The Definitive Short Sale

This article will attempt to address the following:

Define a short sale
Talk about the different ways it can come about and be structured
Talk about how it’s different that foreclosure or bankruptcy
Talk about the implications for the seller
Talk about the implications for the buyer

Definition:

A short sale is an “arrangement” between the current owner of a home and the bank that lent them the money to buy their home to accept an offer for less than the total amount owed to pay off the home. The “deficiency” is the difference between the amount owed and what the bank collects at the short sale.

Although the “arrangement” can take many different forms, there is no other definition of a short sale. I say this because many realtors and some investors simply throw the term around as if it meant “a sale under market value.”
No. A bank owned (foreclosed) house is not a short sale. A seller deciding to lower their price and take less profit is not a short sale. An elderly lady that owns her home free and clear, selling a $150,000 home for $75K is not a short sale. For ir to be a Short Sale, someone must be getting “shorted”. Either the seller or the bank.

Another important definition of a short sale is how it differs from foreclosure. In foreclosure, the homeowner fall way behind on their payments and the bank repossesses the house and sells it. In almost all cases, the bank pursues that homeowner for the deficiency!!! No one seems to know or believe this, but just ask someone who has gone through foreclosure, they will tell you the only way out of this is to file bankruptcy.

How It Can Happen – The Arrangement

Most short sales arise when a seller owes more on their house than they can sell it for (upside down). The owner of the home then attempts to make an arrangement with their lender to sell the house for less than it owed. The term “arrangement” was used in the definition and is intentionally broad because the arrangement depends on the bank that holds the loan. Though there are general practices, every bank does it differently. This articlle will give you the most common arrangements, but if you take part in a short sale, it’s crucial you assume nothing until you have the bank’s policies in writing.

There are some overriding principles:

There is no such thing as a free lunch. This is not some dream come try alternative to foreclosure where the money you owe magically disappears. The deficiency will be accounted for. The deficiency can be 100% loaned to the seller in the form of promisory note, which they then must repay.
It is a cumbersome proces. If you are entering into a short sale as a buyer or seller, don’t expect it to go as quickly as any other sale. There’s a lot of “back and forth”
The employees of the lender that are negotiating th sale ARE NOT there for the benefit of the seller. Their only goal is to collect as much money possible for the lender and they will use whatever means necessary. You can be sure they will misrepresent their own policies and flat out LIE to the seller in order to intimidate and scare them into paying more money. If you think I’m exaggerating, the joke will be on you.

For instance, I was once told by a lender negotiating a shor sale that as a policy, they don’t “write off” any of the deficiency and that the seller would have to have a promissory note for $40,000. This lender also told the seller that their hands were tied and this decision came directly from the investor who provides the money for the lender. The lender also said there is absolutely no negotiation on the amount owed, either pay the deficiency or they will foreclose. The lender made the promissory note very manageable (20 years 0% interest) so that the seller would be more enticed to just roll over.

But the seller called the lenders bluff. The seller then provided a letter from an attorney stating they would qualify for a bankruptcy, thus rendering the lender incapable of collecting anything. That same day, the lender called saying they would reduce the promissory note and write off $30,000 of the debt! It would have to be reported as 1099 income, but it would not have to be paid. Amazing change of policy! Then the seller saw what was happening and just said, “no thanks, we don’t want to owe you anything, we’ll just go ahead with the bankruptcy.” Two days later the seller received a written offer that the lender would completely forgive the debt and simply report it as 1099 income! WOW!

The moral of the story is that the lenders will LIE to obtain their money. Many of the managers of the collections departments are paid on COMMISSION on how much they collect. Just imagine if that seller had rolled over on the first offer! That employee would have been responsible for keeping $40,000 of his company’s money with one five minute phone call.

One other important thing to remember is that if the lender gets. the property back (i.e. short sale doesn’t go through), they have to put it up for auction. This creates the risk that additional money will be lost if the house doesn’t sell for what it is worth. In the case of the example, the short sale offer was for $550,000 and the amount owed was $590,000. The seller faxed in evidence to the lender that most similar houses in the area were now selling for $480,000. So this enabled the seller to make the argument that it was a much more prudent risk to write off $40,000 instead of running the risk of losing $110,000. The seller’s representative was then able to intimidate the employee of the lender asking him “did he really want to be responsible for losing his company $110K when he had the option, right now, to settle for 40K?”

If it seems like I know a lot about “this example” it would be because I was the mortgage broker for the people making the offer and the seller of the property happened to be my wife.

The Details of the Arrangement

Different banks have different policies. The best case scenario is to get a bank actually “writes off” the deficiency. All that happens here is that the seller has some minor derogatory credit reporting, but doesn’t actually owe the bank any more money. This credit reporting can consist of anything from “creditpr settled for less than the amount due” all the way to “foreclosed.”

