FYI on Short Sales

The following is a condensed version of the most popular questions a seller may have on short sales. As a REALTOR®, I am not licensed as a lawyer or a CPA and cannot advise on all matters of the short sale process. Please obtain advice from a competent real estate lawyer on legal issues and discuss with your accountant on the tax ramifications that may be unique to your specific situation.

What is a short sale?
A short sale, also known as a short pay or short payoff, allows a homeowner to sell their property for less than the amount owned to the bank. When the market value of the property is less than the amount owed, the owner is considered up-side-down. The proceeds from the sale are used to pay-off the outstanding amount of the mortgage. Although the proceeds will be “short” amount actually owed on the mortgage, it allows a homeowner the opportunity to avoid foreclosure. Ultimately it may put their credit standing in a better position than if an actual foreclosure were to take place. The entire process hinges on the approval of the lender to accept less than the amount due.

What are the credit implications to a short sale?
The property owner's credit could be negatively and severely affected. Here is why. Say the homeowner owes $100,000 on the foreclosed property, but the lender only gets $70,000 from the sale. The lender can then sue the homeowner for the $30,000 difference. But, the homeowner won't have the $30,000. If he did, he most likely wouldn't have gone into foreclosure in the first place. If the lender chooses to sue, and the homeowner cannot pay, a deficiency judgment would appear on the homeowner's credit report, negatively affecting the homeowner's credit (At present, Arizona has an anti-deficiency law whereas a borrower has protection against a deficiency judgment).

Often, the bank chooses not to sue, but to take the loss as a tax write-off. In this case, there would be no deficiency judgment on the homeowner's credit report; however, there is another implication. The $30,000 that the homeowner did not have to pay would be considered by the IRS to be income. The lender will send a 1099c to the homeowner at the end of the year, and the homeowner will be required to pay taxes on that $30,000. Even when the bank chooses not to sue, the foreclosure can end up showing up in credit checks because it is a public record.

The hit homeowners take on their credit score is much less on a short sale than on a foreclosure. A homeowner involved in a short sale will see an 80 to 100 point drop on his or her credit score. A foreclosure is a 250 to 280 point hit. This is only an estimate, each individual case may vary.

What information will the bank need to decide whether to accept a short sale?
The sellers’ submission package should include W-2 forms from employers (or a letter explaining the seller is unemployed), bank statements, two years of tax returns, and other financial documents outlining income and debt obligations. The bank will also need comps or a broker’s price opinion showing your estimate of value.

In addition, the sellers should submit a “hardship letter,” explaining the circumstances that make it impossible for them to pay the full amount of the loan. The seller needs to be able to show true financial hardship. Someone with the assets or the income to pay is unlikely to be considered, say most interviewees.

What are the options besides a short sale?
Thanks to programs such as those proposed by Fannie Mae and Freddie Mac to assist sub-prime borrowers, many lenders are more willing to offer loan modification options. This option can extend the term of the loan, add on delinquent payments to the loan principal, and/or reduce the interest rate to make the loan more manageable for the home owner. Another option is a repayment plan that requires home owners to increase their monthly payments until the loan is current, says Loni Parmelly, a real estate practitioner and consultant who specializes in short sales. Another option is a “Lease to Own.” Buyer makes an agreement to make “rental type payments” to the owner over a 12 month period (example) and then obtains financing at the end of the buyer/seller lease agreement. Most often a larger down payment is given to the seller at the start of such agreement, which in case of buyer default, the seller retains down payment amount.

Loan Resolution (Loss Mitigation) Options:

Repayment Plan:

A repayment plan distributes the owner’s delinquent payments over a period of time, usually no more than 10 months. The monthly amount is added to the usual mortgage payment and brings the account up-to-date within a specified time-frame. With a goal in sight, the owner can move forward knowing that the home is secure.

Forbearance Plan: 

An agreement to temporarily allow a homeowner to pay less that the actual amount due on their mortgage or it will suspend payments entirely during the forbearance period. More commonly associated with Fannie Mae, Freddie Mac, FHA, and VA, each has various requirements a homeowner must meet. Forbearance is very situation specific so the homeowner should contact the lender directly to see if this is an appropriate option for them. The goal is to put the homeowner back on track to resume full regular payments.

