As the housing market has softened and in many cases, imploded, a lot of people have found themselves facing the unthinkable: foreclosure. People who in normal times would just sell their home and downsize when things got tough are now left facing the reality that they owe $20,000, $40,000, or even $100,000 or $200,000 more on their mortgage(s) than their house is worth. Most folks don’t have that kind of money to bring to closing to sell their house, so many of them have turned to the short sale option to resolve the situation in a way that is equitable for both them and their creditors.
While there are some negative consequences of a short sale, there are also many benefits.
Better Credit Rating
A foreclosure can be very damaging to a person’s credit, making it very difficult for the person to purchase a home in the future once normalcy returns to his or her financial circumstances. Under current (August 2012) lending guidelines, a person with a foreclosure on their record will not be able to purchase a home for at least 4-7 years. However, if foreclosure proceedings are never started (seller stays less than 90 days late), but instead the person sells the home as a short sale, that time is reduced to only two years (could be more if there are other credit problems). It is important to note that to achieve the best results credit-wise, pristine credit should be maintained on all other accounts both during and after the short sale.
Reduction Of Liability: Money Owed After The Sale
While the ideal situation is for a bank to completely forgive the loan there are times when a person accepts a promissory note or even agrees to completely pay off the rest of the mortgage loan after closing a short sale. In these situations a short sale is beneficial because it reduces the amount owed. A foreclosed home generally sells for less in addition to having fees tacked on for the foreclosure proceedings ($30,000 to $60,000 by the estimates I have come across). If the seller were to have liability for the difference after a foreclosure it could be much higher, thus making a short sale a great way to reduce that amount substantially. NOTE: Not all loans are structured so that the seller will have liability after a foreclosure so it is important to check with your Real Estate Attorney about your individual situation.
Reduction Of Tax Liability
The short sale offers a reduction of tax liability in two ways. The first is quite simple. Assuming that the bank forgives the unpaid portion of the debt completely (and this is the majority of what I see here in Arizona), the bank will issue a 1099-C for the forgiveness of debt. Depending on the person’s financial situation this amount may be taxable as ordinary income. Therefore, considering that the bank nets substantially more in a short sale than they do in a foreclosure, it is quite beneficial to the seller to reduce his or her tax liability by selling the home short rather than letting it go to foreclosure. Note that there is no cancellation of debt income on a non-recourse loan, but many homeowners have done cash-out refinances and these loans are often recourse loans. Additionally, investors do not enjoy the same protection as people who are residing in the property they own, so a consultation with your Accountant is a MUST.
Another benefit of a short sale that few people realize is that it dramatically affects how much capital gain (or loss) you have to report on your tax return. In a short sale, the sales price is whatever you sell it for, which in many cases may be much less than the basis (previous purchase price). In that case you would report a loss on your tax return. However, let’s say you purchased the home 10 years ago, refinanced and paid off some credit cards and maybe financed the kids’ college educations (all considered cash-out) when things were great, but now need to sell. You purchased the home for $160,000, can sell for $250,000 but have mortgages on the property that total $425,000. With a short sale, your gain is the current sales price minus the original sales price, which in this scenario equals $90,000 (may possibly be excluded under IRS guidelines).
However, if you let that home be foreclosed upon, the deemed sales price is the amount of debt you owe on the property. So now your gain is $425,000 – $160,000 = $265,000. That’s a huge difference, especially when you consider that they will also issue you a 1099-C for the difference between the amount owed and what they actually sell it for if they forgive the debt. The bank may pursue a deficiency judgment if it is within their rights due to the fact that you took cash out and now have a recourse loan. It is wise to consult your accountant before short selling OR letting your home be foreclosed upon because either option could have some consequences that you did not foresee.
Doing The Right Thing
Many homeowners struggle with the moral implications of walking away from their home and allowing the bank to foreclose if it is within their means to pursue another option. Even though most homeowners are really sick and tired of their banks by this point, they still feel that it is important to honor the obligation they created when they signed the paperwork promising to pay back the loan. A short sale is a way to meet that obligation in a way they can manage and in a way that is less painful to their creditor than a foreclosure. In this case, a short sale is an excellent way to provide a win/win situation and prevent a family’s financial demise in the process.
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