Short Sale vs Foreclosure

An increasing number of homeowners owe more on their mortgage than their property is worth. If the borrower doesn’t want to continue making payments, he could explore executing a short sale of the property, or foreclosing on their loan. Ingrid Case provided some great information on these options in this month’s Financial Planning Magazine. I’ve summarized her thoughts below.

A short sale enables a property owner to sell their home at market value, and the bank forgives whatever part of the loan isn’t covered by the proceeds of the sale. Some experts believe a bank will not begin discussing a short sale on a property until the owner stops making payments. However, there are reports of individuals obtaining an offer for their home and then negotiating with their lender, and the bank approving the short sale in an attempt to minimize its loss and property management responsibilities. There are even stories of people who were able to buy a new home before finalizing the short sale of their previous home. Of course, purchasing a new home likely wouldn't be possible immediately after completing a short sale and suffering such a hit to one’s credit.

Before executing a short sale it is critical for the owner to determine whether the property is located in a recourse or nonrecourse state. In a recourse state, a bank may sue a borrower for the difference between a home’s selling price and the amount the seller still owes on a mortgage. As a result of this policy, in a recourse state a property owner may end up filing for bankruptcy even after the short sale. Consequently, a property owner might be better off keeping the home and paying off the mortgage. By contrast, in a nonrecourse state a bank that agrees to a short sale cannot recoup its full loss by suing the property owner. Find out whether your state is a recourse or nonrecourse state here (Utah is a nonrecourse state).

As you might expect, there are potential tax implications to a short sale. Usually, debt forgiven by a lender counts as taxable income. However, for the tax years 2007 through 2012, the Mortgage Forgiveness Debt Relief Act exempts homeowners from up to $2 million in forgiven debt on their primary residence.  Note that the law doesn’t apply to business property, rental property or second homes, or to debt that was refinanced to pay off credit cards or other consumer debt. Additionally, beware that this law is set to expire at the end of this year.

Foreclosure is an alternative way to dispense with a property. With a foreclosure, the homeowner stops making the mortgage payments and the bank reclaims the house and then resells it in hopes of covering or offsetting the defaulted loan. Foreclosure requires very little from the defaulting borrower. Be aware, however, that in a recourse state a bank can sue the former homeowner for the difference between the amount owed and the resale price. The deficit could even be more than that in a short sale because the home’s post-foreclosure selling price may be hurt by vandalism, theft, or deterioration that can occur when a home stands empty.

Foreclosure also wrecks a defaulting borrower’s credit, making it very difficult for that person to get another loan at a reasonable rate. Experts say that outside of bankruptcy, foreclosure is the worst thing you can have on your credit report. For this reason, in most cases a foreclosure should truly be a last resort.

As you might imagine, with both short sale and foreclosure circumstances an attorney and a real estate agent who specializes in such situations can be helpful, particularly if they have strong connections with the banking community.

Lastly, before exploring a short sale or a foreclosure, a borrower should always attempt to work with their lender to modify their mortgage. Negotiating a reduction in the interest rate or principal can help some homeowners hang on to their property. There is no penalty for requesting a loan modification, so it is likely an appealing route to try before considering a short sale or foreclosure. Pursuing a loan modification is simply a matter of talking to your bank and informing them that you can’t meet your payment obligations as they stand. More information can be obtained about loan modification programs here. 

Postscript - 10/15/2012: One of my clients just completed a home loan modification through www.makinghomesaffordable.gov. Although it was a lengthy process (six months), the client, who had an outstanding balance of $270k on her mortgage, had her interest rate cut from 5.875% to 2.375% for the next five years, 3.375% for the sixth year, and 3.625% for the remaining life of the loan. Over the next five years, the new interest rate will save the client $47,189 in reduced interest payments. Over the life of the loan (27 years), total interest payments will be cut by $138,814.