October 2011 The Short Side of Short Sales Short sales are good for lenders and can be great for buyers. But for many homeowners, a short sale is not the cure-all they were expecting Dave Baker

We frequently consult with homeowners who are in the difficult position of negotiating with their lender about the status of their home loan. If you are unable to make your house payments, it is very likely that you will have to confront the loss of your home.

The three most common ways of relinquishing distressed property are foreclosure, deed in lieu of foreclosure, and short sale. The last of those three options is the focus of this article.

Background

In a typical short sale, you find a buyer for the property, at a price that is less than your loan balance. The lender agrees to accept the buyer and remove the portion of the lien that exceeds the sales price.

For most lenders, a short sale is the preferred method of dealing with a defaulted loan, since the lender gets a new buyer, and the house never goes vacant. Meanwhile, you get the benefit of avoiding a foreclosure on your credit rating. (The value of that benefit is subject to debate, as is discussed later in this article.)

Unfortunately, for many borrowers a short sale is not the cure-all for which they had hoped. While the lender and new buyer are undoubtedly better off, you (as the former homeowner/borrower) can get burned if the transaction is not handled correctly. Your financial exposure after a short sale can come from two directions: (1) a loan deficiency lawsuit filed by your lender, and (2) federal income tax on the unpaid portion of your loan.

Loan Deficiency

First, consider the status of the “deficiency” that resulted from the short sale. Suppose you sold your home for $250,000, and your loan balance was $400,000. Do you have to pay the remaining $150,000?

In Arizona, “anti-deficiency statutes” prevent lenders from foreclosing on a property and then suing the borrower for the unpaid loan balance. These are powerful and effective consumer laws that, during our severe recession, have saved thousands of homeowners from bankruptcy.

However, a short sale is not the same thing as a foreclosure. Some lenders take the position that, after a short sale, you still owe the deficiency, and they can try to collect from you for the next six years. Would they win? The courts have not decided this one yet, but you do not want to finance a lawsuit against a bank in order to get the answer.

The solution: Before agreeing to anything else in a short sale, be sure that the lender agrees – in writing – to give you a full release from liability for the unpaid loan. Then have an experienced real estate attorney review the documents. If the lender refuses to give you a written release, stop the process then and there; all they can do is foreclose, and the anti-deficiency statutes will protect you from post-foreclosure collection efforts.

(It is important to understand that Arizona’s anti-deficiency statutes do not apply to foreclosures on all loans that are secured by your home. If the loan was used to purchase your home, you are probably safe. But if the loan was for other purposes, such as a home equity line of credit, the lender can sue – but only if it waives its right to foreclose).

Tax Liability

In addition to deficiency issues, beware of tax on “phantom” income. When a lender lets you off the hook from a portion of your mortgage, the IRS can, under certain circumstances, treat the “forgiveness of debt” to be ordinary income. That means that, continuing with our example above, in the year in which your debt was forgiven, your taxable income may increase by $150,000 even though you did not see a dime of it.

Thanks to current federal law (which is scheduled to expire at the end of 2012), a foreclosure of your principal residence will not result in taxable income. Also, debt that is “non-recourse” does not result in income when it is forgiven (because it was not a personal obligation anyway).

However, once again, short sales are not foreclosures; thus, the tax liability protection contained in federal law may or may not apply to debt forgiveness stemming from a short sale. And, since the anti-deficiency statutes might not apply to short sales, there is an argument that you have been released from “recourse” debt, even when the lender does give a full release. Some lenders are reporting canceled debt to the IRS, via a Form 1099, showing as income the amount of debt forgiven in conjunction with a short sale. The result: The IRS has been told you have received income – perhaps lots of it. Whether you would actually have to pay tax on that amount is uncertain, but you don’t want to sue the IRS in order to find out.

Conclusion

If your motivation in pursuing a short sale (instead of submitting to foreclosure) is to protect your credit rating, consider this: We have been advised (in legal seminars, by speakers who should know) that a foreclosure will hit your credit rating to the tune of about 227 points, while a short sale is worth about 215 points. For most people, that small difference does not warrant the risks inherent in a short sale.

Again, short sales are good for lenders, and they are great for buyers. But for homeowners who don’t get legal guidance in assessing their situation, a short sale can leave them on the short end of the transaction.