Don’t Have Short Sale Moving Problems

March 31, 2009 by  
Filed under Short Sale Do's & Don'ts

moving-van-for-short-sale-closingIn a real estate short sale, you have a seller with no money who needs to move out of the property. As a part of Realtor training that I have done for agents in Raleigh and Cary, North Carolina, we have to discuss how moving costs money, and have a plan for the proper thing to do.

The best answer occurs when the home mortgage lender allows some payment to the seller at the closing of the home sale that can be used for moving expenses. Some payment is permitted under the HUD Preforeclosure Sales Program to the seller, a sales program used to stop foreclosure and allow the mortgage loss mitigation of a short sale to replace a foreclosure sale. In general, the seller gets $750 at closing. If the property sells quickly, the seller gets $1,000. This money can be received in cash at closing and used for anything the seller wants, such as moving expenses. The seller will also be reimbursed for the cost of the appraisal and title search required by this program and a portion of the legal fees incurred. So, the seller can get some additional money back at closing, even though the seller does not fully pay off the mortgage loan.

Some short sale agents tell the buyer to pay money to the seller outside of the closing, or outside of escrow, so it does not show up on the closing statement. One of the requirements for short sales is that all parties have to certify to the lender getting the short payment that the seller is not getting anything out of the sale. I disagree strongly with having the buyer hide the payment to the seller as you are deceiving the home mortgage lender, and I do not think you want trouble with the home loan authorities as a part of the home buying experience Yet, I have been on a Realtor training webinar where the participants discussed this approach. Be careful who you listen to, they may get you in trouble.

There is another seminar leader whose Realtor training is to pay the seller $2,500 for work the seller is doing as a part of selling a home. The examples given are that the seller does the open houses and other work that the agent would otherwise have to do to market the short sale home. So, the agent is merely paying the seller for work that the seller is doing on the agent’s behalf on the property for sale. I have paid other agents to do open houses for me on houses for sale, but the compensation has been around $100. It could be argued that this may have some merit, because it is a payment for services rendered and the mortgage lender may see that there is some way that the payment can be justified, so they may choose not to challenge it. However, this a risky way of selling a home, as the amount of the compensation is out of proportion to the work done. Also, there may be regulations in your state that prevent a Realtor from paying someone for doing work that requires a real estate license. You could take this idea and modify it to pay the seller a reasonable amount for some useful service, particularly a service that does not require a real estate license, then you can justify the payment as a reasonable business arrangement that is not related to the property for sale.

So what do you do to avoid lying to the home mortgage lender? There should be no problem if you want to take the idea above and pay the seller for work done, and pay a reasonable amount for whatever service the seller provides in a field that does not require a real estate license. I have paid agents to hold open houses at my listings in Wake Forest and Rolesville, North Carolina. It would not be that much different if I paid the seller, so long as the payment was properly disclosed.

My favorite approach is to look at the problem in a different light. The problem is the furniture, the cost of moving it and the cost of storing it. So, eliminate the problem and raise cash at the same time. Sell the furniture as a different approach to loss mitigation. There is nothing that prevents the seller of real estate from selling any asset they may have to raise money, including the furniture. Separate from selling a home, just sell the furniture to anyone, and there are auction companies that specialize in selling a home full of furniture. You can also put in your MLS listing that the furniture is for sale. Even if the buyer wants to buy the furniture for a reasonable price, there is nothing I can see that is objectionable. The buyer gets fair value, the seller gets some money, and the seller does not have to pay for the moving and storing of the furniture that was sold.

There is another solution that is relies on the goodness of the community. Particularly where I live in the South, there is a principal of helping people who are down on their luck, particularly a family facing foreclosure. The church members will help the seller move. The relatives will take them in. Other community members will pitch in to help get the family resettled, or take care of the yard after the seller moves. See if you can find other resources to help out the seller so that you are not tempted to mislead those who make mortgage loans.

This is a recurring problem and there are solutions that will not get you in trouble.

