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 the property for less than the amount owed 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 that 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 judgement 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 judgement).

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 judgement on the homeowner's credit report; however, there is another implication. The $30,000 that the homeowner did not 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 the $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.