Homeowners who are pressed to make their mortgage payments – or are already behind – may consider trying a short sale as an option to letting the bank foreclose. A short sale is when a mortgage lender agrees to accept less money than the amount the homeowner owes on the loan.  Many homeowners who are “underwater” on their home – meaning that they owe more on their mortgage than their home is now worth – may consider attempting a short sale so that they can sell their home, avoid foreclosure and not have to repay mortgage debt they would otherwise owe to their lender.

For lenders, a short sale is a last resort before taking physical and legal possession of the property.  Most lenders would prefer to modify a borrower’s loan – either through forbearance (allowing partial payments or payments to be skipped and then the difference added to the total loan balance) or a temporary or permanent modification such as lowering the interest rate – than to have to take ownership of the home.  However lenders will often accept a short sale if it means they can recoup more of the unpaid loan balance through the sale versus trying to sell it at auction after foreclosure.

How it Works

There are numerous reasons that a homeowner may become financially strapped and find it difficult to keep up with their mortgage payments.  For example:

• if you or a family member become ill or have an accident and incur unexpected expenses (and possibly lose time at work),
• if the terms of your mortgage change – i.e. the interest rate on your adjustable rate mortgage “resets” to a higher rate
• if you are laid off or lose hours due to company downsizing

If you are behind on your mortgage or are at risk for missing a payment and you want to request a short sale from your lender you will first need to put your house up for sale.  That means that you will either need to put your home on the market yourself (as a “for sale by owner” listing) or secure a real estate agent who can list the property for you.  If you are at risk of missing a payment, or if you have already missed one or more payments, you might want to consider working with a real estate agent because they can list the property more quickly.  It’s best to work with an agent who has short sales experience so be sure to ask a prospective agent before signing an exclusive representation agreement.

Just because the property is listed as a short sale doesn’t mean that your bank will accept it.  First you will need a buyer.   Once you have a buyer’s offer then your real estate agent (if you are using an agent) will present it to the bank.  If the bank accepts the proposed short sale then you can proceed and at closing the bank will take the loss on the amount of money you owed on the loan.

The Potential Difficulties Surrounding a Short Sale

While it may sound like a relatively simple way to walk away from your home, it’s not.  In a difficult economy, particularly when more people are out of work and the housing market is depressed, more homeowners seek out short sale resolutions; therefore the increased volume can mean long delays.  Depending on your financial situation (i.e. if you are current on your mortgage, if you are in default, and/or how much you have in assets), and the buyer’s situation and offer (i.e. if they do not have a strong credit history, if they do not have an adequate down payment, etc.) the bank may deny your request for a short sale.

Your desire for a short sale can be made more difficult – even impossible – if you have a second mortgage, home equity loan or line of credit, or another lien on the property.  That’s because banks can sell off each loan taken out against the property to a different financial institution or investor.  Those institutions can demand that they still receive the repayment owed on the loan and refuse to settle for less, or they might demand a higher portion of the short sale proceeds than the primary loan holder wants to give.  In some states lenders and investors holding second liens can go after a homeowner to recover the unpaid balance of the loan even after a short sale.

Even if the bank approves the short sale the deal could fall through – as any home sale can – for any number of reasons.  For example, the buyer may have a contingency in the offer to buy the home that requires renovations to be made prior to closing, meaning that s/he will not purchase the home unless specific repairs are made.  If the bank refuses to pay for repairs and the seller cannot finance the repairs, the buyer can walk away from the deal.  Or if the appraisal comes in low and the buyer wants to negotiate for a lower sales price the bank may refuse that lower sales price.  It’s important to realize that just because you have an offer and the bank accepts the short sale, it’s not a done deal until you actually go to closing and all the contracts are signed.

Before You Pursue a Short Sale

If you are at risk for defaulting on your loan, or if you have already missed payments and are in the foreclosure process, contact your lender as soon as possible to discuss your situation.  You may be able to get a temporary or permanent loan modification or forbearance.

