Short sale- Things to consider
A. Personal Liability
A major concern for homeowners contemplating short sale is whether they will be personally liable for any shortfall. If, for example, Sophie Seller owes $340,000 on her mortgage loan, but sells the property for only $300,000 (less costs) in short sale, will she be obligated to repay the $40,000 shortfall?
The answer depends on what the homeowner and listing agent can successfully negotiate with the short sale lender. in some situations, a short sale lender may be willing to accept a short payoff and forgive the borrower for any short fall(which the borrower should get in writing). In other situations, a short sale lender may only agree to the short payoff condition that the borrower promises to, for example, repay the entire shortfall or portion or to allow the lender only a borrower to sign a new promissory note or to allow the lender to place a lien on another property the borrower owns. Of course, the borrower may reject these requests and attempt something other than a short sale, as further discussed below. After all, a borrower who loses a property through foreclosure is, in may circumstances, protected against personal liability under California anti-deficiency rules.
In background, if a lender sells a property for fair market value through foreclosure any difference between what the borrower owed and the foreclosure sales price is called a “deficiency.” The lender may sue the borrower and obtain a deficiency judgment, which allows the lender to collect the amount owed through the legal process, such as by garnishing wages, levying bank accounts, and place a judgment lien on the borrower’s real property holdings.
California’s anti-deficiency rules are consumer protection laws that shield certain borrowers from the harsh result of both losing their homes and remaining personally liable for the unpaid debt. A deficiency judgment is generally prohibited in the following situations:
ü If the lender foreclosed by a trustee’s sale (rather than by judicial foreclosure).
ü If the loan is a purchase money loan for owner-occupied one-to-four units.
ü If the loan is seller carry back financing
(Cal. Code of Civ. Proc 580b and 580d).
To add another wrinkle, however, the anti-deficiency laws may ultimately not apply under the following circumstances:
ü If the borrower committed loan fraud when originally applying for the loan.
ü If, during the loan term, the borrower committed bad faith wasted which means recklessly or intentionally impaired the value of the property
ü Federal Housing Administration (FHA), U.S. Department of Veterans Affairs (VA) or Small Business Administration (SBA) loans.
B. Credit Consequences
A short sale may adversely affect a borrower’s credit rating. The short payoff may be reported on the borrower’s credit as a loan that has been, for example, “settled” for less than its balance. Any delinquent mortgage payments may also be reported. These negative marks may stay on the borrower’s credit report for seven years.
A borrower arranging a short sale may attempt to convince the lender to report something more favorable to the credit bureaus. A lender is unlikely to agree. However, under certain extenuating circumstances (such as when the borrowers agree to sign a new promissory note), the borrower may have better chances of getting a favorable credit rating from the lender.
Whether a short sale has less of an adverse effect on a borrower’s credit compared to foreclosure is a greatly discussed and controversial topic. Many credit experts seem to believe that a short sale will have less of a negative impact on a borrower’s credit, both in terms of the borrower’s FICO credit score as well as length of time the derogatory mark will detrimentally affect the borrower’s credit. As the very least, homeowners with credit worth saving are more likely to be interested in doing a short sale. Other experts, however, claim that a short sale on a credit report will fare no better than a foreclosure. Both opinions are too broad-brush.
Whether a short sale or foreclosure is worth for someone’s credit greatly depends on what purpose the credit report or credit score will be used. A credit report may be used for many different purposes, such as, but not limited to, financing a home loan, financing an auto loan or lease, obtaining credit cards, obtaining student loans, renting an apartment, or getting a new job. For obtaining a new mortgage loan, a short sale on a credit report could be better than foreclosure in terms of the wait time before the homeowner can buy a new home again. However, this prediction is a wild speculation at best given the uncertainties posed by the current mortgage market crisis. As for other reasons for checking credit, such as obtaining auto financing, auto leasing, student loans, rental housing or new employment, the difference between a short sale and foreclosure on a credit report may be minimal.
C. Tax Consequences.
Even if a property is sold at a loss in a short sale or foreclosure, the transaction may nevertheless have tax consequences for the seller. For some homeowners, the tax implications for a short sale may be so significant that it would not be in their best interest to do a short sale. Yet other homeowners doing short sales may owe no taxes at all. Again homeowners should plan ahead and discuss their particular circumstances with an attorney, accountant or other appropriate professionals.
There are two major potential tax implications for a short sale: debt relief income tax and capital gains tax.
