Short Sales – How they Really Work

Lunch and LearnJust about everyone has heard of Short Sales, but few people really have a handle on what they are and how they work. Let’s therefore take a minute to run through the details, using a fictional family, the Andersons, as an example.

The Basics

In 2006, Bob and Jenny Anderson bought a 2-bedroom condo in Downtown West Palm Beach for a whopping $325,000. They had good jobs back then, and they made their mortgage payments on time. Unfortunately, things for the Andersons would later take a turn for the worse. Their little boy began a long-term battle with asthma, and a month later Bob’s employer downsized his job away. Medical expenses mounted just as their household income fell, and before they knew it they were a year behind on their mortgage payments. They knew that if they could only sell the condo, they’d be in good financial shape again, but they owed $275,000 on a place now worth $175,000. There seemed to be no way out. That’s when they decided to put their place up for short sale.

As the name implies, a short sale occurs when a homeowner sells a property for less than what is owed on it. In this instance, the Andersons hired a Realtor and marketed their condo for short sale. They found a buyer willing to pay $175,000, and a contract was written. The Andersons then turned to their mortgage lender to try to get the deal approved. For the next several weeks, they submitted bank statements, tax returns, pay stubs, and profit/loss reports to their lender. The process was tedious, and they were asked for updates more than once. Finally, after about 100 days, the Andersons’ lender finally decided to approve the deal. A month later, the transaction closed. The Andersons secured a new place to rent, and they found themselves living with a surplus again.

In this instance, the Andersons had genuine “hardship” to share with their bank.  Bob suffered a lay-off right as the family was taking on medical debt. Folks with a genuine hardship typically have a better chance of getting a short sale approved. Medical bills, loss of income, divorce, a death in the family – all of these are factors that a bank might consider when deciding whether or not to forgive a borrower for a substantial portion of debt. The Andersons were fortunate. Their lender decided to let them out of their debt. The bank issued a 1099 identifying the amount of the loan that was forgiven (more on that below), but the bank took no further action. It was the ideal solution for a nice, responsible couple who unfortunately fell on hard times.

Stumbling Blocks

As you might imagine, not every short seller has it that easy. In many cases, sellers pursue the same path as the Andersons, but their lender are less forgiving.  Sometimes a bank will approve a short sale, but only if the seller makes a cash contribution to be paid at closing. Such sums can be modest – perhaps a few thousand dollars – or quite hefty, as in tens of thousands. Obviously, if a seller doesn’t have the money, the deal breaks down unless the buyer is willing to cover the seller’s tab. Buyers sometimes will, but only if the investment makes sense. If it doesn’t, the buyer will go bye-bye, sending the sellers back to square one.

In addition to cash contributions, there are other factors that can make short sale transactions challenging. Had the Andersons taken out a second loan on the property, their path to success would have been more complicated.  Primary and secondary lenders don’t always agree on who gets paid what, and if they can’t agree the deal won’t close. Or, if the Andersons had refinanced their property at some point, and taken cash out to buy a car, take a cruise, or invest in the stock market, their lender would likely be far more difficult to work with. After all, banks aren’t happy about forgiving debt when the money was used to buy things other than the subject property. In some cases, a lender will grant an approval in a circumstance like that, but only if the seller will sign a promissory note essentially agreeing to keep paying on the loan even after the property isn’t owned anymore. (Not a popular option for most home sellers, as you might imagine.) Lastly, if the condo association doesn’t get paid, the transaction can’t close. The Andersons were smart in that they kept current on their dues even when they weren’t paying their mortgage. Condo associations can be awfully ornery, so it was wise of the Andersons to keep the association out of the picture.

Tax Implications

Keep in mind that there are tax implications whenever a short sale is approved and a portion of a mortgage balance is written off. The Andersons received a 1099 for the $100,000 forgiven on their property, which is treated  by Uncle Sam very much like income. Fortunately, they were able to call upon the Mortgage Forgiveness Debt Relief Act to alleviate themselves of the tax liability on that $100,000.  But not everyone qualifies. The Andersons’ debt was entirely tied to the purchase of their condo, which was their principal residence. Had this been an investment property or second home, for instance, they would not have enjoyed that protection. Sellers who can’t qualify under the Debt Relief Act can end up with very big tax bills to pay.

Is it Right For Me?

So, with all of that said, is pursuing a short sale worth it? The answer is different for everyone. Legal counsel and tax advice should be sought before deciding.  But, for many people, there is little downside to pursuing this path. Had the Andersons’ bank responded to the short sale request with unacceptable terms, the Andersons would not have been bound by them. They could have instead withdrawn from the process altogether. They would still have an upside down property on their hands, but the short sale attempt, in and of itself, would not have harmed them.

The housing market has improved, and there’s no doubt that some folks, who have been living on the cusp, will have the need to contemplate a short sale go away completely. Others are far too underwater, and the foreclosure clock has started ticking. If you believe you might be in the latter category, find a qualified Realtor/distressed property expert and explore your options. Taking action sooner, rather than later, might make all of the difference.