Owner’s Choices: Short Sale versus Deed In Lieu of Foreclosure

March 14, 2009 by  
Filed under Short Sale How To

warranty-w-red-110A deed in lieu of foreclosure occurs when an owner gives a deed to the property to the lender in order to avoid the foreclosure process. It is commonly called a deed in lieu. The benefit to the lender is it saves the time and expense of the foreclosure. The lender will only accept a deed in lieu if there are no other liens on the property i.e. not other loans, judgments or secured debts. The reason for this is that the lender does not want to take over the obligation to pay the other debts that are secured by the property. If the lender has a first lien and forecloses, that foreclosure eliminates the other junior liens, other than IRS liens. So the deed in lieu has to be the same result of clean title as a foreclosure in order for the lender to be interested.

The advantage of a deed in lieu is that it only takes one negotiation. If the bank accepts, the owner is done with the house. One of the essential goals of the negotiating with the bank is to get a complete release from the debt. In other words, the owner wants the bank to accept the property in full satisfaction of the entire debt, so that the owner will not be chased by any debt collectors after the recording of the deed.

The byproduct of this result is a benefit for tax consequences. If the property is taken in full satisfaction of the debt, there is no debt relief i.e. the debt was fully paid. Without debt relief, there is no income tax consequences of the deed in lieu, unless the IRS wants to challenge the transaction by claiming that the market value of the house was less than the full value of the debt. So, the owner needs something like a market analysis to have on file showing that the amount of the debt was equal to the market value of the property.

The owner can also negotiate as smooth transition out of the house, with a reasonable time to move to a new location.

One disadvantage of a deed in lieu of foreclosure is the effect on your credit score. Under the Fannie Mae guidelines, a deed in lieu will make you ineligible for that type of loan for four years. In contrast, a short sale takes two years to “season.” Also, the standard loan appllication not only asks about foreclosures in the last 7 years, it also asks about a deed in lieu of foreclosure for that same period of time. For a deed in lieu, you have to answer the question “yes” for 7 years. For a short sale, the answer is “no.”

A lender does not have to accept a deed in lieu. There have been owners who have written out a deed, recorded it and sent it to the lender. They do not have to accept it. So, a deed in lieu is not a sure thing. Neither is a short sale, a bank does not have to do a short sale either.

The deed in lieu is a sale for purposes of income tax, just like a foreclosure and a short sale. So, if you made a profit you may owe tax on the gain. But section 121 of the Internal Revenue code eliminates the tax on a gain of up to $250,000 for a single tax filer and up to $500,000 for taxpayers filing jointly for a qualified principal residence.

Why aren’t there more deeds given in lieu of foreclosure? Many people do not know about them and some Realtors do not discuss that alternative as there is normally no commission paid. Since the short sale is a sale, the Realtor gets a commission. Since the deed in lieu is not like a normal sale, there is normally no commission.

Do Price the Home Like Goldilocks

March 13, 2009 by  
Filed under Short Sale Do's & Don'ts

goldilocks-70Goldilocks found that one item was too hot, another was too cold, and one was just right. The pricing a short sale listing needs to follow the Goldilocks principle, not too high, not too low, but just right.

If you price the house too high, you will not get showings and offers. To get the short sale process started, you normally have to present an offer to the lender. There are some lenders who will pre-approve the seller’s qualification for a short sale, but that is in the minority. So, you need to price well to get an offer.

You might have to ignore this rule briefly, depending on the lender you are working with. Some lenders want to see that you tried to get them fully paid. In other words, they want to see that the listing price started at a figure that would give enough money to fully pay the lender. If the market tells them there is no way to get that amount after you tried, they are more satisfied that it is the market, and not the Realtor, who is forcing them into a short sale situation. If you have to do this, leave the price high for a while, then drop it. How long is a while? That depends on whether you are facing foreclosure or not. If not, a while is a couple of weeks. If foreclosure is looming, you might want to skip this altogether, or price it high for a few days.

Why not price too low? You want to get an offer to start the short sale process, but if the offer is outrageously low the lender will not even open a file to review it. Also, if you do not generate an offer that is close enough to the market value for the lender to accept, you will not get the lender approval so you will not close the sale. Generally, most lenders will take 90% of the market value from a Broker Price Opinion (BPO) or an appraisal, although some will go as low as 80%. In some markets, the buyer’s agents will not bring you offers above the asking price. So, your low price generates offers that are too low and you do not close.