Loan Modification: 

This option applies any past-due interest and escrow amounts to the unpaid principal balance, which is then re-amortized over a new term and gives the owner a fresh start on managing their loan and brings the account up-to-date immediately. There are many requirements; the homeowner must contact the servicing lender for details of their individual circumstances.

Partial Claim (only for FHA loans): 

The Department of Housing and Urban Development (HUD) advances a loan to repay the past-due interest and escrow amounts. HUD loan is interest-free and brings the account up-to-date immediately.

Short Sale: 

Allows the owner to sell the home and use the proceeds to pay off the mortgage if they are unable to maintain payments, even if the home’s market value is less than the total amount owed. Avoids the lengthy legal process involved in foreclosure and is generally less damaging to the credit rating than a foreclosure.

FHA Pre-Foreclosure/Short Sale Requirements: 

The property is owner-occupied or reasonable circumstances exist if it is not. The loan is at least 2 months delinquent. The house can sell within 3 to 5 months. A new appraisal (obtained by your lender) shows that the value of your home meets HUD program guidelines. It has been reported that FHA does not allow for short sales, which is inaccurate, FHA does allow them.

Deed In Lieu of Foreclosure: 

Allow the owner to transfer the property voluntarily to the servicing bank if the seller is unable to maintain payments and cannot sell the home at market value. Avoids the lengthy legal process involved in foreclosure. May be less damaging to the credit rating than foreclosure (this option is a foreclosure and will be reported as such).

How should the property be priced in a short sale?
In general, most short sale experts say to price the property at or near fair market value, although a few will begin with the total payoff amount owned by the seller. How frequently prices are dropped will depend in part on whether the property is in pre-foreclosure. Most banks have a formula for what percentage under market value they will accept, say interviewees. Figures cited vary from 8 percent under to almost 20 percent under.

How long does it take to complete a short sale?
Although response times vary from lender to lender, it can take two weeks or as long as 60 days to receive an approval of a short sale from a lender. That’s why it’s critical that buyers and their representative understand and accept that time frame before they make an offer.

What can the seller and I do to make a short sale more attractive to a lender?

Getting a lender to approve a short sale is primarily a question of economics. You have to provide hard numbers to show that the amount of money a bank will realize on the short sale is better than the amount it may recoup from foreclosing on the property and selling the property.

A 2002 study by Craig Focardi of the Tower Group estimated that the entire cost of a foreclosure was $58,759 and took 18 months. Other factors that can influence a bank’s decision include the liability risk it assumes by owning the property after foreclosures, the money tied up during the holding period for a foreclosure and REO resale, additional costs associated with an REO such as attorneys’ fees, and the additional reserves it will need if REO’s rise in the bank’s portfolio.

What are the seller’s options if a short sale is rejected by the lender?
There are a variety of reasons a bank will reject a short sale — from too low a price to too many files on the loss mitigation’s desk. You can look for another buyer or even try resubmitting the same contract. Banks don’t want to take properties back in foreclosure, so they are going to do everything they can to make it work. Keep in mind that throughout the process there’s the possibility of foreclosure.

What tax liabilities will a seller have as a result of a short sale?
Again, one often overlooked aspect of short sales is that a seller must count any amount forgiven by the lender as income and pay taxes on that income, even if no actual money was received. The IRS requires lenders to submit a Form 1099 stating the forgiven amount. Sellers who meet the Internal Revenue Service definition of insolvency (either in bankruptcy or with debts exceeding assets w/o bankruptcy) will not have to pay taxes on the forgiven amount. See IRS Form 982 for this exclusion. Ask your CPA for all details.

Credit Reporting

Credit scores are obviously going to suffer: there is no way around that. There are just way too many variables going into the credit score to know the actual effect of a short sale. The loan will show on the credit report as “Paid,” however, in most cases it will also note, “Settled for less than amount owed.” Depending on how far behind on payments a borrower gets, it may also reflect as “Pre-foreclosure” on the credit report. Many lenders consider 90 day past due to be a foreclosure whether or not the property was formally sold by the bank. It would be a good idea to ask for the lenders policy on reporting short sales to the credit bureaus.

This disclosure does not list all possible repercussions of a short sale. It is designed for upfront disclosure only, individual circumstances may vary. Once again, please obtain advice from a competent real estate lawyer on legal issues and discuss with your accountant on the tax ramifications that may be unique to your specific situation.

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