Simply speaking, a short sale is when a bank or mortgage lender agrees to allow a homeowner to sell their home for less than the outstanding balance on the home. Lenders often only consider this option if it makes if the cost of a foreclosure is greater than the loss it will suffer as a result of the short sale. Typically, lenders do not accept short sale offers or requests for short sales until a Notice of Default has been issued or recorded with the locality where the property is located. In other words, the lender wants to be assured that the homeowner truly is suffering financial hardship at the time the homeowner requests short sale relief.
As the foreclosure epidemic continues unabated, more and more people are considering the option of a short sale on their home to avoid foreclosure. While many real estate agents are touting this option as a way to avoid the impact on the homeowner’s credit, there are other consequences that any potential homeowner must consider as well.
First, in some states like Texas, even if the lender agrees to the short sale, it may be still come after the homeowner for the difference between the amount owed and the amount of the sale, even it approved the short sale. This is known as seeking a deficiency judgment. Indeed, some lenders may not tell a homeowner this until well down the line when the homeowner is less likely to back out. The key issue to consider is whether the loan is a "recourse" or "non-recourse" debt. If the debt is recourse, the lender can come back after the borrower, even if the short sale has been approved. If the debt is non-recourse, the lender’s only collateral is the property itself.
Fortunately for borrowers, Arizona has anti-deficiency statutes to protect against a lender going after a borrower for any deficiency.
The other major consideration in a short sale is the potential tax hit to the seller. As if they pressures of a potential foreclosure are not enough, the IRS may hit you for any forgiven debt. In other words, if the bank agrees to a short sale, any amount between what was owed on the mortgage and what the property sells for may be viewed as income by the IRS.
Mortgage Forgiveness Debt Relief Act of 2007
As the foreclosure crisis mounted, Congress and President Bush took action. The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007. Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage or foreclosure on a homeowner’s principal residence.
Usually, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. The Mortgage Forgiveness Debt Relief Act of 2007 allows an owner to exclude certain cancelled debt on his or her’s principal residence from income.
The Act applies only to forgiven or canceled debt used to buy, build or substantially improve the owner’s principal residence, or to refinance debt incurred for those purposes. Rules for debt forgiveness:
- The debt must have been discharged by the lender in 2007, 2008, or 2009.
- The amount of debt that can be excluded is limited to $2 million.
- The exclusion can be used only if the loan was taken out to acquire, build or substantially improve a principal residence. Forgiveness of debt on vacation homes, second homes and investment property doesn’t qualify. This is a huge exception given the number of speculative investment purchases that have helped fuel the foreclosure crisis.
- Debt forgiven on a cash-out refinance or home equity loan must be apportioned between the amounts used for home acquisition, construction or improvement and amounts used for other purposes such as tuition, travel or repayment of other debts. Only the allowable portion qualifies for the tax break, says John W. Roth, a senior tax analyst at CCH, a provider of tax services, software and information in Riverwoods, Illinois.
So, if a lender accepts a short sale, and the borrower does not meet the exceptions above, again, the IRS normally views the discounted loan amount as income. For the real estate investor, the taxable income may be used to offset other income, but that is an issue best handled by a tax adviser.
In the end, while the short sale seems like a good option on first blush, any sale is discretionary the part of the lender and it will take a significant amount of time to consummate any transaction. Finally, a short sale can have tremendous tax implications to a seller. This is an issue I am not sure that real estate agents are in a good position to advise their clients of. Sellers need to understand there are several issues at play in a short sale, and jumping in without adequate advice can only add more trouble to an already difficult situation.