The pros and cons of a short sale, and how to do it.

In a short sale, you sell your house before it’s auctioned off in foreclosure, usually for an amount that falls short of what you owe on it. For a short sale to work, your lenders must agree to receive less than they are entitled to under the terms of the loans you signed. Why would they do that? They aren’t in the business of owning homes, and generally do a poor job of it. Also, foreclosures are expensive for lenders, who might not get all they’re owed anyway.

Advantages of a Short Sale

The main benefit of a short sale is that you get out from under your mortgage without liability for the amount of the loan that is left unpaid. You also won’t have a foreclosure or a bankruptcy on your credit record. The general thinking is that your credit won’t suffer as much as it would were you to let the foreclosure proceed or file for bankruptcy to get out from under any liability you might incur in the course of the foreclosure.

Your credit rating will take a hit regardless of which option you choose—short sale, foreclosure, or bankruptcy. But a short sale might mean that you could buy a big-ticket item on credit a year or two earlier than you otherwise would, or get a credit card at 15% instead of 19% interest. You will need to balance the prospect of improved credit against your opportunity to stay in your house longer and save money, as described below. Only you can decide which path suits you better.

Disadvantages of a Short Sale

Short sales have some drawbacks when compared to letting the foreclosure happen or filing for bankruptcy.

No Chance to Stay and Save

If you sell your house, you will be expected to leave as soon as escrow closes. But if you let the foreclosure happen and stay in the house until you are formally told to leave by written notice, you can build a nest egg that you can draw on in the future to obtain good rental housing. (See our article on how foreclosure can help you save money .)

It’s very difficult to accomplish a short sale if you don’t get started as soon as you learn about the pending foreclosure, especially if you have to negotiate with several mortgage holders. Needless to say, if you don’t complete the short sale before the foreclosure sale, you’ll have nothing to sell.

Those Mysterious Credit Ratings

Nobody really knows how a foreclosure or short sale will affect your credit. Only the folks who set the credit scores can really tell you—and they won’t, because certain important factors used to derive credit scores (and the criteria used in follow-up “manual” examinations) are kept confidential as a business secret.

In past years, credit grantors would subjectively assess the raw information in your credit file when deciding whether or not to grant you credit and at what interest rate. For instance, they might have seen that you did a short sale and given you a break for at least being responsible enough to sell the house rather than just walking away or giving the house back with a deed in lieu of foreclosure.

Now, however, this type of examination is made only if your credit score is low enough to trigger it. And because you already have two strikes against you because of your low credit score, the results will seldom cheer you.

Even if current information we do have about credit scores indicates that a short sale is marginally better for your credit, things might change. Credit card issuers are reporting skyrocketing default numbers that predict a crash-and-burn scenario for that industry. Also, because of trillion-dollar government deficits (financed by foreign loans and the printing of money), it’s not hard to see that we’ll be living with inflationary pressures for some time to come. Because issuing credit expands the money supply, the government will likely rein in the credit industry to help fight inflation when the time comes.

All this means it’s next to impossible to predict what role, if any, credit scores will play in the new economy. If consumer credit gets tight enough, the very concept of the credit score may be an artifact of times gone by. For now, the best and most current information on the subject of consumer credit, and how to rebuild it, can be found in Credit Repair by Robin Leonard and John Lamb (Nolo).

Potential Tax Liability

A short sale may generate an unwelcome surprise: taxable income based on the amount the sale proceeds are short of what you owe. It can happen if you borrowed against your principal residence and used the money for any purpose other than acquiring or improving that property. For example, if you used the loan to buy a second house, to pay college tuition for a child, or to take a vacation, and you end up not paying it back in full, the amount your lender writes off (typically whatever amount wasn’t paid back) is considered forgiven debt. Although the concept is not at all intuitive, the IRS treats forgiven debt as taxable income, subject to regular income tax.

EXAMPLE: Joan owes $150,000 on her first mortgage and $50,000 on the second, which she borrowed to pay for her daughter’s first year of tuition at an exclusive Eastern college. Joan loses her job and is facing foreclosure. She arranges to sell the house for $140,000 and gets permission from her first lender to pay off the first mortgage for $135,000 and permission from her second mortgage lender to pay off the second mortgage for $5,000.

The $15,000 the first mortgage holder will write off (forgive) is not considered taxable income because Joan used it to acquire the house. But the amount the second mortgage holder will write off, $45,000, is forgiven debt and considered taxable income to Joan because it wasn’t used to buy or improve her principal residence.

If you face this situation and can prove you were legally insolvent at the time of the short sale, you won’t have to pay the tax. Insolvency is when your total debts are more than the value of your total equity in your real estate and personal property. You can also get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn’t much point in doing the short sale, because any benefit to your credit rating caused by the short sale will be negated by the bankruptcy.

Will You Be Able to Negotiate a Short Sale?

In some areas, short sales are increasingly hard to get approved while in others they are on the increase (or so I’m told). So even if the short sale option looks good to you, there’s no certainty that you can make it work.

The Crowds

As you might guess, a lot of people are trying to negotiate short sales about now. Many lenders apparently haven’t greatly increased their personnel or streamlined their decision-making processes to keep up with the greatly increased volume of homeowners seeking short sales. And even if they have, short sale negotiations often occur in a rushed setting because many homeowners start thinking about short sales only when they are about to lose their house to foreclosure. And you’ve got to have a bona fide offer from a buyer before you can find out whether or not the lender will go along with it. In a market where sales are hard to come by, this can get frustrating because you won’t know in advance what the lender is willing to settle for.

