Negotiate Short Sales Better: Find the Investor

August 9, 2009 by  
Filed under Short Sale How To

Money Shirt 70

Short Sales Need Artful Negotiating

Negotiating a short sale requires an understanding of the process. When you submit the short sale package, you are dealing with a servicer, who collects the payments and administers the loan. They do not have as much “skin in the game” as the investor who owns the loan. So, you need to be able to involve the investor to get the right result.

How do you find the investor? You can ask the servicer. Sometimes they will not tell you if you ask “who is the investor”? However, some servicers like Bank of America have rules that if you ask a question that can be answered yes or no, they will answer. So, ask if the investor is Fannie Mae? If no, ask is the investgor Freddie Mac? You might get lucky.

The Internet provides an abundance of information. To see if the investor is Freddie Mac, go to
www.freddiemac.com/mymortgage and look it up. You can also call them at 1-800-FREDDIE (8am to 8pm EST). Similarly, to find out if the investor is Fannie Mae, go to www.fanniemae.com/loanlookup or call them at 1-800-7FANNIE (8am to 8pm EST). This brings up some legal requirements.

In order to use the online services for Fannie or Freddie, you need written authorization from the borrower. So, include this in your letter of authorization that you get the seller to sign at the first meeting, so you are not only authorized to talk to the lender, but you are authorized to look up the investor on the Fannie, Freddie or any other website.

What if Fannie or Freddie are not the investor, which is a frequent even for luxury housing. Many servicers will not tell you who the investor is, possibly because they do not want the investor to know how poorly they are processing your short sale request.

However, many servicers have rules that require them to furnish the investor’s information if the borrower/seller requests that information in writing. So, add that to your letter of authorization, i.e. the borrower requests the lender to furnish you with the name, address, phone number and contact person for the investor who owns this loan.

Some commentators say that another way you can find the investor is to look them up in MERS, the Mortgage Electronic Registration System. It allows borrowers to see which company manages and owns their loan. The site was made public as part of The Helping Families Save Their Home Act. The claim is that the site will inform borrower’s when the ownership of their loan changes. However, the only part of the site that is directed to homeowners allows you to check the servicer of your loan. How to check the owner is well hidden. So, if you can make this site work, please leave a comment on this post so we can share this service with everyone.

Why do you want this information? I was dealing with Bank of America/Countrywide on a California short sale. They were taking way too long to assign the request to a loss mitigation negotiator. Wells Fargo had the second loan on the property, and they had already assigned their short sale request to a negotiator, obtained a Broker Price Opinion (BPO) and were ready to negotiate a short payoff. Meanwhile, Bank of America/Countrwide is still waiting to get it to someone’s desk to order the BPO. On my weekly phone call, I made it clear to the “gatekeeper” that a written request to get the contact information for the private investor who owned the loan had been submitted. She found a way to order the BPO immediately to speed up the process. In other words, when the servicer knows that their client, the investor, will be looking into how the short sale is being processed, the servicer wants to make it look better.

If you want to get more tools for negotiating in real estate, look at my book, Create A Great Deal, the Art of Real Estate Negotiating by going to http://www.CreateAGreatDeal.com

Short Sales and the Military

April 27, 2009 by  
Filed under Short Sale How To

Special Military Benefits Make Short Sales Easier

armed-forces701One of the causes of financial distress is relocation. Being in the military is a frequent cause of relocation, so it makes sense that there are special programs for short sales and other assistance for the military. Members of the Armed Forces do so much for our country that it is important for real estate agents to provide special service to them.

Military personnel and federal employees who are ?under water? with their mortgage can benefit from a program by the Department of Defense that is administered by the US Army Corps of Engineers under the Base Closure Act known as HAP (Homeowner’s Assistance Program). This program was extended under the American Recovery and Reinvestment Act of 2009. For full information, go to http://hap.usace.army.mil/

This program was originally designed to apply to members of the military or federal employees who owned a principal residence in an area where a base closure or realignment caused the values of the homes to decline. However, it has been extended to military personnel who were reassigned and had to move more than 50 miles during the mortgage crisis. These military homeowners qualify if they were reassigned between February 1, 2006 and September 30, 2012, they purchased the principal residence that they are selling before July 1, 2006 and they sold it between July 1, 2006 and September 30, 2012.

