What to Know About Short Sales

A short sale occurs when the proceeds of a home sale fall short of what the seller still owes on the mortgage. As scary as it may sound, it can help you avoid foreclosure.
Neutral Home Exterior With "For Sale" Sign

Neutral Home Exterior With "For Sale" Sign

By: Douglas Trattner

It's a position no homeowner wants to find themselves in: having to sell their home at a loss. Known in the real estate trade as a "short sale," the situation occurs when the proceeds of a home sale fall short of what the seller still owes on the mortgage.

As depressing as this scenario might sound, it certainly beats the most common alternative: foreclosure.

"Homeowners can find themselves in this situation by putting very little down on the house when they bought it, taking out sub-prime loans with rising mortgage payments, or removing a lot of equity through home-equity loans," explains Sherrie Bennett, a Seattle-based attorney.

Nobody wants to sell in a down market, but circumstances such as divorce, illness or unemployment may make it impossible for a homeowner to stay on top of mortgage payments.

With a short sale, the seller is left with a balance still owed to the bank. In these situations, the bank can hold the borrower liable for the full amount, reduce that amount to something more manageable or decide to forgive the debt altogether.

"This happens more often than you might think," Bennett says of debt forgiveness. "If the situation occurs through no fault of the homeowner, and they don't have many attachable assets, the bank may forgive the balance."

Financial Implications

Technically, any amount of debt that the bank forgives is considered taxable income in the eyes of Uncle Sam. And until December 2007, that included unpaid mortgages. That means homeowners who were facing foreclosure were also taking on huge tax liabilities.

The federal Mortgage Forgiveness Debt Relief Act of 2007, enacted in December, now excludes this amount as taxable income. The bill created a three-year window for homeowners to refinance their mortgage and pay no taxes on any debt forgiveness that they receive. Consult your tax advisor for details.

Something else to consider: Let's assume you purchased a home for $250,000 and were compelled to sell it for just $200,000. That $50,000 loss is not tax deductible. "You can't deduct losses on a primary residence," Bennett says.

Still, doing a short sale is far better than being dragged into foreclosure. Not only does a homeowner have to suffer the hardship of being evicted from his or her own home, foreclosure significantly impairs one's credit. The inability of a borrower to keep up with house payments, inarguably one of the most important personal financial obligations, would prove a huge red flag to any potential future credit providers.

"Foreclosure would be the last thing a homeowner wants to happen," Bennett says.

Your Options

While short sales and foreclosures are becoming all-too-common occurrences in this slumping housing market, Bennett says there are alternatives.

Consider, for example, taking in boarders, renting out the home or borrowing money from family to weather a temporary financial crisis. If a short sale or foreclosure seems imminent, talk to your lender as soon as possible. "Banks may be willing to lower interest rates or reduce monthly payments to keep the owner in the house," Bennett says.

If you find yourself unable to keep up with your mortgage payments, follow the advice of the U.S. Department of Housing and Urban Development (HUD):

  • Don't ignore the problem
  • Contact your lender as soon as you realize there is a problem
  • Open and respond to all mail from your lender
  • Study the foreclosure laws and timeframes in your state
  • Contact a HUD-approved housing counselor by calling (800) 569-4287 

Note: Homeowners should always seek the advice of a professional in situations like these.

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