Saturday, February 7, 2009

Notes on Short Sales

Home in Short Sale
Buyers are more and more frequently hearing that a particular property is in “short sale." A "short sale" – frequently also called a “short payoff” – is a sale in which the amount owed on a property is greater than proceeds from the sale of a property. (Take the example where the loans on a house are $500,000 and the sale of the same house nets only $400,000.)

The bank does not have to accept the diminished pay-off amount – their alternative is to foreclose upon a property. The benefit for the lender is that the property is sold to another buyer – they do not bear the foreclosure expense, and the home is not taken into the bank’s (burgeoning) inventory as an REO (“real estate owned” – i.e., a property owned by the bank).

The benefit for the borrower is that the short sale is less damaging to their credit report than a foreclosure, and relieves the debt that the borrower could not afford to repay.

The short sale will appear on the borrower's credit report as a negative mark for seven years. In order to salvage their credit, a borrower, in his or her negotiations with the bank, can attempt to negotiate the reporting of the short sale to the credit rating agencies.

As an alternative, homeowners who can no longer afford to pay (or desire to pay) their outsized mortgages may do “mortgage modification” or a “loan workout” in which the terms (and possibly even the principal) is renegotiated with the bank. The obvious benefits are more favorable loan terms and lessened damage to the borrower’s credit history.

The tax implications for a “short sale” have diminished dramatically with federal legislation introduced in 2007 that largely has waived taxation of cancelled mortgage debt on a primary residence.

Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) signed by President Bush on December 20, 2007, Internal Revenue Code §108(a)(1)(E) was added and provides that a taxpayer will not be taxed upon cancellation of debt income.

If you are considering a short sale on a property, consult a qualified accountant to discuss its tax implications, which may vary from state to state and case to case.

For buyers, short sales tend to be the most complex and frustrating transactions. The complexity is due to the fact that the 1st (and possibly 2nd) mortgage holder(s) must agree to a smaller payoff amount than the loans they hold. Multiple negotiations must take place to get all parties to agree to the lessened loan payoff amounts.

Because banks are deluged paperwork, these negotiations may drag on for several months. (On the other hand, REO sales are straightforward and typically close in 30 days, like ordinary sales.) Even worse, a signed sales contract may be voided by the bank at any point during the escrow period, for instance if a higher offer is submitted by another buyer.

In cases where sellers are underwater, a short sale can provide sellers an amazing “out” where the bank picks up the loss on the property rather than the borrower.

It is unclear whether this is ethically correct – common wisdom is that when a buyer borrows money, it is intended to be repaid in full. The reality is, if a property is “underwater” the bank often has little or no collateral for their loan, and a short sale is better for the bottom line than a foreclosure.

Jamie Adner