It also applies to members of the military and federal employees who were wounded in the performance of their military related duties after September 11, 2001, as well as the surviving spouse of someone who was killed in action after that date. The website encourages people who may not fit all of the requirements to apply anyway to see if they can get benefits.

The website says that ?HAP provides assistance in four ways. For eligible applicants, the Government may:

  1. Reimburse you for part of your loss from selling your home.
  2. Assist you, if you don?t have funds from the sale of your home to pay-off your mortgage.
  3. Purchase your home by paying off the mortgage.
  4. Help, if you default on your mortgage. ?

For short sales, the private sale reimbursement program is the most applicable. Under that program, the military member or qualified government employee sells their home and gets reimbursed for some of the losses on the sale of the home. This reimbursement is used to pay off the lender so that if there are enough proceeds the lender gets fully paid. If not, it is a short sale that is partially reimbursed. The website indicates that the amount of reimbursement can be 95% of the difference between the value of the house before the base closure and the current value (or sales price), but it also indicates there can be a payment of 90% of the original value of the home, with the added value of any improvements to the home. The seller can also be reimbursed for closing costs, including the real estate commission.

So, the home is sold with a short payment to the lender, but with an agreement to reimburse the lender later when these benefits come in. This is an excellent use of the short sale process, as it gets the seller moved gracefully and may get the lender fully paid. At a minimum, the lender will get more than just the sales proceeds of the short sale, as the reimbursement is in addition to what the buyer will pay for the purchase price.

So, if your seller is in the military or a qualified federal employee, look into these special benefits. The members of the Armed Forces deserve to get every benefit allowed, as they have definitely earned it.

Short Sales With Multiple Loans and Liens

March 15, 2009 by  
Filed under Short Sale How To

multiple-70Some short sale sellers will make your life extremely “interesting” with their talent for putting on multiple mortgages and collecting liens. You get to negotiate them all, because if any one will not sign off, the short sale does not close. As the picture shows, you have to get every lender to jump into the deal.

This is why some Realtors will not take short sales with too many mortgages and liens. Some short sales do not close, and ones with multiple liens are the hardest to close. Once you have done some short sales, you will understand why. Refer the short sales you do not want to another Realtor who is willing to deal with the mess. A separate post discusses the priority of liens and their effect on how much to offer each lien holder in Lien Priority Determines Who Gets Paid & How Much

The first issue is how do you negotiate with all the liens. Some of the people providing Realtor training say to negotiate with the last one first . In other words, if you have a first loan and a second loan, find out what the second loan will settle for first, then negotiate with the first loan. There may be some merit to that, because you know what you have left to offer the first loan as a short pay.

I do short sales differently because I negotiate all of the debts at once. The reason is that there is not a linear relationship between them. In other words, the results of each negotiation is interdependent on the results of all the other negotiations, so you need all the answers all the time. If the property is in foreclosure, you do not have enough time to submit the package to the second lender, wait for their review and approval, then submit it to the first lender. I had a property in foreclosure in Palos Verdes, California with a first and second loan with Washington Mutual and a third with CitiBank. Citibank gave us an approval on the third loan one day before the deadline set for the foreclosure on the first loan. If I had waited to get that short pay approval first, then submitted to the other lenders, the sale would not have gone through.

To understand the interdependence, some lenders on a short sale home have guidelines for how much they will let a junior lienholder be paid. I am working on a short sale in Rancho Palos Verdes, Calfironia where the first loan is with Countrywide and the second loan, a line of credit, is with Bank of America. The seller cannot pay the mortgage. Countrywide will not allow the second lender to be paid more than $3,000 on the closing statement (HUD-1). Bank of America will not settle for less than $5,200, because they have a rule that they will not take a short sale that does not pay them at least 10% of the outstanding balance of the loan. The entertaining part of this standoff is that Bank of America is merging with Countrywide, so it is like a one member of a couple saying you have to put all the money in my right pocket, then the other member of the couple saying no don’t do that, put money in my left pocket.

