Owner’s Choices: Short Sale versus Foreclosure
One of the most important functions of a short sale expert is to help troubled property owners look at the available choices. Do not push the short sale, it might not be the best choice for the owner. Here is what you need to know to let the seller make an informed choice when comparing a short sale to a foreclosure.
Foreclosure does have an advantage. In most states, it is swift and certain, just like an execution. After the sale on the courthouse steps and the expiration of any redemption period or time for an upset bid by another buyer, it is over and the house is no longer the former owner’s responsibility. The owner does not have to deal with keeping the property in good condition, dealing with repair issues that come up in a sale and the warranties that go to the buyer after a sale.
In North Carolina, the foreclosure procedure has an unusual feature of a 10 day period after the sale where anyone can upset the successful bidder at the sale. So, when the bidder walks away from the sale on the courthouse steps, no sale has actually occurred. If no one bids during this ten day period, the original bidder gets the property. If someone bids, the ten day period starts all over again, so other upset bids may make the process continue. So, in North Carolina, it is not swift and certain as it can be a slow death. The one thing to know about the ten day upset bid period is that the former owner still owns the property, so you can complete a short sale after the “sale” on the courthouse steps but before the upset bid period ends.
In comparison, the short sale may take a while to get a buyer and a period of time for the lender to approve it. Then, there is additional time for the buyer to close the sale.
The disadvantages of a foreclosure start with the emotional effects. It is not pretty to have the children see the house posted and watch the sheriff throw the family out. All the neighbors know. Theoretically, you do not get to arrange time to move gracefully, as you have to be out when the sheriff says so. On a practical basis, the REO Realtor who is going to market the home after the foreclosure will probably offer the family two weeks to move out, and a little money to help in the move called Cash for Keys (or CFK).
In contrast, a short sale allows the family to stay in the home until the closing of the sale and move out in the normal manner.
The second disadvantage is to your credit report and future loan applications. A foreclosure causes one of the largest hits to your credit score. Under Fannie Mae guidelines, you will not qualify for a loan for at least five years, and probably seven years. You will have to answer the questions on loan applications saying you have had a foreclosure within the last seven years, which will almost automatically get the loan declined.
On the other hand, a short sale causes a smaller hit to the borrower’s credit report. You can try to get the loan reported as “paid as agreed” to have the effect on the credit score minimized, but it not common that you will succeed. The answer to the questions on future loan applications about foreclosures or giving a deed in lieu of a foreclosure is no, so your loan is not automatically declined.
A third disadvantage is that you do not get to negotiate a settlement of any balance due on the loan. In states like West Virginia, North Dakota, Montana, Mississippi, Minnesota and California, this is not a factor as state law prohibits a “deficiency judgment” i.e. a judgment that you owe the balance of the amount that the lender did not get paid in the foreclosure. The rule is complicated in California, because deficiency judgments are prohibited if the lender forecloses using a “power of sale” in the deed of trust (which is the vast majority of foreclosures), but it is not prohibited if the lender forecloses by going to court (even though there are other laws that prohibit deficiency judgments even if the lender goes to court). In other states, banks can chase the borrower not only for the balance of the loan, but for the attorneys fees and other charges that were incurred in the foreclosure. It does take extra attorneys fees to get the deficiency judgment and collect it, so many lenders do not bother to do this. But it is possible the lender can sell the deficiency to a collection agency and they will make the borrower’s life miserable.
One of the advantages of a properly negotiated short sale is to get a full release of the obligation. In other words, in return for the short payment, the lender releases the obligation in writing so that there is a complete settlement of the debt. After this release, there is no remaining balance due. You cannot guarantee a seller that you can accomplish this, as some lenders will refuse to do this. You can guarantee that you will try.
The fourth disadvantage of a foreclosure may be tax consequences. The rules for the “non-recourse” states of West Virginia, North Dakota, Montana, Mississippi, Minnesota, and California are complicated, so consult your tax advisor, particularly in California where the IRS seems to say that they treat sellers there like the “recourse” states for some situations and not for others. If it is truly non-recourse situation, there are no tax consequences of a foreclosure. For the rest of the states, you look at the IRS forms that tell you to start with the amount of the debt right before the foreclosure and add the attorneys fees and other costs to that debt. Then, you subtract the fair market value of the property (which means you get to argue about whether the amount paid at the foreclosure sale was the fair market value, which it usually is not because fair market value is a willing buyer and seller with neither one under any undue pressure and I think foreclosure is the ultimate in undue pressure). The difference is usually taxable, unless you qualify for one of the exemptions in the Internal Revenue Code. In short, the difference between what you owed and the fair market value of the home is taxed as income tax, and the lender will send you a form 1099 A or 1099 C to specify the size of the tax consequences.
Both a foreclosure and a short sale may qualify to be non-taxable under The Mortgage Forgiveness Debt Relief Act of 2007. The tax consequences of a short sale are discussed in detail in another post “Income Tax and Short Sales”, and the rules are similar for a foreclosure. If the debt relief is not excused by the recent legislation, the short sale will normally cost less in taxes, as the house typically sells for more in a short sale than a foreclosure sale, so more of the debt is paid off. Also, the cost of the foreclosure sale is added to the debt in a foreclosure sale, so the amount owed is larger than in a short sale possibly resulting in worse tax consequences.
The tax consequences of a short sale, a foreclosure and a deed in lieu of foreclosure are all similar because all three of these are considered a sale by the IRS. You have the normal tax consequences of a sale, so if you had a gain on the sale, you own tax on it. Internal Revenue Code section 121 exempts the first $250,000 in gain for a single filing taxpayer, and $500,000 for taxpayers filing jointly, so unless there is a large gain, there is no tax consequence.
Every now and then, a foreclosure is better for an owner than a short sale. But, the vast majority of the time, the short sale is preferable.