If you fail to make payments on your mortgage and go into default, then you run the risk of having the bank take your house in foreclosure proceedings. If you have lost your job or other income, then it seems inevitable that the foreclosure will happen and significant damage to your credit history will result. However, there may be possible options available to avoid the financial consequences that happen after foreclosure. One of those options is a “short sale”, also known as a preforeclosure sale.
In a short sale, the homeowner makes an agreement with the bank to sell the house for less than what is owed on the mortgage. The bank would then generally accept the proceeds of the sale as full satisfaction of the loan in many cases. For example, if a home has a $200,000.00 mortgage, the bank could accept a short sale offer of $160,000.00 in full satisfaction of the loan is sold at that price. The advantage to the homeowner is that an actual foreclosure is avoided and the damage is minimized. The advantage to the bank is that they do not have to spend money on foreclosure by advertisement proceedings or judicial proceedings. In addition, the bank will not have to manage the property after foreclosure until they find another willing buyer. It seems like a win for both sides, but homeowners should be aware of all the pros and cons that come with a short sale.
For starters, the lender must agree to allow the property to sell in short sale proceedings instead of foreclosure proceedings. From the bank’s prospective, they would opt to accept a short sale if they determine it will net a greater financial return then going through with the foreclosure process and then selling the property themselves. The first step for the homeowner in starting the short sale process is call the lender and ask to speak to the loss mitigation department to obtain a short sale package. There is a number of documents that need to be provided to the lender before they will even think about considering a short sale which include, but are not limited to:
- Authorization To Release Information Form
- Hardship Letter
- Financial Information worksheet
- Listing agreement with realtor and any signed purchase offer.
- Mortgage and lien information for each and every outstanding mortgage and lien against the property.
- Copies of signed federal and state income tax returns from the last two years from all borrowers.
- Copies of all bank statements from the last two months for all borrowers.
- Copies of the two most recent pay stubs from all borrowers.
- Signed Request for Individual Tax Return Transcript (IRS Form 4506-T) for all borrowers.
- If the loan is not already escrowed, provide copy of the most recent property tax bills, current insurance declaration pages (for fire, flood, wind etc.) and current homeowner’s association fees with proof of current payments for all.
- If there is a homeowner’s association, then a resale certificate will have to be provided.
- If FHA loan, complete HUD Form 90045 (Approval to Participate Preforeclosure Sale Procedure Property Sales Information Property Occupancy & Maintenance) or other forms as updated by the government from time to time.
The homeowner must generally be able to demonstrate financial hardship to the lender and an inability to make payments on the mortgage. Some examples of accepted hardships include unemployment, death of spouse, or inability to work due to illness or other medical conditions. Homeowners may have to consider missing a payment or two on their mortgage deliberately to show the lender they are serious about their inability to pay. The lender evaluates any claimed hardships on a case-by-case basis. Even if the lender does not find or accept a claimed hardship, it may still be willing to agree to a short sale if it determines it can still make more money than going through traditional foreclosure proceedings.
The end result of a short sale or foreclosure is that you will lose your home. However, a short sale has some advantages over a foreclosure that may help the former borrower get back on his or her feet sooner:
- FUTURE FANNIE MAE LOAN: Generally, a homeowner who loses a home to foreclosure is ineligible for a Fannie-Mae backed mortgage for a period up to 7 years. However, a homeowner who successfully closes a short sale will be eligible for a Fannie Mae backed mortgage after only 4 years (or 2 years if there were extenuating circumstances). B3-5.3-07. Extenuating circumstances are nonrecurring events that are beyond the borrower’s control that result in a sudden, significant, and prolonged reduction in income or a catastrophic increase in financial obligations such as divorce, death of family member, job loss, high medical bills or major casualty to property such as fire. B3-5.3-08.
- FUTURE FHA LOAN: Generally, a homeowner who loses a home to foreclosure is ineligible for a new FHA loan for a period of 3 years. However, a borrower can be eligible for a new FHA loan right away following a short sale if “all Mortgage Payments on the prior Mortgage were made within the month due for the 12-month period preceding the Short Sale” and” installment debt payments for the same time period were also made within the month due.” HUD 4000.1. In addition, “[t]he [lender] may grant an exception to the three-year requirement if the Short Sale was the result of documented extenuating circumstances that were beyond the control of the Borrower, such as a serious illness or death of a wage earner, and the Borrower has re-established good credit since the Short Sale.” Id. Divorce is generally not an extenuating circumstance but an exception can be granted on a case-by-case basis if the mortgage was current at the time of the short sale, the ex-spouse received the property, and there was a short sale which followed.
- CREDIT SCORE HIT: A foreclosure can result in a drop up to 300 points on the borrower’s credit score for 7 years. However, the drop is much lower after a short sale, generally not exceeding 100 points. A short sale is generally reported as “paid as agreed”, “paid as negotiated” or “settled”. Any late payments leading up to the short sale will also reduce credit score somewhat, but not as severely as a foreclosure.
- CREDIT HISTORY: A foreclosure will appear and remain on a person’s credit history for at least 10 years. However, there is no such entry on credit history for “short sale”. The result of the short sale transaction on your credit history will be that the loan is paid in full or settled.
- DEFICIENCY JUDGMENT: A foreclosure sale may not satisfy the full unpaid amount of the mortgage, so the lender could add insult to injury by pursuing a deficiency judgment against the borrower for the unrecovered balance. In a successful short sale, the borrower may convince the lender to waive the right to pursue a deficiency judgment if the house sells for a minimum amount. Some lenders may be willing to accept as little as 80% of the amount of the outstanding mortgage in full settlement and will decline the right to pursue the rest.
A short sale will also avoid the other collateral consequences that come with a foreclosure. For example, a foreclosure can affect current employment, future employment and even government security clearances because it creates concerns about the individual’s ability to manage sensitive financial affairs. A short sale does not have these effects.
However, there are still some drawbacks to a short sale that have to be considered:
- NO MONEY RECEIVED FROM SHORT SALE: By its very terms, any money realized from the home sale will go to the lender. The borrower will not get a single dollar.
- LENDER MAY NOT APPROVE AND WASTE TIME: Despite providing everything requested in the application process for a short sale, the lender may still not approve your request and move forward with traditional foreclosure proceedings. The lender may refuse because they are not satisfied there is a financial hardship or they believe the market value of the home well exceeds the debt owed. This wasted time could have been better spent on other alternatives such as the borrower listing the home for sale during a seller’s market for maximum return, filing for bankruptcy, modifying the terms of the loan with the lender, or even executing a deed in lieu of foreclosure.
- TAXES MAY BE OWED ON FORGIVEN DEBT: If the short sale is successful, the lender may forgive a portion of the debt owed. However, the Internal Revenue Code considers forgiven debt to be taxable income. The lender will issue Form 1099-C to both the borrower and the IRS indicating the amount of the loan that was forgiven, so you can be sure that the federal government will be looking for the borrower to declare that amount on his or her income tax return and pay any taxes owed. It is possible that this amount can fall under the sale of primary residence exclusion for gain, but you should consult with a tax professional to be sure if this will apply to your situation.
A short sale may be a good option to avoid foreclosure proceedings, but whether or not it fits your situation is best determined in consultation with skilled legal counsel. If you or a loved one have further questions about short sales and foreclosures or need legal representation, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.