When you are behind on and can't keep up with your mortgage payments, a short sale is an option that a homeowner has to avoid foreclosure. Most people choose to do a short sale instead of being foreclosed on because a short sale looks better on your credit report compared to a foreclosure. Also, if you wanted to obtain a home loan again in the future, lenders will usually view having a short sale on your record more favorably as opposed to having a foreclosure on your record. So what exactly is a short sale?
A short sale occurs when your lender agrees to release the lien on your property for an amount of money that's less than what you owe them on the loan they originally gave you. For example, let's say you bought your home 6 years ago for $400,000 and you took out a $350,000 mortgage on your home when you bought it. Currently your home is only worth $275,000. You list your home for sale and you get an offer on it for $275,000. Your lender agrees to release the lien from your home for $275,000 so that you can sell your home. This would be an example of a short sale. However, just because your lender agrees to release the lien from the home so you can sell the home does not necessarily mean you would be off the hook for that $75,000 difference of what the lender received from the short sale and what you owed on your home loan.. The reason for this is that when you get a mortgage not only is your mortgage secured by the property, but you also sign a promissory note in which holds you personally responsible for paying back the loan. When a lender agrees to release the lien from a property so you can sell it, that just means that they can't hold the property as collateral for your debt any more, but they still can hold you personally responsible for that debt because you signed a promissory note personally agreeing to pay back the loan. The only time a person would not be liable to pay their lender for the deficient amount owed to the lender after the short sale is if the lender chooses to forgive the homeowner for that debt. From my experience, lenders usually do forgive the homeowners for the deficient amount of money still owed after the short sale. This is probably because the lenders can write this off as a loss and get a tax break for doing so. This is not always the case though, so if you are thinking about doing a short sale, it would be a good idea to ask your lender if they would forgive you for the entire amount of debt if you do a short sale.
So that's good news if you can do a short sale and your lender will just forgive you for your mortgage debt right? I mean, in the example above that would mean you got off the hook for $75,000. Right? The answer to this is yes and no. Yes, it's true in the case above that the homeowner would be off the hook from paying their lender $75,000. However, while you don't have to pay your lender that $75,000, there is another party that you will have to pay out a large amount of money to if you are forgiven by your lender for this $75,000 debt. Who is this other party that is spoiling your excitement from having just been forgiven for your $75,000 debt? None other than the beloved Internal Revenue Service. Yes, it's the tax man who's going to want some money if you are forgiven for mortgage debt that you did not pay.
So why do I have to pay the I.R.S. money if my lender forgives me for my debt? I will tell you why. When you are forgiven the debt for a home loan you received, that forgiven debt is treated as income. Using the example above, let's say you were forgiven for $75,000 of debt on a short sale that you completed. That same year you earned $50,000 from your job. Now instead of paying taxes on $50,000, you will be paying taxes on $125,000! While paying taxes on $75,000 is still better than paying the whole $75,000, it's still a bummer that you are going to be left with a hefty tax bill if you do a short sale. What if I told you though that there is a way to get out of having to pay the I.R.S. on the forgiven amount of debt from a short sale? Would you be excited? Well, you should be excited because there is a way to get out of paying the I.R.S. on the forgiven debt from a short sale.
According to the Mortgage Forgiveness Debt Relief Act of 2007, if you do sell your home via a short sale agreement with your lender, you will be forgiven for the deficient amount of debt owed to the lender. The property has to be your primary residence and you have to close on the property before December 31st 2012. The exact reading from I.R.S. Publication 4681 states that "You can exclude cancelled debt from income if it is any mortgage you took out to buy, build, or substantially improve your main home.". This means that any first mortgages you took out to purchase or build your home as well as any subsequent home loans that you received where you used the loan proceeds to improve your home can be forgiven.
You are probably asking yourself, "Well this is all good information, but what does this all mean?" What it means is that if you have been thinking about doing a short sale, you better start the process very, very soon. We have less than 5 months now before the Mortgage Forgiveness Debt Relief Act of 2007 expires. Once you put your property on the market it's going to take some time to find a buyer even if you price the property aggressively. Once you do find a buyer and they make an offer on your property, it could take months before you close on the property. This is because the short sale process adds to the length of time it takes to close on a home. Doing a short sale is a good option to choose if you are struggling to keep up with your mortgage payments and you want to avoid foreclosure. If you know you want to do short sale and you want to avoid owing taxes to the I.R.S. on the forgiven debt arising from a short sale on your primary residence, you need to act soon. Of course, before proceeding with a short sale I always advise to seek the council of an experienced real estate attorney, tax attorney and/or C.P.A. to be certain of the consequences of proceeding with a short sale.
I have plenty of experience with handling short sales, so if you have any questions about short sales, please feel free to contact me. I would be glad to help you in anyway I can or answer any questions that you have.