What is just right? You want to stand out below the price of the other homes for sale, because you will have to give the buyer an incentive to go through all the difficulties of a short sale. What it takes to stand out depends on your market. In Raleigh, a 5% discount is enough to get the buyer’s attention. In other markets, it may take more or less, depending on the inventory of homes for sale.

There is an exception to the Goldilocks rule. If you are facing foreclosure, do whatever it takes on the price to get an offer. Some lenders will not proceed with a foreclosure if they see that the home is being aggressively marketed and they will keep the property in the loss mitigation department. But, once your file is transferred to the foreclosure department, the lender goes full speed ahead to foreclose. The foreclosure department’s mission is to either get the loan fully reinstated, or to sell the property on the couthouse steps. The only thing that will stop the run away train heading toward foreclosure is an offer.

On one property in Raleigh, I was trying to sell it around $450,000. When the foreclosure notice came out, we dropped the price to $425,000 and got more showings but no offers. So, we dropped it to $400,000 and got multiple offers that bid the price back up to $420,000. If you want to see how to get multiple offers to bid up the price, go to www.CreateAGreatDeal.com. Without an offer, the home would have been foreclosed.

Which side to your err on? Go toward the low side in pricing instead of the high side. It is better to have offers to submit, and get a counter offer from the lender, then try to get the buyer to accept the lender’s counter offer than to have no offers at all. One monkey wrench in this plan is the occasional lender that will just turn down your offer without a counter offer, leaving you with nothing to present to the buyer. Luckily lenders are getting smarter in short sales, so they are doing this less.

Seller Qualifications for a Short Sale

March 10, 2009 by  
Filed under Short Sale How To

treasury-70With my first short sales in 1992, the seller had to be totally destitute to qualify with their bank for a short sale. If they had any money, or any way to get some money, they bank wanted it. If you were a bank, you would not want to let a borrower get away without paying you back unless there was no way they could pay you back.

Now, the qualifications are easier. Software has even been created to review the qualifications of a seller for a short sale. Just like Desktop Underwriter will review whether a borrower is qualified to receive a loan, this software will review the seller’s qualifications for a short sale.

The borrower cannot have sufficient assets to come to the closing with the money necessary to pay the loan in full. Some people say that the seller has to be insolvent. That is a bit stronger than necessary. The borrower does not have to be totally bankrupt, just unable to use any assets to raise the money to pay the balance due on the loan.

The second thing that will make it easier for the bank to approve the sale is if the seller has a negative cash flow. In other words, if the seller has less money coming in than what is going out, every month the seller is short of money to pay the household obligations. This is where some sellers will hurt themselves. Most people are used to filling out financial statements to make themselves look good. They have a hard time facing their financial problems so they will fill out their financial statement to show that they balance each month i.e. the same amount of money comes in as goes out. Encourage the sellers to be honest, if they are financially losing ground every month, put it down that way.

The third thing the lenders look for is financial hardship. The hardship letter is discussed in detail in a separate post. You want to show a reason for a change in the financial situation from when the loan was originated to the present. So, if the sellers lost a job, watched their business fail, had the mortgage payments adjust, had a family tragedy or had a medical problem, show the financial consequences of the hardship.

Having poor credit is a problem for getting a loan. Having poor credit is no problem for getting a short sale. Do not worry that the credit is bad. It should be if there is serious financial distress. But, bad credit is not a requirement for a short sale, as I have done a number of short sales for people who have made every payment right on time.

Qualifying for a short sale is the reverse of qualifying for a loan. To get the loan, you have to show that you have a positive cash flow, plenty of assets in reserve and no financial problems. To get a short sale, you have to show a negative cash flow, minimal assets and serious financial problems.