How do you break this standoff? You have to know what is allowed under your local rules, the disclosure rules for lenders and the National Association of Realtors code of ethics. In California, the commission is paid by separate commission instructions to the escrow officer that are not part of the escrow instructions signed by the parties. You can consider having one of the Realtors send the amount of the difference to the junior lender. You can also have the buyer buy something from the junior lender that happens to equal the amount of the difference. You cannot do anything that is beyond the rules for proper presentation of information to a lender i.e. do not lie to a lender. See the post Don?t Put Your Client In Jail for more discussion, and substitute Yourself for Your Client.

If you watch a good chef, you will be amazed at how many things can be prepared at once with all of them finishing at the same moment. When you get good at short sales, you can handle many liens at once and get them to a closing at the same time, and be able to avoid foreclosure at the same time.

Lien Priority Determines Who Gets Paid & How Much

March 11, 2009 by  
Filed under Short Sale How To

capital-building-70When you first start to list a short sale property, you need to figure out how much is owed on the property. Most homeowners can give you the mortgage statements and you can calculate the balance due. However, I have had some “special” clients, who have mortgages, liens, judgments, unpaid property taxes, IRS tax liens and all sorts of items to keep my life interesting.

Unless you are absolutely certain you know all the debts secured by the property, do a title search to find out how what needs to be paid to close the sale i.e. find out how many liens there are and how much each one is. A lien is something that is attached to the property that must be dealt with when you transfer the title. Normally, you pay the debt and the lien is released. The type of lien you may be familiar with is a deed of trust that secures the payment on a mortgage loan. If there is a lawsuit that results in a judgment against the property owner, it can be recorded in the county where the property is located, and the judgment becomes a lien against the property. If people who do work on the property are not paid, they can file a mechanic’s lien. If the homeowners association is not paid, they have the ability to file a lien under the terms of the declaration of covenants, conditions and restrictions that cover the neighborhood. The taxing authorities can file a lien if the property taxes, state income taxes or other assessments are not paid. Similarly, if the Internal Revenue Service is not paid, they can file a lien.

It probably does not surprise you that the IRS has special rules. No matter when they record their lien, they are in first position. But, you may be able to work out an arrangement with the IRS to get the property released from the lien if the seller enters into a payment plan with the IRS. As you might expect, the IRS is slow, so you need to start work on this lien as soon as the property is listed by presenting whatever paperwork the IRS wants. Sending the hardship letter discussed in the post “Do a Compelling Hardship Letter” is a good way to start. One of the reasons to start early is to open a file on this request and have it assigned to the right department in the IRS. In this manner, when you get an offer, you are ready to submit the closing statement and other documents to the right person. Just like all the other creditors, the IRS wants to see that the owner is walking away with nothing, because if there is any money left over, they want it.

If there are more liens than there is money, who gets paid and who doesn’t? Normally, it is based on the priority of the liens. The standard rule is that the date the lien is recorded with the county recorder determines its priority. So, the one filed first is first, the one filed second is second and so on. But, if it was that easy, lawyers would not have to spend all that time dealing with title issues. Also, the rules of priority change from state to state.

The effective date of a mechanics lien is usually the date work was started on the property. So, if a custom home was built starting on January 2, 2008 and the landscaper was not paid for work done in June, 2008, and a mechanics lien is filed in July, 2008 the effective date of the lien is January 2, 2008, which would give it priority over a judgment filed in April, 2008.

How do you figure it out? You let the professionals do it. In my short sale addendum, I specify one closing attorney that will close the sale if a buyer wants to purchase a short sale property listed with me. That closing attorney may as well do the title work early, as nearly all of my short sales sell and close. The attorney can do the search and tell me the priority of the liens. Once you know the lien holders, order the payoffs on the mortgages as early as possible. You will need accurate numbers to put in the draft HUD so that you can determine how much money you will need. It is always interesting to see just how much it would take to fully pay everybody. After you know the totals, you work backwards to decide how much you can pay each lien holder.

