Short Sale: a Way Out From Under a Crippling Mortgage

On the national level, the prolonged stagnation of the housing and employment markets has had devastating consequences for the economy. On the micro-level, the effects of the stagnation can be seen in families struggling to pay bills, find work and losing homes to foreclosure. While government officials search for ways to move the country down the road to recovery, many families are left searching for ways to make ends meet.

For families who have experienced job loss, one of the biggest worries may be making the monthly mortgage payment. In situations such as this, the best possible scenario would be to sell the home to get out from under the burdensome mortgage payments and into more affordable housing.

However, for many homeowners, especially those that bought a home at the height of the housing boom, selling their home has become an extremely difficult task. In many regions, when the housing market crashed, there was a surplus of new, unoccupied housing for sale, which caused the price of homes, occupied or not, to fall. Families that purchased homes prior to the crash suddenly found themselves underwater in their mortgages – a situation where the house is worth less than what is left to be paid on the mortgage.

When a mortgage is underwater, the homeowner may feel as though the only options are to continue to scrape together the monthly mortgage payment or stop paying on the mortgage and let the home go into foreclosure. Selling the home may still be an option for the homeowner though; selling the home through a process known as a short sale.

Short Sale

A short sale is the process of selling a home for less than what is owed on the mortgage. To complete a short sale, a homeowner needs to have the approval of the mortgage holder and the assurance that the mortgage holder will accept less than what is owed for the mortgage.

A short sale will not result in a profit for the homeowner; however, the homeowner is able to walk away from the house and the mortgage without being foreclosed upon, which tends to be a much longer process.

A Few Considerations

Short sales are negotiated agreements with mortgage holders; thus, in certain situations mortgage holders may be reluctant to agree to accept less than what is owed to them. Typically, mortgage holders will only agree to short sales when homeowners are in default. If homeowners are making mortgage payments on time, what is to say that they won’t continue to do so?

Also, if there is a second or third mortgage on the home, the holders of those additional mortgages also will need to agree to the short sale.

During negotiations with mortgage holders, homeowners will want to negotiate a provision in the agreement that states that mortgages holders will accept the short sale amount as payment in full for the mortgage – forgiving any debt that remains after the short sale. This is important because some states allow lenders to pursue deficiency judgments against homeowners for the amount still owed on the mortgage after the short sale – mortgage balance minus short sale amount equals deficiency. So, even after the completion of the short sale, a mortgage holder may still seek the remaining amount due on the mortgage from the (former) homeowner.

Tax Implications

While mortgage holders may be willing to forgive any debt remaining after short sales, the government may seek to get its share of the forgiven debt.

In a typical debt situation, money is loaned with the expectation that the full amount plus interest will be repaid to the lender; therefore, loans are not taxed as income. However, when lenders forgive debts, the amount forgiven is not repaid and provides a benefit to borrowers. The amount forgiven – the benefit to the borrower – will be taxed as income for the borrower by the Internal Revenue Service (IRS). Lenders report the amount forgiven to the IRS on a Form 1099-C, Cancellation of Debt.

Amid the housing crisis, the federal government realized considering debt forgiven after short sales as income would make an already precarious situation worse. Therefore, the Mortgage Forgiveness Debt Relief Act of 2007 was passed.

The act allows for forgiven debts, up to $2 million, on short sales to be excluded from borrowers’ income tax. To qualify under the act, the forgiven debt had to be used to purchase or remodel the borrower’s principal residence, and the residence had to be used as security for the loan. Further, the act only excludes debts forgiven in calendar years 2007 – 2012. Debts forgiven after through short sale in 2013 will be considered income by the IRS.

Talk About Your Situation

For homeowners who are struggling to meet their financial obligations, speaking to an experienced bankruptcy attorney will help you fully understand your situation and all of your options, including a short sale, for addressing your situation. All situations are unique and very personal; therefore, what works for one homeowner may not work for another.