Don’t Practice Law, Unless You’re a Lawyer

scales-of-justiceThe relationship between Realtors and Lawyers is interesting. Lawyers do not want Realtors intruding on their turf. When a foreclosure proceeding is filed, it may be considered a lawsuit depending on the foreclosure procedures in your state. Many foreclosures are done by a power of sale in the deed of trust, so it is just a series of notices and other requirements leading to a non-judicial foreclosure. In other words, it is not a court proceeding. However, in many states a foreclosure is a filing with the court, so it can be considered a legal proceeding or lawsuit.

In North Carolina, the Short Sale Addendum to the Listing Agreement says “If a foreclosure or other judicial proceeding is filed with respect to the Property, although Firm may continue to solicit and negotiate offers to purchase and contact, communicate with, obtain information from and supply information to Lienholders, Firm may no longer negotiate the terms and conditions of a Short Sale with Lienholders, as such negotation would constitute the practice of law.” This did not come from a determination by the North Carolina State Bar, as they have no official opinion issued on this issue. What that means to you is that the bar association has not agreed on where the line is between the practice of real estate and the practice of law. This wording came from the North Carolina Association of Realtors. I talked to an attorney at the North Carolina Real Estate Commission who felt it would take an extreme situation of negotiating with a lender for the Realtor’s activity to be ruled to be the unauthorized practice of law, as he felt that presenting an offer to a lender and encouraging the lender to take the short sale is a permissable activity for a Realtor.

Other states have similar interpretations of the line between what a Realtor can do and the practice of law. For example, click on this determination by the Florida Bar’s Standing Committee on the Unauthorized Practice of Law.

Luck for me, I am an attorney. How about you?

If you are not licenced as a lawyer in the state where the property is located and where the client lives, you need to know about the rulings that may restrict what you do in negotiations when a foreclosure has been filed. For states like California, where nearly all the foreclosures are non-judicial in nature, the line may be drawn in one location. For states like North Carolina, where the foreclosures involve a court filing, the line may be in a different location.

One other pitfall to avoid is the regulations on debt counseling. If you charge the seller a fee that is not contingent on the closing of the sale, it can be argued that you are doing debt counseling. So, do not charge any up front fees, just collect commissions if the sale closes.

How do you stay out of trouble? Follow the wording in your forms. For example, in North Carolina, you contact, communicate with, obtain information from and supply information to the lender. You do not use words like negotiate or advocate in any correspondence. Be sure to phrase everything, particularly everything in writing, in terms of contacting, communicating, obtaining and supplying information. You are just communicating, you are not advocating.

How do you find the line? Talk to your broker in charge. You may also want to talk to an attorney, particularly if your firm has one on retainer. Just know where the line is so that you will not have problems. Some of your communication with a lien holder that are in writing might be lasting proof that you are engaged in the unauthorized practice of law, so stay away from the line.

Don’t Take Away the Owner’s Lifeline

March 9, 2009 by  
Filed under Short Sale Do's & Don'ts

lifeline-70x70There are times when you should not do a short sale, or you need to do it carefully. If the seller has a home equity line of credit, it may be the only lifeline available to the family. If the seller can still withdraw any substantial amount of money from that line of credit, it may be the only thing keeping the family afloat while they look for another source of income. In the current economy, people who have lost their jobs or had major setbacks need to keep their one means of support in hopes that something will be found in time. If you are not careful, you could ruin their chances for recovery.

Some Realtors submit the financial information to the lender early in the process, to see if the seller qualifies for a short sale. The seller’s financial information can be fed into a computerized review system to see if the seller qualifies for a short sale. Most of us are familiar with Desktop Underwriter where a loan application is fed into a computer to see if a borrower qualifies for a loan. Some loss mitigation departments have software for the reverse situation, to see if the borrower is in enough financial distress to qualify for a short sale. In some situations, the loss mitigation department will review the financial situation before you have an offer and determine that the seller qualifies for a short sale. This can shorten the review process once an offer is presented.

The last thing you want to do is to give the home equity lender a financial statement showing that the borrower no longer is able to qualify for the home equity line of credit. Nearly all of these lines of credit have a provision that if your financial situation changes, the lender can take away the line of credit. By submitting this information while there are still funds available on the line of credit, you will be eliminating the one lifeline that the family has.