Why does priority matter? Because if the first lien is foreclosed, all the lower priority liens are no longer attached to the property i.e they get wiped off by the foreclosure. The creditors may be able to chase the former homeowner after the foreclosure, but they will not be able to get money out of the property (unless it sells at the foreclosure sale for enough to pay the first debt with money left over, which will go to the next debt until it is used up, which is about as rare as a chicken with lips). So, the first loan will normally get paid much more in a short sale than the second, third and fourth. This is particularly true if the first loan has started a foreclosure proceeding, because all the other loans will get nothing if the foreclosure occurs.

Are there any rules of thumb? All kinds of them, and each lender tries to make them up as they go along. Many of the first lenders will insist on getting fully paid before they will let the second lien holder get anything. Many first lien holders will let you give the second lien holder up to $3,000 when they are not fully paid. Others have administrative rules that are a reflection of their business model. For example, Bank of America has decided it is not worth their while to process a short sale on a second or lower priority lien unless they get 10% of the outstanding balance. Their claim to logic is the cost of the staff time would exceed the amount they could recover on extremely small payoffs. I happen to disagree, because it takes no time at all to say you will take something instead of nothing particularly if you change your review process to minimize the number of documents you want in the short sale package. So, this is just a negotiating technique referred to as “higher authority”.

The other fun thing in negotiating with junior lien holders is the “south end of a north bound horse” effect. Some lien holders are so upset with the seller that they will not settle for less than full payment. If they mess up the seller’s short sale, there is an emotional satisfaction that is worth the financial loss. So, they will force the foreclosure unless you find a way to get them paid.

When you are negotiating with each lien holder, try to get a full release of the entire debt in return for the payment. You can negotiate a settlement where the lien holder will release the lien and apply the payment toward the debt, but not release the rest of the debt. It gets the property sold, but the creditor can chase the seller after the sale. If you can get the lien released and get the rest of the debt satisfied and released, the seller walks away clean. So, you have accomplished the full payment of a debt with the limited proceeds from the sale. You will not always be successful in getting a full release, but if you do not ask, you do not get. If you only get the lien released, you have succeeded sufficiently for the task at hand.

My policy is to deal with any type of lien holder and any number of liens. One of the more complex short sales had first, second and third mortgages, a judgment and unpaid property taxes. You have to realize that the more liens the more complex the sale. A sale with four liens is much more than four times the complexity and more than four times the work. If you are smarter than I am, you might want to refer complex short sales with multiple liens to another Realtor who is set up to handle difficult cases.

If all this gets too complicated, sit down with your favorite closing attorney and let them figure it out for you.

Step By Step Short Sale

February 24, 2009 by  
Filed under Short Sale How To

baby-on-steps-70x70You need to know how to get through the entire process, step by step. Part of your education is to know when each step is to be taken, and how to do it gracefully.

1. The very first step is to decide if you can sell the home for enough money to pay off the mortgages. If so, list it at that price, even if it is debatable. Some lenders ask for a history of the marketing of the property. If you can show that you tried to sell it for enough to pay off the loans, that will help your presentation for a short sale. In other words, your first step is to try to avoid the short sale all together.

If it is clear that the market will not support a regular sale, explain the entire process to the seller to be sure they are willing to go through everything it takes to get it sold. There is nothing worst than doing all the work of a short sale, then failing to close. Even before you list the house have the sellers get everything they will have to submit to the bank. Many times it is the same information they gathered to get a loan.

2. The sellers have to qualify for the short sale. Before you list the home, be sure they have the financial hardship that will enable to lender to cooperate with the short sale. If the sellers have plenty of income, and plenty of assets, the bank will not be cooperative, asking the sellers to bring money to closing to pay off the rest of the debt, or to sign a note to make payments after the sale closes. If the sellers have no way to pay the balance of what is owed to the bank, you will have an easier time convincing the bank to accept the short payment.

Even before you put the house on the market, ask the seller to find all the financial information that you will need to supply to the bank. Every bank ask for different items, but typically they want a hardship letter, a financial form showing their assets and liabilities, two month of bank statements, their last two pay stubs as well as copies of the mortgage statements. If the sellers are self employed, you may need two years of tax returns.