The Terms

Short sales are also difficult to come by if there are investors in the picture who might not approve of getting less return on their investment than they were counting on.

A short sale will benefit you only if the lenders are willing to accept the amount a buyer is willing to pay and let you off the hook for the rest. For example, if you owe $300,000 and you can sell your house for just $200,000, you are unlikely to be successful in negotiating a short sale. There’s a chance, though—the lender might decide that even a 33% loss on the short sale is better than what could happen in a foreclosure, where houses can sit vacant for months and rapidly depreciate in value before being bought by a new owner.

Clearly, the closer the offer is to the principal balance of the loan, the quicker the lender will sign off on the sale. It would be nice if there were a hard and fast line for how much a lender will forgo. In fact, as foreclosures continue apace, real estate agents and HUD-approved housing counselors should have a pretty good idea of the kind of deals lenders are accepting in your area.

You’ll want to work with a real estate professional anyway when you’re trying to get your house sold at a price that will be acceptable to all the mortgage lenders. A real estate agent’s negotiating help can be critical, because the lender may agree with the proposed offer, or it may make a counteroffer. This may go back and forth until everyone is satisfied or the deal falls through.

EXAMPLE: Toby and Tyler face foreclosure on their first mortgage and decide that a short sale is their best option. They contact a real estate agent, who tells them that they should list their house for at least 75% of their mortgage debt—or $225,000—for the sale to be acceptable to the lender. The 75% figure is based on the agent’s knowledge of the going rate for lender acceptance of short sales.

As the foreclosure sale date grows nearer, and the house goes unsold at the 75% figure, Toby and Tyler finally get an offer that would pay 60% of their mortgage; they accept, contingent on approval by the lender. The agent takes the offer to the lender and quickly receives a rejection. The buyer raises his offer to 70%, and the lender agrees.

Convincing Multiple Lienholders

Multiple lenders (or anyone else who has a legal claim, or lien, on your property) can fatally complicate short sales. If you have only one mortgage, you have only one lender to convince. If you have two or more mortgages (or other types of home loans or liens on your property), you must convince all of the lienholders. So the more lienholders there are in your picture, the harder it will be to obtain a short sale.

This is especially true if the property’s value has substantially decreased, and a sale will probably produce little or no money for a second or third mortgage holder (typically, the holder of a tax lien, home equity loan, or line of credit). If these other lenders won’t be getting anything out of the short sale, they won’t have any incentive to release their liens (legal claims on the property) so that a new buyer can have clear title. And more important to you, they won’t absolve you from liability for what you owe them—which defeats a central purpose of the short sale.

EXAMPLE 1: Carlos has a first mortgage on his property of $240,000, a second mortgage of $30,000, and $15,000 out on a home equity line of credit. He can sell the house for only $230,000. All of that money would typically go toward the first mortgage. The second mortgage and line of credit lenders wouldn’t get anything. They would rather let the foreclosure go through and sue Carlos for the deficiency than accept a small percentage of what they are owed and agree to not sue him for the balance. Without their agreement, he won’t be able to sell the house with clear title, because the property would still be subject to the liens of the other mortgage holders.

EXAMPLE 2: Johnny owes $225,000 on his first mortgage, $50,000 on his second mortgage, and $25,000 on a home equity loan. He falls behind on his mortgage payments and decides to put the house up for sale. Johnny receives an offer of $260,000. This amount will more than please the first mortgage owner, because its $225,000 loan will be paid off in full. The second mortgage owner won’t be so happy because it will get only $35,000 of the $50,000 it’s owed. But considering the fact that it wouldn’t get anything if the house went into foreclosure (“junior” liens are wiped out in foreclosures brought by senior lienholders), it agrees to the sale.

Unfortunately, when the home equity lender hears that it won’t get anything, it nixes the sale. And without all lienholders agreeing to the sale, it can’t happen. So Johnny goes back and asks the second mortgage holder to take $25,000 (half of what it’s owed) and offers $10,000 to the home equity lender. The second mortgage holder is even unhappier now, since its share is being reduced, but it still wants the sale to go through, so it agrees. Finally, Johnny manages to negotiate a deal where everyone gets something but not as much as they would like.

When a Short Sale Might Make Sense

• You can sell your house for a price that the lender (or lenders) will likely sign off on.

• You don’t plan to file for Chapter 7 or Chapter 13 bankruptcy (because if you’re hoping a short sale will preserve your credit record, a bankruptcy would undermine that goal).

• All your lenders are willing to let you off the hook for the deficiency (the amount by which the sales price falls short of what you owe).

• You have time before the scheduled foreclosure sale to find a buyer and to explore other options (such as filing for bankruptcy). This can be a problem in states (such as Georgia and Alabama) that don’t give you much notice before the sale.

Scam Alert

More and more companies out there operate scams aimed at defrauding homeowners who are trying to put together a short sale. Make sure you are dealing with a reputable real estate company and with the company that is servicing the loan (the company to which you have been sending your payments). You should also be getting guidance from a HUD-approved housing counselor (see our article on using a HUD-approved housing counselor ).

For more information on foreclosure rescue scams, see Nolo’s article Don’t Lose Your Home to Foreclosure Rescue Scammers. Also check out Nolo’s Bankruptcy, Debt & Foreclosure Blog  for updates. Scams are like viruses —new ones pop up every day.