So, if you are going to do the short sale, you have to time it right. Be sure that selling the home is the best thing for the owner by determining if the payments on the house are substantially higher than the cost of other shelter available to the family. If the house payment is one of the things that is pushing the family “underwater”, the short sale may be appropriate. But, you only want to present the financial information at the last minute and keep the line of credit available as long as possible.

The BPO is Critical to a Short Sale

March 9, 2009 by  
Filed under Short Sale How To

bpo-house-70x70A short sale is a way for a bank to minimize its loss and get as much as possible for their loan. To judge whether the proposed sale is reasonable, the bank wants to know what the market value of the property is. Most banks will accept an offer that is around 90% of the market value of the property, some will go as low as 80% under exceptional circumstances. To get a market value, some banks hire appraisers for a full appraisal. Most ask for a Broker Price Opinion, commonly called a BPO.

BPOs are done by Realtors, typically ones who sell the properties that banks foreclose on, commonly called REOs (for Real Estate Owned, a category on the bank’s books to show the foreclosed properties they own). The bank contacts the REO broker with an order for a BPO. Typically, the Realtor has a series of instructions from the bank that have to be carefully followed. The BPO form is just a few pages long, asking for a comparison of the short sale property to three properties that are for sale and three recent sales.

The standards for the properties to be compared are set down by the bank, and the reviewers for the BPO company are meticulous in enforcing these standards. Most of the forms are extremely inflexible, with little room for comments or description of any issue that does not fit into a box on the form. In other words, you need to be aware that the form does not normally allow for any unusual information, and most of them only allow a limited number of pictures. Imagine trying to get the information for the house in the picture on this post into a BPO form. So, you could have a serious ideosyncracy for the property with no place to put it in the BPO form. However, the banks process thousands of these forms, and standardization makes them much easier to review.

There are interior BPOs and exterior BPOs, commonly called drive bys. Both involve taking pictures of the property and the neighborhood. The interior provides much more information, the exterior just looks at the outside. The pay for an exterior BPO is around $40 to $60. The pay for an interior BPO is higher, typically around $100. Some companies get the BPOs done for free with the promise that Realtors who do enough BPOs will get the REO listings. You have to get used to the alphabet soup, if you are talking to a bank, you need to know the acronyms.

You can tell from the pay, or lack of pay, the BPOs cannot take too much of the Realtor’s time. Many of the Realtors who do BPOs have a staff to do the administrative tasks, so the agent gets involved only on evaluating the information to give the price range. In short, they are mass produced.

Most of the people who teach about short sales want the Realtors to try to influence the BPO. You want to provide accurate information about the market, the repair issues in the house, the features that will make it hard to sell and other factors that affect the value. Some seminars say to take the lock box off the door to the house, so the BPO agent has to meet the listing agent to get into the property. That is difficult to do if the house is still on the market and being shown by Realtors. The idea is to give the listing agent an opportunity to provide information about how the sales price is close to the market value, such as handing the BPO agent three listings that are for sale and three that have recently sold. Some instructors say to fill out a sample BPO form and give it to the BPO agent. There are a great deal of new regulations prohibiting Realtors from trying to influence appraisers, so if you are dealing with an appraiser, be sure you know the rules for your area.

A good idea is to furnish the bank with pictures of any repair issues or damage, along with bids for the cost of repairing those items. These pictures and bids should be sent to the loss mitigation negotiator, as the BPO agent may not be able to put them into the form. Ask the negotiator whether the BPO discusses these issues and adjusts the price accordingly.

It is prefectly appropriate to try to get accurate information of the value of the property into the BPO. The whole process depends on comparing the offer to the market value. A high BPO does no one any good, except for the people who make money off of foreclosures. There is a new state law in California that prohibits an unfairly high BPO price by an agent who may get the listing on the property if there is a foreclosure. The California legislature found there were agents who gave a high BPO value to prevent a short sale from being accepted so they could list and sell the property after a foreclosure. I am skeptical that agents would do that, because it is extremely hard to predict who will get the foreclosure listing. It is the law in California none the less.