3. Get a letter of authorization that allows the bank to talk to you in the same manner that they would talk to the seller. Send it to the bank when you list the house, as most lenders take days and sometimes weeks, to review these documents. Some banks have odd requirements for what those letters have to say, and the only way to find out about those requirements is to send in the letter and have them respond to it.

4. Find who you will be dealing with at the bank. Some are Loss Mitigation departments, others have different names. Most of them will not talk to you until you have an offer. If they will, find out what they want, how they want it done, and how you can make their job easier. Try every way you can to avoid dealing with the collections department, they get bonuses for getting the loan reinstated but get penalized if the property does not get back into performing status, so they usually are not helpful for short sales.

5. Research the title to the property to find out all the liens, judgments, unpaid taxes and assessments. Get the amount necessary to pay off each of the liens, e.g. order the payoff statements from the mortgages and contact the attorneys for the other lien holders. Many Realtors will not do short sales if there is more than one mortgage. My record is three mortgages, one judgment and unpaid property taxes, the second place finisher was one mortgage, four judgments and unpaid property taxes. If the situation is too complex, either walk away, or call me.

6. When you put the property in the MLS, you have to price it in accord with the time you have . If the seller is facing foreclosure, you do not have time to test the waters, just price it aggressively. Even if you are not pressured, you still want to be competitive. Look at the recent sales in the last three months, so you are aware of what it takes to be sold. Also look at the homes for sale to be sure you stand out from your competition. You need a reason for a buyer’s agent to put up with all the trouble that comes with a short sale, so you need at least an appealing price.

7. Get a buyer, and you hope for a fair market value. But, take the best you can get. The review time by the lender is long, so get it started with any reasonable offer. If you get a better offer during the review period, you can submit it. The contract provisions have to include a Short Sale Addendum that provides that the sale is contingent on the approval of the lender. If you do not have that provision in your contract, your sellers are signing a contract that obligates them to pay the “short” amount at closing.

One of the ironies of a short sale is that lenders take long to review them, but when they approve them, they want them to close quickly. So, try to get a contract that has a quick closing, but have the time for the closing start when the bank approves the sale.

8. Develop a HUD-1 closing statement. If you are in an area that does not use a HUD-1, get some software and develop one. You are dealing with a bank that is reviewing massive numbers of short sales, so you have to put the information in a format that is easy for them to review. Put the HUD-1 in with the rest of the short sale package.

9. Send the short sale package to the bank. How you send it is extremely important, and we will discuss it elsewhere in more detail. Watch out for a bank that requires you to fax it to a number that is constantly busy. If they do, fax it in the middle of the night, or send it to one of the supervisors in the loss mitigation department. Send a separate copy by registered mail, requiring a signature to prove that it was received. This prevents the loss mitigation department from claiming that they never received your short sale package.

10. Some of the traditional documents for a short sale package are the following:
a. Fax transmittal

b. Letter of Authorization (to talk with you)

c. Cover letter discussing the offer

d. The complete contract of sale

e. HUD 1 with an estimate of the payment to the bank

f. Listing agreement

g. History of the Listing: Dates of the listing and price reductions

h. Form showing the seller’s financial condition, such as a financial statement or worksheet

i. Hardship letter describing the reason for the financial problems

j. Last two pay stubs. if employee, profit and loss if self employed

k. Last two bank statements for every bank account, include all pages

l. Last two years tax returns, particularly if self employed, including all schedules

m. The pre-approval letter for the buyer’s loan or verification of funds on deposit for a cash buyer

n. recent mortgage statement to help identify the loan.
This is where you have to know what the bank wants. For example, Bank of America normally wants only the hardship letter, letter of authorization to talk to the Realtor, the HUD-1 and short financial statement. Give them what they want, and no more. Some lenders will ask for statements of all accounts, such as IRAs, stock brokerage and similar accounts. If they ask, provide them. If they do not ask, do not volonteer them.

11. If there are judgement liens, send the purchase contract as well as the HUD 1 to the lien holders along with a letter describing your offer to pay their debt for less than the amount owed.

12. Call to see if the package has been received and put into the system. You will need the loan number, name of the seller/borrower, the address of the property, and sometimes the last four digits of the seller/borrower’s social security number to get past the initial person that you talk to. You have to be sure your package gets into the system. My record is sending the package four times before it was finally registered properly.

