less than you owe. With a short sale, you’re also the one in the driver’s seat during the sale of the house.

“With a short sale, negotiations are between the homeowner and the purchaser, not the mortgage company,” explains Soldwisch.

“The terms are subject to approval by the mortgage company, but the seller is still very much in control of determining the price, the terms, the closing date, and so on.”

4. What documents do I need to apply for a short sale?

Lenders aren’t in the business of giving away free money to just anyone. You’ll need proof that you’re in dire financial straits and unable to pay what you owe on your home.

“You’re going to have to show your lender all of your personal finance documentation. That’s going to include your most recent bank statements, your pay stubs, your credit card debt, and also your monthly expenses”, says Soldwisch.

“You’ll also have to provide documentation of your retirement savings—although your lender can never ask you to use retirement savings to get caught up on your mortgage.”

Aside from financial statements, your lender will also require several other documents when you apply for a short sale arrangement, including:

  • Third-party authorization letter (gives your agent permission to work with your lender on the short sale)
  • Client information form (your application)
  • Tax returns from the past two years
  • All bank statements from the last two months
  • Most recent mortgage statement(s) (all mortgages loans on the property)
  • Financial statement (including all assets and debts, such as retirement account statements, credit card debt, etc.)
  •  Hardship letter

5. How is my home’s current value determined during a short sale?

The only way to qualify for a short sale is if you currently owe more than your house is worth. So, how is the current value determined? That depends.

There are basically two options to get to your home’s current value, either with a broker price opinion (BPO), or an appraisal by a licensed appraiser.

“With a BPO, the agent prepares the valuation—versus a licensed appraiser, whose perception of the market can be different. Which one will be required in your short sale depends on the lender,” advises Soldwisch.

A table used in a real estate short sale meeting.
Source: (Arlington Research/ Unsplash)

6. Who pays closing costs in a short sale?

In traditional home sales, closing costs are typically up for negotiation between the buyer and the seller.

The same is true with short sales, although in this scenario you have a third-party, the lender who needs to approve those negotiations—which may throw a wrench into the works.

Your mortgage company may agree to pay the seller’s closing costs, but refuse any requests to cover the buyer’s costs.

Some lenders will also ask for a contribution from the short seller, which is a payment made at the close of the sale. This contribution is requested to offset the lender’s losses, and may be used to cover any closing costs the lender agrees to pay.

7. How does a short sale impact my credit?

Yes. Going through with a short sale will have a negative impact on your credit.

In fact, FICO data suggests that a short sale and a foreclosure will have an equally negative impact on your credit score and recovery.

A table explaining what a short sale in real estate means.

A table explaining what a short sale in real estate means.
Source: (FICO)

The news isn’t all bad, though.

“A short sale can have a serious impact on your credit,” explains Soldwisch.

“However, your credit score can recover more quickly after a short sale than it can after a foreclosure. And once your credit score has recovered, you’ll qualify for a guaranteed mortgage more quickly after a short sale versus a foreclosure.”

The impact on your credit from a short sale versus a foreclosure largely depends on your previous credit history. If you had great credit before the short sale, the negative impact will be a bit less than if you had a history of unpaid debt, defaults, and credit dings.

This is only true if you return to your good credit habits after the short sale, by keeping your credit debt low and making payments on time. If you do, then your credit could potentially start to recover after two years post-short sale.

Unfortunately, there’s no guarantee that your credit will recover more quickly after a short sale than a foreclosure. However, a short sale is reported as “settled” debt, which is not the case with a foreclosure.

Debt marked as settled rather than paid isn’t great, but it’s better than having a foreclosure on your credit report.

Since a short sale reflects the borrower’s willingness to settle debt, many lenders will take this under consideration when you apply for future loans.

A tax document used in a short sale in real estate.
Source: (Country Gate Productions/ Shutterstock)

8. What are the tax considerations of a short sale?

Remember how the debt forgiven by your lender is kind of like free money (on paper)? Well, in some states this forgiven debt may be taxable.

“Short sellers need to understand that in some states, after the mortgage company approves their short sales they’ll receive 1099s for the amount of the discharged mortgage debt,” explains Soldwisch.

“So basically, the 1099 reflecting that discharged debt will show up on your taxes as if it were income that you received, which will have tax ramifications.”

The IRS refers to this loan forgiveness as a cancellation of debt. Whether or not it’ll be taxable depends on whether or not your state laws allow for recourse or non-recourse loans.

If yours is a recourse loan, the bank can go after your other assets to collect on the deficiency amount left after the home sale. Lenders who instead decide to forgive the remaining debt on a recourse loan will send you a 1099 because it’s considered income.

If yours is a non-recourse loan, the bank cannot go after your other assets to collect on any remaining debt. Any debt amount left after the house is sold to pay off a non-recourse loan is not considered cancellation of debt income. So you will not receive a 1099.

9. Can I hire any agent to handle my short sale?

It’s in your best interest to hire an agent well-versed in short sales because they are different than a traditional listing.

Lenders require a lot of financial reporting that needs to be gathered and coordinated. Your agent will also help coach the buyer on how the short sale process works and keep their expectations realistic.

There’s a high rate of fallout when buyers don’t understand what’s happening during a short sale. When your buyer backs out, you’ll need to start the short sale process all over again with another buyer.

“Mortgage companies want you to use an agent to help you through a short sale,” says Soldwisch.

“Lenders are happy to pay the real estate fees because they know the short sale will be more successful if an experienced agent handles it. But, if you hire an agent who hasn’t gone through the process before, then you’re rolling the dice and hoping that it’s going to be successful.”

A binder of paperwork related to a short sale in real estate.
Source: (NORTHFOLK/ Unsplash)

10. What are the alternatives to a short sale?

Believe it or not, the government and your lender don’t want you to default on your mortgage and face foreclosure—it’s bad for the economy and your lender’s bottom line.

So the government provides a lot of resources to help you avoid foreclosures and short sales.

“One option is to borrow funds to make improvements to the house in order to raise the market value. Then you can sell it at a higher price to pay off the loan, including your delinquent payments, and maybe even get some money out of the property,” suggests Soldwisch.

“Also, many mortgage companies offer loan modification options, which restructure the loan terms. Rather than making up your missed payments, the deficiency total is added onto your principal loan balance. I’ve had clients do that.”

One such modification option is the FHA-Home Affordable Modification Program (FHA-HAMP). This program helps FHA homeowners who are behind on their mortgages to reduce their monthly payments and avoid foreclosure, if you qualify.

11. Is a short sale right for me?

When debt threatens the roof over your head, the situation becomes desperate and a short sale may be the only viable alternative to foreclosure. But that’s not always the case.

“I’ve had financially distressed clients behind on their mortgage payments who didn’t realize they had equity built up. We were able to help renegotiate the loan terms, or sell the properties to pay off their debts. A few even walked away with a bit of a payoff,” recalls Soldwisch.

“So, even if you feel hopeless, there are options and remedies that can help.”

When in doubt, reach out to a HUD-approved housing counseling expert who can help guide you toward the best available solution.

Header Image Source: (Francesca Tosolini/ Unsplash)

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