1. Debt relief income tax
In a short sale or foreclosure, the debt forgiven by a lender may be taxable to the borrower as a debt relief income. Why? When a tax payer obtains a new loan, the loan proceeds the tax payer receives are not taxable income because there is an offsetting obligation to repay. However, if the debt is later cancelled, such as in a short sale or foreclosure, the debt discharged may be taxable as ordinary income.
Debt relief income is not always taxable. Some situations where debt relief income is not taxable for either a short sale or foreclosure are as follows:
ü Debt discharged through bankruptcy
ü When the owner is otherwise insolvent (i.e., current liabilities exceed assets, but this exemption only applies to the extent that the liabilities exceed assets).
üPurchase-money seller financing (but the discharge debt is treated as a reduction in the owner’s tax basis).
ü Qualified real property business indebtedness (but the discharge debt is treated as a reduction in tax basis)
ü Qualified farm indebtedness
ü Forgiveness of a non-recourse loan resulting from foreclosure. The IRS defines a non-recourse loan as a loan for which the lenders only remedy in case of default is to repossess the property and not the borrower personally.
With many homeowner in short sale or foreclosure being upside-down, they are likely to qualify for the above insolvency exemption from paying taxes for devt relief income. However, because determining insolvency can be complicated, the assistance of a tax professional is highly recommended.
In addition to the avobe exemption, congress recently enacted the Mortgage Forgiveness Devt Relief Act of 2007 exempting from federal income tax any debt forgiven for a loan secured by a qualified principal residence. “Qualified principal residence” indebtedness under federal law is debt incurred in acquiring, constructing, or substantially improving a principal residence up to $2 million. This tax break applies to debts discharged from January 1, 2007 to December 31, 2009. Any discharged debt excluded from income under the new law must nevertheless be subtracted from the tax basis of the taxpayer’s principal residence for purposes of calculating capital gains. 26 USC. 108(h).
2. Capital Gains Tax
In addition to debt relief income, a homeowner in a short sale or foreclosure may owe taxes for capital gains, even though the property is sold at a loss. Capital gains are, in very general terms, the price the seller sells the property minus the price seller paid when the seller originally acquired the property. Capital gains are not based on whether a seller has any equity in property. However, generally speaking homeowners who purchased their properties in recent years for more money than they are currently worth do not have to worry about taxes for capital gains.
More specifically, capital gains for a short sale are usually calculated as the difference between the sales price of the property (minus selling expenses) and the adjusted basis of the property. The adjusted basis is, roughly speaking; the homeowner’s originally purchase price plus improvements made to the property. Capital gains for a foreclosure are calculated somewhat differently than for a short sale. For a foreclosure of a nonrecourse loan, capital gains are generally calculated as the difference between entire outstanding debt or the fair market value at time of foreclosure, whichever is greater, and the adjusted basis of property. For the foreclosure of recourse loan, capital gains are generally calculated as the difference between the fair market value and adjusted basis of the property.
Despite capital gains, homeowners generally qualify for a tax exemption up to $250,000 (or $500,000 for married couples filing jointly) for properties owned and used as their principal residence for at least of the last five years.
D. Possession of the property
Another consideration for homeowner contemplating a short sale is the length of time the homeowner may remain in the property. In theory, a homeowner may not be able to stay as long in the property in a short sale as compared to foreclosure, because a short sale must occur before the homeowner loses the property through foreclosure. However, in practice, whether a homeowner can stay longer in a home by opting for a short sale or foreclosure is highly dependent on homeowner’s circumstances and what the lender intends to do.
In a short sale, the buyer is likely to want possession of the property at close of escrow. However, some buyers may agree to have the seller remain on the premises. To put this arrangement in writing, C.A.R. has a standard form Residential Lease After Sale – Seller in Possession After Close of Escrow (Form RLAS) for a long-term possession of 30 days or more, or use paragraph 3 of the Purchase Agreement Addendum (Form PAA) for a shorter term of possession.
In a foreclosure, if the previous owner remains on the premises after the foreclosure sale, the new owner may serve a 3-day notice to terminate possession of the premises. If the previous owner still does not vacate, the new owner may file an unlawful detainer action or eviction proceeding to obtain possession of the property. The unlawful detainer action is a summary court preceding that may take about four to six weeks to obtain a judgment and have the local county marshal or sheriff’s office remove the previous owner from the property.
Instead of an eviction, the previous owner may be able to make other arrangements with a foreclosure sale purchaser, such as a case-for-keys agreement or rental agreement. For a rental agreement, C.A.R. has a standard form Residential Lease or Month-to Month Rental Agreement (Form LR)