13. Call regularly to see when the package is assigned to a loss mitigation negotiator. The lender will tell you it makes no difference if you call. In fact, your package will languish unless you see that it is moved along, and each time you call, someone will look over what you sent to tell you if they need something more.

14. Hopefully, the lender will order a Broker’s Price Opinion (BPO) before the case is assigned to a negotiator. Some will only order the BPO when the negotiator takes the case. The BPO is what the negotiator will use to determine if the price offered is close to the market value, so the lower the BPO price, the more likely your offer will be accepted. Be sure to point out the issues with the property and problems with the market to try to get the BPO price to be reasonable. The best practice is to have pictures of the problems and two bids for repairing them.

15. Occasionally, you get to talk to the negotiator. Other times, they only send emails. Other times, they will have no contact with you at all, so be sure that your letter explaining the transaction is clear and complete.

16. Sometimes you can learn the BPO price. Most of the time, you cannot. If you can communicate with the loss mitigation negotiator, show the merits of the offer and how it gets the bank a better result than all their other choices. The negotiator has a huge effect on your offer, so try to get their support, and definitely do not alienate them.

17. Find out who is taking the loss. If you are dealing with a bank, is it their loan, or are they representing an investor. Is there a guarantor or mortgage insurance, so the bank will get paid but the guarantor will take the loss. You need to know who is making the decision, so you can appeal to them.

18. Keep calling to see how it is progressing. Many banks will not notify you of their decision. The only way you will find out is when you call the loss mitigation department.

19. Get the response to your proposal. First mortgage holders will generally take 80 to 100% of the value established by the BPO. The second mortgage will generally take 5-20% of the outstanding balance of the loan. The third mortgage holders will generally accept 5 to 10% of the balance owed. Depending on the priority of a lien, they will typically take 5-10% of the debt.

20. If they do not accept your offer, see if they will give you a counter offer. Some lenders are extremely difficult when they just turn down your proposal and give you nothing to aim at. If you get a specific counter offer, see if your buyer will accept it. If so, send the revised contract to the loss mitigation negotiator. If not, see if the buyer will give you a counter offer to present. The revised offers will need a revised HUD-1.

21. During the negotiations, you may need to escalate to the supervisors and their supervisors. Remember, if you do that, you will alienate the loss mitigation negotiator, so figure you have lost their support by going over their heads. If you cannot get the bank approval and their is a guarantor (or mortgage insurance) move your negotiations to the guarantor. If you have problems with the bank, find the investor who actually owns the loan, and negotiate with the investor.

22. As a part of the negotiations, you will also negotiate how the lender will report the short sale to the credit reporting agencies. This is covered in more detail on this site. You will also be negotiating whether your short payment will be in full satisfaction of the debt, or if the lender will be able to pursue the seller after the sale closes. Occasionally, the lender will want the seller to execute an unsecured note promising to pay some of the balance due.

23. Watch out for commissionectomy! Many banks will try to take your money, even after you have done all this work to get them paid. Look at all these steps that you are doing to make the sale work, but many banks only look at their loss. To counteract this tactic, refer to the Servicing Guide of Fannie Mae saying it is against their policy to reduce the commission on a preforeclosure.

24. If the offer is approved, you must get the approval in writing with all its terms, then give it to the attorney or escrow that is closing the sale. The lender will require that they approve the final HUD-1 before the closing of the sale, and specify how the funds will be sent. If the settlement will not only release the lien but also eliminate the balance of the debt, be sure to get that inwriting.

25. If you do not get an approval, but learn what the lender(s) will accept, adjust your asking price to make it more likely that you will get offers that match the lender(s) requirements.

26. Once the bank has approved the sale, all the items that are normally done when a seller signs the contract are accomplished. Most of the time, the bank will insist that the buyer take the property “as is” because they do not want to have any more money taken out of their proceeds. You may have a problem closing if the buyer objects to the condition of the property and the seller has no money to do the repairs.

