Making 'short sale' may not help homeowners facing foreclosure
A short-sale can help some troubled owners to bail out of their homes, but sometimes accepting a foreclosure sale is better.
Q. I am in foreclosure, and there is no way that I can come up with the money to prevent the bank from taking the home. I tried to work out a deal with the lender to restructure the mortgage, but I did not qualify because my monthly income dropped a lot after I lost the first of my two jobs 10 months ago. The bank now suggests that I try to arrange a "short sale" instead of letting it move forward with the foreclosure, apparently because such a sale would not negatively impact my credit record as severely. How do short sales work? Would a sale really do less damage to my record than a foreclosure?
A. Arranging a short sale instead of letting the bank foreclose can provide a handful of benefits to financially troubled borrowers, but protecting their credit rating against further damage usually isn't one of them. There's so much confusion about the two options today that I'm devoting this entire column to answering some common questions about the differences and potential advantages of choosing one over the other.
Q. How does a short sale differ from a foreclosure?
A. A bank orders a foreclosure sale after a borrower misses a number of payments, typically three to six months in a row. In most states, if the customer can't make up for the missed payments or is unable to strike a new loan deal to save the home, the bank will set a date for the property to be sold at a foreclosure auction. Proceeds of the sale are first used to reimburse the lender for its unpaid loan balance and foreclosure-related expenses: Any money that may be left over is turned back to the borrower.
Conversely, in a short sale, the lender and borrower work together to voluntarily find a buyer for the home through traditional marketing methods. The bank usually agrees to forgive some or all of the debt, even if the ultimate sales prices is "short" of the outstanding balance of the loan, because a voluntary sale eliminates the need for the lender to pay the extra legal fees and other expenses involved in a forced foreclosure. The borrower, meantime, gets to prevent the foreclosure from being added to his or her credit record.
Q. If I can keep a foreclosure from being added to my record, then wouldn't agreeing to a short sale be a no-brainer?
A. Not necessarily, especially if your primary motivation is to protect further damage to your credit rating. The fact that you're already several months behind on your payments suggests that most of the damage to your score has already been done: A short sale wouldn't do much to improve it.
You would also have to deal with negotiating terms of the sale with the lender and marketing the home, both of which can be frustrating and simply add more to the agony that many owners feel when trapped in a property that they can no longer afford.
Q. What are the benefits, then, of agreeing to a short sale instead of just letting the lender foreclose?
A. There are a few. One is that a short sale may let you purchase a different home sooner after you regain your financial footing than a foreclosure would, especially if the loan would be backed by the quasi-federal Federal National Mortgage Association, commonly called Fannie Mae, or the Federal National Mortgage Corp., called Freddie Mac.
Fannie and Freddie back about one-half of all home-loans by purchasing the loans from banks, pooling them together and then selling shares in the pools to investors. Both recently amended their guidelines and now say that they will consider backing loans for short-sellers after a relatively brief two-year period from the date the sale occurs, provided that the sale was caused by a job loss or other circumstances that were beyond the seller's control. That's better than having a foreclosure or bankruptcy on your record, which could make you ineligible for a mortgage for several years.
Q. What are the tax implications of a short-sale or foreclosure?
A. The federal Mortgage Debt Relief Act of 2007 and more recent legislation allows you to exclude up to $1 million of debt that's forgiven if the bank allows you to restructure the loan or if it forecloses on the property at a loss. The limit is $2 million if you're married and file your taxes jointly.
That's a huge tax break for many troubled sellers today because, under previous Internal Revenue Service rules, such debt-forgiveness was taxed much like the income from a job.
The new rules could save you thousands of dollars, but you should talk with a tax expert (and maybe an attorney who specializes in real-estate law) before deciding whether to make a short-sale or simply let the bank foreclose.
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