If you get a BPO that is out of line, it is difficult to correct. Many loss mitigation negotiators will not tell the agent what the BPO value is, which makes little sense because the listing agent could provide great insight into any mistake in the BPO.

I had one short sale where the propety was appraised at a value of $520,000 while the sales price in the contract was $420,000. The property had been for sale for over a year, with the highest asking price being $475,000. I had to drop the price several times to get other agents to show the property, which indicates the $475,000 asking price was too high. When the bank started foreclosure proceedings, the price was dropped to $400,000 to get a quick sale. The low price resulted in three offers, and buyers who bid the price up to $420,000. If the property was worth anywhere near $520,000, there would have been dozens of buyers much earlier.

The bank would not disput the appraisal, and ignored the comparable values I sent. Radian Guaranty, the mortgage insurance guarantor, would listen to me, and reviewed an extensive market analysis that I sent. As a result, they overturned the decision to reject the short sale and the sale closed gracefully. The lender, the guarantor and the investor will be skeptical of your figures, feeling that the Realtor is just trying to get the sale approved to make the commission.

In short, the secret to success in short sales is to get a good BPO that allows the sale to be approved by the lender.

“Don’t Cut Commissions” – Fannie Mae

fannie-mae1These are some of the most beautiful words in the Fannie Mae Servicing Guide:

Effective March 1, 2009, closing of preforeclosure sales may not be conditioned upon a reduction of the total commission to be paid to real estate agents to a level below what was negotiated by the listing agent with the borrower, unless the fee exceeds 6 percent of the sales price of the property in aggregate. Servicers are reminded that they must continue to obtain any approvals that may be required by interested third parties in connection with preforeclosure sales. (Part VII Section 504.02)

You need a translation from Fannie Mae speak to Realtor language. Preforeclosure is Fannie Mae’s term for a short sale. As long as the total commission is 6% or less, Fannie Mae as the investor is directing the servicer to leave the commission alone.

I have grabbed the microphone at REOMAC meetings to question the practice of cutting Realtors commissions. I have button holed Fannie Mae and Freddie Mac executives to discuss this practice. I lead an ovation for the Freddie Mac executive on a Short Sale panel who said they did not want the practice of cutting Realtor’s commissions to be allowed. I questioned a short sale panel that was so proud of paying a closing attorney extra money when the attorney worked to help loss mitigation, yet they condoned cutting the Realtors commission, and objected to me getting paid when I advised Realtors how to work their way through the short sale process.

Fannie Mae has said that Realtors are not to be treated like dogs.

Why is this important to the homeowners? Because it is the Realtor who is taking on the challenge of selling the home, getting the buyers to put up with the delays in a short sale review, and negotiating with all the lien holders. If the Realtor knows that the commission will be cut, they are much less likely to take on this task that is much more difficult than a traditional sale. If the Realtor knows that they will be properly compensated if the sale closes, there will be many more short sales with their benefit to the borrower, the lender and the neighborhood.

In an individual case, the bank will make more if it steals some of the Realtor’s commission. That is what CitiMortgage did to me in the short sale of a property on Crest Road in Rancho Palos Verdes, California. By negotiating in a questionable manner, they withheld approval of their short payoff until everyone else was up against a foreclosure deadline. Then, they would only approve a much larger payoff than allowed by the first and the second loans, so the only way to accomplish that was to have the Realtors pay CitiMortgage. Their negotiating trick left no time to get the situation corrected. In this one situation, they made more money. I have not done a short sale involving Citi since. Also, I disclose this experience to any Realtor that I educate on short sales. I will not do a short sale where Citi is involved unless they are representing a loan where Fannie Mae or Freddie Mac is the investor.

So, Citi made $25,000 more in this one situation. I will bet that they are losing many other short sale opportunities, where their total loss dwarfs the one time savings.

Fannie Mae has done an excellent job of emphasizing the long term benefit of short sales and eliminating the short term gain of stealing one commission. If Realtors know they will not have a commissionectomy, it is much more likely that they will do short sales.

Thank you Fannie Mae.

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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