27. Have the attorney or the escrow officer close the sale and pay off the mortgages and liens. The seller will probably receive a 1099 from the transaction reporting to the Internal Revenue Service how much of the loan was not paid off. There may be tax consequences from having a portion of the debt forgiven, which is covered in detail in the post Income Tax and Short Sales. There may also be tax consequences from the sale itself, unless the gain is not taxed due to Section 121 of the Internal Revenue code (sindle tax return can make $250,000 and joint tax return can make $500,000 profit and pay no tax)

28. Celebrate your success.

Income Tax and Short Sales

February 23, 2009 by  
Filed under Short Sale How To

internal-revenue-building-70x70One of the problems with a “short” sale used to be that a seller had to pay income tax on the amount the payment was “short”. So, if you owed the bank $300,000 and you paid back only $250,000 when the sale closed, the $50,000 that you are short is taxed as ordinary income. That phantom income of about $50,000 could cost you $14,000 to the IRS and more to the state taxing authorities.

The Mortgage Forgiveness Debt Relief Act of 2007 was signed into law eliminating the income tax for some sellers whose sales close between January 1, 2007 and January 1, 2010. There are several requirements:

1. The property sold must be your principal residence, as defined in section 121 of the Internal Revenue Code.

2. The debt that is forgiven must be “Qualified Principal Residence Indebtedness”, i.e. the money used to acquire a principal residence.

3. There is a limit of Two Million Dollars for the amount of non-taxable Debt Forgiveness, a limit that will not affect the vast majority of homeowners.

These rules raise some questions. The biggest one is what is Qualified Principal Residence Indebtedness. The law says “For purposes of this section, the term `qualified principal residence indebtedness’ means acquisition indebtedness . . . with respect to the principal residence of the taxpayer.” So, if you refinanced the house for more than what you owed and took money out to spend on other things, that additional amount is not covered by this law. For example, you had a loan of $200,000 when you bought the house. You refinanced it with a loan of $400,000, and used the additional money to pay off your other debts. If you sell the home and pay $350,000 instead of the $400,000 debt, this new law does not protect you from paying income tax on the $50,000 that was “short”. If you take out a mortgage to buy the house, refinance it for the amount owed on that mortgage (and no more), then your payment to pay off the mortgage is $50,000 short, you will not pay tax on that amount.

Another question is do you need to have lived there for 2 years out of the five years before your home is sold, as that requirement exists to establish a home as your principal residence in order to avoid paying tax on the gain when you sell your primary residence. This question comes from the reference in the law to section 121 of the internal revenue code, which is normally used to eliminate tax on a home where you made up to a $500,000 profit when you sell it. To qualify for that exclusion from tax, you have to live in the house for 2 years out of the five years before you sell it. It does not make sense to impose that requirement based on the purpose and intent of the legislation, but there is a lot of the Internal Revenue Code that does not make sense. For example, this law was designed for people who bought a home with financing and did not pay back that same financing that was used only to buy the home. If someone is forced to live in the home for years before they are excluded from the income tax on a short sale, it defeats the purpose of the legislation. Also, the longer someone lives in a home the more likely it is that there was a “cash out” refinance, and failing to pay back the cash that you got out of the homes is taxable under this new law.

A property that is purely an investment property does not qualify for the exclusion from taxes if you sell it short. But, a property can be rented for a while and still be your principal residence, so it could qualify. Under section 121 of the IRC, if you lived in the home for two years, then rented it for up to three years, then you sold it, it is still your principal residence. So, if you sold it short in this situation, you may qualify for the exclusion. New legislation restricts this provision, so that the time your rent the property decreases the amount of the deduction.

One more question is what happens if you refinance the home and use the additional funds to remodel the home. Normally, that would increase your basis in the home, so it would decrease your tax liability if you sold the house. So, it would be logical to allow this type of refinancing to be subject to the protection of the new law. Again, it is hard to rely on logic when dealing with the IRS, so I hope there are some regulations developed to interpret this situation. The new pamphlet “Tax Relief For Struggling Homeowners” says that the Act “applies only to forgiven or canceled debt used to buy, build or substantially improve your principal residence”, so the term “substantially improve” implies that a refinance where the money goes into remodeling the house would be covered by this Act.

