One of the many solutions we offer to overwhelmed homeowners is the opportunity for a short sale. The following briefly describes the short sale option.
What is a short sale?
A short sale is an opportunity for financially distressed homeowners who have encountered hardships. In a short sale, an overwhelmed homeowner sells his home for less than the value of his loan (or the net proceeds from the sale are less than what is actually owed). The lender accepts the sale as payment in full (or “paid as agreed”) for the loan. The difference between the accepted sales amount and the loan balance is called a deficiency. The following example illustrates a short sale:
John, who is a couple of months behind on his mortgage payments, has his home listed for sale. John receives an offer to purchase his property for $175,000 however his current mortgage balance is $200,000. Clearly, there is a difference of $25,000 between what has been offered and what is owed to the lender. A short sale, or “short pay”, must be negotiated. The bank must accept $175,000 as payment in full for what it’s owed otherwise the sale cannot occur (as John, already months behind on his mortgage, cannot afford to come out of pocket for the difference).
What is a deficiency?
As mentioned above, a deficiency results when a property is sold for less than the value of the loan on the property. A deficiency is the difference between the sales and loan amounts. Rick Mauch attempts to secure a purchase contract that results in the smallest deficiency amount possible. The smaller the deficiency the more likely the bank will accept the terms of the short sale.
In many states, a homeowner may always be pursued legally for a deficiency balance. However, in many situations, this is not the case in Arizona. As outlined in Arizona Revised Statutes, Title 33, Chapter 6.1, a person may not be sued by his lender if the property is located on 2.5 acres or less and is a single family residence or duplex. This only applies if the decrease in value is not due to the homeowner’s neglect.
Though a homeowner may not be pursued legally for a deficiency in certain situations, the forgiven debt may be taxable income. I strongly encourage all homeowners to discuss this matter with a licensed accountant prior to pursuing a short sale. We are not a licensed accountant and do not advise clients regarding tax matters.
Why would a lender agree to a short sale?
Generally, if a homeowner has a legitimate hardship and is in financial distress, and it is determined that the proceeds the bank will receive in a short sale exceed any other options the bank has to recover its funds, the short sale has a high likelihood of being approved. Of course, there are several other criteria used in the bank’s analysis, hence why it is imperative to have a skilled short sale negotiator representing you in the transaction.
A lender would agree to a short sale for several reasons including:
• The mortgage is in default or foreclosure
• The property is in poor condition
• The homeowner has suffered a hardship and can no longer afford payments
• The area or neighborhood has depreciated in value
• New homes in the area are being chosen over existing homes
• The bank’s shareholders are concerned when there are too many defaulting loans on the books
• Some banks are required to have loss reserves of 6 times the retail value of each REO on hand
• An REO is a liability, not an asset, and too many liabilities will cause the bank to go under
Why would a lender NOT agree to a short sale?
There are a few reasons why a lender would not agree to a short sale. These reasons may include:
• Two-thirds of all mortgages are securitized and sold on Wall Street. Servicers must abide by agreements with Wall Street investors that limit their ability to modify the terms of short sales
• Carrying out a foreclosure eliminates junior liens
• The lender is covered by private mortgage insurance
Who Qualifies for a Short Sale?
The decline in market value of a property below the total debt owed on that property does not automatically qualify a homeowner for a short sale. Banks take several factors into consideration when determining if it will allow for a short sale to occur. First and foremost, the homeowner must have experienced some sort of hardship that has caused her to no longer be able to afford her mortgage payments. Hardships include but are not limited to loss of job, divorce, death in family, significant decrease in income, medical issues, inability to pay higher adjusted interest rate on the mortgage, bankruptcy, and other unforeseen circumstances that cause financial burden. The bank will request that the homeowner write a detailed hardship letter explaining their situation. Next, the bank will analyze the homeowner’s current financial situation by requesting items such as bank statements, pay stubs, tax returns, and/or other relevant financial detail. The reason for this is twofold – first, the bank wants to corroborate that what is stated in the hardship letter ties to the homeowner’s financial data, and next the bank wants to be assured that the homeowner does not have significant cash reserves that could be utilized to make future mortgage payments.
New Law Passed That Impacts Short Sale Transactions
In December 2007, the United States Government passed H.R.3648 Mortgage Forgiveness Debt Relief Act of 2007 (“Mortgage Cancellation Relief Act”). The Act amends the Internal Revenue Code to exclude from gross income amounts attributable to a discharge, prior to January 1, 2010, of indebtedness incurred to acquire a principal residence.
What does this mean to you? This means that, in most cases, when a short sale is negotiated on a homeowner’s primary residence and the lender(s) opts to cancel or forgive the remaining debt (deficiency amount) the cancelled debt is no longer taxable income to the homeowner. Prior to this Act, the homeowner had to report the cancelled debt as taxable income. This usually resulted in a hefty, unaffordable tax bill! Needless to say, I strongly encourage all homeowners considering the short sale to speak with a licensed accountant to learn if they qualify under the conditions of the Mortgage Forgiveness Debt Relief Act. There may be other alternatives to limiting the potential tax liability resulting from the sale that a licensed accountant may be able to assist you with as well.