It would be prudent to also contact a real estate lawyer – even for a one-time fee-based appointment – to get legal advice related to your situation.  For example you would want to know if your primary mortgage lender or other lenders (i.e. home equity or second mortgage lenders) could sue you for a deficiency judgment.  A deficiency judgment is when a court orders you – as the homeowner – to pay the balance of any debt remaining (the remainder of the mortgage loan you owed to the bank) after the home has been sold and the bank has received the proceeds from the home sale.   Lenders in your state may be able to pursue a deficiency judgment because as part of the short sale you defaulted on the promissory note associated with your mortgage, which was your promise to pay the money you owed.  If, in your state the promissory note makes you as a seller personally liable for the debt, lenders can demand that you liquidate assets to repay them.  That could mean that even though you no longer own the home you would still have to sell off assets to repay the lender for all or a portion of what you owed.

You should also consider working with an accountant to learn how a short sale could affect your taxes.  For example, the IRS can consider the debt that your lender forgives as income which you would have to then pay income tax on.  So for example if the bank allows you to do a short sale that earns them only $120,000 and you owed $200,000 on the mortgage the IRS could view the $80,000 loss the bank took on the sale as income the bank essentially “gave” to you – even though you didn’t actually walk away with that cash in hand.  Depending on the amount of your forgiven debt, your income and taxes withheld, you could end up with a very large – and unexpected – tax bill as a result of the sale.

Documents to Gather

When you request a short sale from your lender you will need to have your paperwork in order.  Specifically you will need:

• * Hardship Letter – this letter simply outlines how you arrived at your current financial situation where you are requesting the short sale.  You will want to include any and all relevant pieces of information such as a job loss or reduction in work, the loss of a spouse or divorce, extraordinary increase in expenses due to a medical condition, etc. As part of this letter (or in a separate document) you will want to detail your current income and assets including personal savings, equity investments, real property (i.e. second car, boat, piece of land, etc.), negotiable instruments, etc.  The bank will need to review all of your financial resources to determine if you are in a position to be able to repay the loan if you liquidated some of your assets or if you are truly without any financial reserves.  Be prepared to provide your lender with copies of recent bank account and investment account statements.

• * Letter of Authorization – the information your lender has about you and your mortgage loan is considered confidential.  In order for the bank to share that information you will need to sign a letter authorizing them to disclose your personal and financial information.  This letter will give your lender permission to talk with any professionals you may already be working with, or are considering working with, such as a real estate agent, attorney or accountant.  You will need to provide your name, contact information, property address, loan reference number, and the name and contact information for any professionals who may be contacting them or whom they would need to contact.

• * Preliminary Net Sheet – once you have the home priced, listed and a prospective buyer with a firm offer, your real estate agent can prepare this statement that outlines proceeds and costs at time of closing such as the unpaid loan balance (UPB), sale commission due to the agent, sales-related costs such as home inspection, termite inspection, etc.  Your lender will reply with a list of costs they are willing to pay and what costs you will be responsible for paying.

• * Home Sale Agreements – your lender will require copies of the listing agreement for the home, as well as a sale contract from the prospective buyer.

• * Comparative Market Analysis (CMA) – any real estate agent should be able to prepare a CMA for your property, which will outline the recent activity on comparable properties in your market such as how many properties sold within the past 6, 12, 18 months; how long properties stayed on the market; and what price they listed for compared to the actual price received.  The CMA helps your lender determine if the short sale is likely to be more financially beneficial for them than other another course of action.

The Potential Costs of a Short Sale

While a short sale may enable you to walk away from the remainder of the mortgage debt you owe, you may still have pay out of pocket to make the sale happen, as the bank is not required to accept all losses and expenses related to the sale.  For example, the bank may not agree to pay your real estate agent’s commission or to pay for a home inspection or appraisal.

Another potential cost of a short sale is that it could lower your credit score.  Although it is not obligated to do so, your lender will most likely report the short sale to the credit bureaus.  That will lower your credit score, which can make it more difficult to get credit in the future.  However a short sale will have less of an impact on your credit score than a foreclosure or bankruptcy, which will remain on your credit report for five years (foreclosure) or seven years (bankruptcy).  Make sure you understand all the short and long-term consequences before you attempt a short sale.