As the example noted, many banks will fo a promissory note for the deficiency.

Some bank are stupid enough to require that the deficiency be paid at cloing. Think about it. This does no good because it’s the same thing as a seller selling their house without doing a short sale and simply bringing cash to the table. If a bank tells the seller they need to bring cash to the table in a short sale, they are either idiotic, or more likely LYING.

In cases where the money is “written off” it’s important to understand that the lenders will never actually “write something off.” In most states (I don’t know the law in every state), the lender has the ability to show any deficiency as 1099 income for the seller. All this really means is that the seller has to pay taxes on that income. Depending on one’s situation, it could mean that people that are dependent on some form of aid because of “low income” will have some explaining to do come tax time.

Another way that the deficiency can be written off is in the form of a judgment. This will often occur in conjunction with the 1099 reporting. It might say something on the seller’s credit report such as “judgment filled against John Doe in the amount of $xx,xxx by ABC lender.” This will appear in the “public record” section of the seller’s credit report for 10 years (7 years is only for late payments, 10 years for public record info). It can either show up as satisfied or unsatisfied. Satisfied is obviously better because it means that the worst thing that can happen is that the lender will report 1099 income.

Unsatisfied could be a problem, because it means that a court has found in favor of the lender to collect the deficiency from you. Now they still might simply do the 1099 thing, or they might try to collect it from you. They can keep trying to collect it from you until they get it. The can garnish your wages. Your only hope then is that you qualify for a Chapter 7 bankruptcy.

This brings up an important note. Never ever assume that a debt that you owe a lender is gone unless you have the details of the release of that debt in writing. For instance, someone who had done a short sale had a first and second loan. The bank agreed to a short sale, which ended up being enough to pay off the first loan, but not the second loan. The seller assumed that because the bank agreed to the short sale that they wouldn’t have to worry about the deficiency from the second mortgage. Now they are surprised that they are being pursued for the deficiency. Remember, the lender(s) will always want ALL their money accounted for somehow. NEVER assume something is written off unless you have a formal, signed, written, unconditional release of lien and/or judgment the lender specifically stating that no further action to collect this debt will be taken.

How did we get to this place?

A short sale can come about for many different reasons. In my wife’s case, she was the owner of the house and had been making payments. We bought an investment property and put it solely in her name to protect our family in the event the market took a turn for the worse. It did. We owed $590,000, but the best offer we had after 6 months was $550,000.

Despite popular belief, you do not have to be behind on your mortgage to request a short sale. You just have to demonstrate that your house can’t be sold for what you owe.

In other cases, short sales happen when a seller can’t afford to make their payments and is nearing foreclosure or bankruptcy. It makes life much more complicated if you are living in the house in question. The bank’s ability to scare you is much greater in that case. In this case, a short sale is only slightly better than the alternatives. You will still lose your house, and your credit is still destroyed just because you’ve made 4-5 late payments on your mortgage.

Despite popular belied, a bankruptcy, foreclosure, or repossession do not hurt your credit as much as the multitude of late payments that often lead up to them!!! I just cannot stress this enough. People think that a bankruptcy damages their credit beyond repair in and of it’s own accord. I’ve had many clients file bankruptcy with 750 scores and no late payments only to have their scores drop to 680. It’s the clients with 20+ late payments that are having their credit hurt.

A final not on how the short sale can come about. Most banks will not agree to a short sale in writing until you have a formal offer. You can simply call your bank and ask them if you could do a short sale at a certain price and they might say “ sure, no problem, we’d be happy to facilitate that offer.” BEWARE. That doesn’t mean a thing. Before your short sale Is APPROVED, you’ll have to submit an application, hardship letter, financial statements, tax returns, pay stubs, the purchase agreement from the buyer, a HUD statement from the pending transaction, payoff letters from all lenders involved and several other things depending on the lender.

Once this huge packet of information is submitted to the lender, they will acknowledge receipt of the package in 1-4 weeks and their TERMS and APPROVAL could take 6 weeks to 6 months according to the lender. Be warned their approval will most likely be thinly disquised attempt to collect their debt and will almost never be the “write off” you were hoping for.

Conclusion

Again, a short sale is not a magic cure, it’s also not some mystical solution that only an elite few know about. It’s usually not easy and hardly ever will truly “win.” But in most cases, it can leave you much better off than the alternative of foreclosure and bankruptcy.

Remember, that this is a complex process and you should always seek the help of a professional when considering a short sale.

UPDATE:

Below you will find an excerpt from the irs.gov website concerning taxes on deficiencies to the lender as a result of a short sale.

The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

More information, including detailed examples can be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17.

Source: Matthew Graham
Mortgage Backed Securities