Understanding
the Nature of a Short Sale
Short
sales all of à sudden became a popular term in real estate.
Some buyers are hunting for them, others, to the opposite, get
turned off by them and run fast from any deal called a short
sale. The reason for such mixed reaction is not a mystery. On
the one hand buyers know that if it is a short sale, the price
most likely is a bargain, on the other, those who have tried
to put an offer in a short sale setting know how frustrating
it could be.
Short
sales existed long before, but were usually addressed to as
"loan workouts". Short sales are a process of "shortening"
or decreasing the debt (the mortgage) encumbering a parcel of
real estate (the house or investment property). Shortening
the debt means that the person holding the debt (the lender,
your Bank) agrees to release its lien on the real estate for
less than the amount the lender is due according to the promissory
note. For example, you bought your property for $500,000, after
all your mortgage payments your outstanding debt (the debt on
the principal) is $450,000. You realized you can't afford to
make payments any more due to change in personal circumstances.
Another rather sad realization that hit you is that you can't
sell your house now even for $450,000. Say, you can sell it
for $430,000 and you want to convince your Bank to accept $430,000
for the property and release you of any obligation to pay the
remaining “short” amount of $20,000. This is a short sale.
You
should also note that your goal in a short sale setting is to
convince the Bank to forgive not only the remaining amount of
outstanding debt, in our example, $20,000, but also the broker's
commission, which usually equals to 6% of the property value,
and closing costs, which could easily run up to $10,000.
The
execution and the details of a short sale are highly complicated.
The nature of each short sale situation is not identical and
quite often the goal you want to achieve is a moving target
seemingly and frustratingly impossible to reach.
What
Does Short Sale Mean for the Seller?
Who
Qualifies - And Why a Lender Would Want to Accept a Lower Payment
than the outstanding debt -
Obviously,
the Lender might accept less money for what you owe not out
kindness of his heart. Lender has its own incentive of not going
to want to keep a secured loan on its books where it has evidence
that the security has decreased in value dramatically and the
loan to value ratio under which the loan was originally made
is now "reversed”, meaning the value is less than the amount
of the loan. The portion of the loan that is not in compliance
with the original loan to value ratio is, for bank auditing
purposes is clearly unsecured. This is bad for the lender,
the lender is required to set aside finances himself to back
up (secure) the loan.
Depending
on the language in your loan agreement, the negative value could
be a reason to declare your loan to be in default by the bank
and demand full payment immediately.
Most
often, the desire to unload the property with negative value
is made based on economic calculations made by the owner of
the property. The owner decides that it is better to take
a loss now of a known amount of money rather than continue to
pay interest, insurance and taxes in excess of the income from
the property. With current situation on the market no one knows
when will the values go back up and the losses could be recouped.
In
any event, the lender would prefer to get rid off the negatively
secured loan. The borrower has the same goal – get rid
off the property. The question remains, which bears the loss
of the dropped values? Each party wants to shift the losses
on the other, and the panic on the market brings the property
values yet even lower.
There
are several case scenarios of the disposal of the property.
First and most obvious one is where the owner has extra cash
and can just sell the property (if they decided not to keep
it with the hope of return to original value) and pay the remaining
amount to the bank at the closing so that the loan is paid off
in full.
Second
case scenario is where the borrower lacks liquidity to pay off
remaining amount for the loan, however, he has other assets,
which can be used to either (1) to provide alternative secured
collateral to the lender, such as a first or second mortgage
on another borrower owned property that has equity value, or
(2) having the borrower sign a new or modified promissory note
that is unsecured and payable over a fixed period of time.
Third
case scenario is where the borrower is experiencing extreme
financial hardship. Only in this case, the Bank may decide to
forgive the unpaid amount to the lender. Just having no equity
or drop of value is not a hardship from the Bank's standpoint.
As long as the debtor is collectable, meaning has assets, the
Bank will collect. The hardship can be loss of income, divorce,
medical problems and necessity to pay very high medical bills,
which came unexpected. The hardship has to be outlined in a
clear cut letter and supported by evidence and financial statements.
A package that is summarized and well organized has a greater
chance of succeeding. Your representative should be persistent
in contacting the Bank on the status on a weekly basis. Properly
utilized short sale concept can be a benefit to the lender and
the borrower and an opportunity for a buyer with patience to
obtain a relative bargain in the marketplace.
Hidden
Traps of a Short Sale
An
owner should be aware of several bad aspects of a “short sale”.
First,
the borrower may be required to report the “phantom” income
on his tax return. As illogically as it sounds, but for IRS
purposes the borrower is considered to have earned income on
a short sale. His income is his forgiven debt. The Bank will
issue an IRS 1099 form, which states the amount of forgiven
debt. If, however, the Bank is trying to collect on the unpaid
portion, that unpaid portion is not income that the borrower
has to report to the IRS.
Another
unexpected surprise might hit the borrower. The lender may sell
the unpaid promissory note (the remaining amount of the deft)
to some investor for 5 or 10 cents on the dollar and then that
investor will definitely come after the borrower for as much
as they can get above that 5 or 10 cents on the dollar.
We
will discuss foreclosure versus a short sale, affect of credit
score, possibility of a deficiency judgment (Bank imposes a
lien on all the personal assets of the borrower) in our next
article.
Foreclosure
versus a Short Sale
In
today's market everyone knows what foreclosure is. Foreclosure
is involuntary repossession of your home by the bank which used
to hold the loan for your home. Such repossession is expensive
for the bank, because the bank has to go to court repossess
your home.
Trying
to save what ever is left of your credit score after your default
on the loan is the goal of any borrower who is in default. Short
sale usually doesn't damage your score as dramatically as the
foreclosure. However, only few people are aware of the fact
that in bank's credit score ratings a short sale occurring after
3-4 missed mortgage payments is treated like a foreclosure on
the borrower's credit report. Some borrowers are surprised that
even though they made every attempt to save their credit score
and worked out a “short sale deal” with the bank, four, five,
six years down the road, they are still unable to obtain financing
from lenders for a new home. This is because of this hidden
treatment of a short sale as a foreclosure.
Foreclosure
carries another dangerous and horrible effect compared to a
short sale – deficiency judgment. Lenders today - more than
in the past - are investing a few hundred more in attorney fees
to get a deficiency judgment.
A
deficiency judgment is obtained when a property is foreclosed
and sold (usually at an auction at the courthouse by the clerk
of the court) to the highest bidder. In most states a
"deficiency" judgment can be obtained for the difference
between the wining bid and the foreclosure judgment amount.
Usually the court determines which value is higher, the high
bid or the appraised value of the property on the date of the
public sale, and the higher of the two is taken to determine
the difference from the judgment amount, and this difference
is the deficiency judgment.
Deficiency
judgments are regular court judgments. They are issued
against the debtor and can only be removed by paying it off
or by bankruptcy. Further, money judgments usually earn
interest until paid. In Florida for example that rate
is 11% a year!
Quite
often banks simply sell the judgment for 5 to 10 cents
on the dollar to a collection company. Yes, that's right
by investing extra $600 in attorney's fees, they can get a judgment
against the debtor for $100,000 - $150,000 and in an instant
transaction can get $10,000-$15,000 in return for the paper.
It is then the collection company that would be trying to collect
from you the full amount of the deficiency judgment and your
lender is out of the picture.
Deficiency
judgment is something that puts your life on hold, you can't
buy anything on credit, you can't sell anything. All recorded
transactions, or more precisely, proceeds thereof are subject
to seizure by the collection company.
What
Does Short Sale Mean for the Buyer
[
to be continued ]