It is possible to qualify for a partial exclusion from tax. If some of the debt that was not paid back was for money used to buy your principal residence, that part is not subject to income tax. So, you buy a home with a mortgage of $200,000, you refinance it for $250,000 and use the other $50,000 to pay off your credit card debts. Then, you sell the home and do not pay back $75,000 of the mortgage. The first $50,000 that is not paid back is subject to income tax. The last $25,000 that is not paid back is not taxable.

The amount of forgiven debt that is not taxed is subtracted from the basis of your next house, so that when you sell it, you have to recognize more gain on that sale. For example, you go short by $75,000 when you sell a home, you buy another one later for $400,000. Your basis is not $400,000, but $325,000 as the $75,000 is subtracted from your basis. So, when you sell it, you will have $75,000 more gain. Remember, there is an exemption from tax for $500,000 of gain for a married couple filing jointly, so this amount of additional gain could be covered by this exemption. Even if it is not, if you make more than $500,000 in gain and have to pay some tax, you should not cry.

It is hard to find the text of the law, but here is a link to how it looked when it passed, so you can click here read it for yourself. http://tinyurl.com/2qdnwj . Also, you can look at the information available with IRS Form 982 that a taxpayer must file even if all of the forgiven debt is covered by the Mortgage Forgiveness Debt Relief Act so that there is no tax due. Another source of information is the instructions for IRS form 1099-c that is filed by the bank to tell the IRS how much debt was forgiven. The seller will receive a copy of form 1099-c by January 31 of the year following the sale that will specify the amount of the debt that has been forgiven.

This law is new enough, and in need of interpretation, that if you find yourself in this situation, you need to consult a tax professional before you sell.

So, for people who bought a home, did not refinance it for more, and sold it for less than they owed, there is no income tax due on the short sale, so long as the payment on the mortgage is less than two million dollars short. This legislation eliminates one of the most miserable parts of a short sale, as it was obnoxious for a homeowner to loose all their equity, have to sell their house, and then get a tax bill.

There are other provisions of the Internal Revenue Code that forgive the income tax that could be due on forgiven debt if the taxpayer is insolvent. The IRS Tax Relief for Struggling Homeowners pamphlet says “Normally, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent. A taxpayer is insolvent when his or her total liabilities exceed his or her total assets.” If the seller wants more information, refer to the instructions for IRS Form 982 that goes in to other ways to exclude forgiven debt.

Do not try to be a tax professional for your sellers. If you are a Realtor, you sell real estate, you do not give tax advice. If the seller wants to know about the tax consequences of a short sale, refer him to this post for general information. When my sellers want specific answers to their individual tax questions, I refer them to Richard deButts of Jewell, deButts & Roberts, PLLC , because he has experience with short sales. Do not hesitate to refer your seller to competent tax advisors, first because they will get quality advice and secondly your errors and omissions insurance probably does not cover any mistakes you might make giving tax advice.

One other practice that will protect you from liability is to put a contingency in the contract similar to “this contract is contingent on Seller’s apporoval of the tax consequences of this sale within 10 days of the execution of this contract. Seller is advised to consult a tax professional.” If you have a contingency in the contract for the seller’s review and approval of the tax consequences, there is conclusive proof that the understanding of the tax consequences is an important part of the contract, as the contingency gives the seller the right to terminate the contract if the owner is unhappy with the tax consequences. A similar method to protect yourself is to advise the owner in writing that they must consult a qualified tax professional and putting hold harmless and indemnity provisions in that document so that if the owner later decides that there is a misunderstanding concerning the tax consequences, you are indemnified (financially protected) by the owner against any liability.

The IRS just published a pamphlet that will explain many of the tax issues in a short sale. Click here to get a copy of it. If the sellers ask you tax questions, one of your simplest ways to answer them is to refer to the pamphlet, and give them a copy with your listing materials as you refer them to a qualified tax professional.

Short sales require a wide variety of talent. You thought a regular sale was interesting. Now, you can have a more complicated sale that raises issues from the nearly impossible to read Internal Revenue Code. Just be careful and you can help our financial crisis by getting distressed homes sold.

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