A short sale is an written agreement with a mortgage lender(s) where they agree to accept less money than they are owed to pay off the mortgage, so that they do not have to own the property as a result of the foreclosure process. Short sales have been around for years but they are more prevalent now than at any time in history due to the economic turmoil caused by unemployment, bad loans made by lenders and outright mortgage fraud and predatory lending.

Eventually, borrowers who are delinquent on their mortgage(s) will receive a Notice of Default or a Notice of Election and Demand. This is the mortgage lender’s way of saying they are moving forward with the foreclosure process. Borrowers who are delinquent often try to do a loan modification in order to get a lower payment and stay in their home. Once borrowers have exhausted the loan modification process, their options are reduced to letting it go to foreclosure or doing a short sale. Approximately 1 in 4 homes throughout the United States are worth less than the amount that is owed on the mortgage(s). So, even if borrowers wanted to sell their home they may be prevented from doing so because the sale of the property may not generate enough in proceeds to pay off the loan(s) on the property.

This is commonly called being “upside down” on a mortgage. In some areas of the country, home prices have fallen to such a degree that it is unlikely that the value of the property will ever again equal what is owed on it in the remaining life of the borrower(s). Increasingly, borrowers who come to understand that their home will likely never return to its former value are defaulting on their loans in what has become known as “strategic default.” The logic is this: Why would a borrower continue to pay for a house month after month if there is no chance of ever being able to re-finance the loan or pay it off by selling it or of the value coming back up while the borrower was still alive?

There are two ways for a borrower to do a short sale: The conventional way; find a buyer and negotiate with the borrower’s lender(s) for a short payoff or the borrower can apply for a Home Affordable Foreclosure Alternative (HAFA) short sale where the lender agrees in advance how much they will accept and then the borrower tries to find a buyer who will pay that price. The conventional way is often a long and drawn out process with months of delay because the mortgage companies have many other borrowers facing foreclosure that are ahead of them in their short sale process. (This is not all bad for the delinquent borrower because they get to live in the home for free during the short sale process which allows them to save money and create an exit strategy for themselves and their family.) Both short sale approaches require that the borrower share their financial information with the mortgage companies so they can see that the borrowers are indeed facing a hardship or are distressed. (Job loss, illness, divorce or job related relocation are examples)

This is the most common type of short sale. Borrowers who are delinquent will eventually get referred to the foreclosure department of the lender for non-payment. Each lender has their own policy about how many months delinquent a borrower can be before the foreclosure process is initiated. Most lenders will postpone a foreclosure sale if the borrower is involved in a short sale and there is an offer in process. Some lenders, most notable, Ocwen Mortgage, will not postpone a sale for any reason. In those cases, the short sale must be closed and the funds sent to the short sale lender prior to the sale date.

Typical financial documents required include: 2 most recent years of Federal Tax returns, 2 most recent bank statements for all accounts, 2 most recent paycheck stubs or a letter stating there are no check stubs due to unemployment in which case an unemployment award letter is required. A social security benefit letter or similar from any pension plan is required as well as a financial information form detailing monthly income and expenses. Lastly, a hardship letter is required explaining what the hardship is that is preventing the borrowers from making their mortgage payment.

Once the required documentation has been reviewed, the lender(s) will order an appraisal or Broker Price Opinion (BPO) from a one or more Realtors. This allows the lender(s) to see what the fair market value is so they can evaluate the quality of the offer from the buyer. Once the evaluation study has been completed the lender(s) are then able to give a counter-proposal or accept the offer as is, subject to investor approval. At this point the short sale package may be ready to go to the investor who actually owns the loan. It’s important to understand that Wells Fargo or Bank of America or JP Morgan Chase or US Bank, and others are loan servicing companies. The investor may be Bank of New York, Deutsche Bank or Bank of China or some group of Arabs in Bahrain or Fannie Mae or Freddie Mac. The people the borrower gets to speak with on the phone when they call the 800# simply work for the investor. So, if it took 10 or 12 weeks or more to get to the point where the package is ready for investor review, it may take even more time because the investor’s already have a big line of short sale packages waiting for their review and approval.

Eventually, the mortgage lender issues a written approval of the short sale specifying the exact minimum amount the lender will accept as proceeds from the sale and a deadline by which they must receive the money or the approval will expire. If there is a 2nd mortgage, this same process goes on in parallel but it can’t get approved until the 1st mortgage investor has agreed how much money they will allow to go to the 2nd mortgage company or any other junior liens. This is where many short sales run off the track. A 2nd mortgage company that is owed $50,000 for instance may only get $2,500 or $3,000 from the short sale and they are reluctant to only get six cents on the dollar. They often demand more money, seeking it from the Realtors or even the sellers of the property or the buyers. The letter details the amount to be paid for commissions, buyer closings costs, title fees, water and sewer bills, HOA dues or liens and any relocation incentive payable to the borrowers at closing.

Many lenders will mention in their short sale approval letter whether they will pursue the borrowers for a deficiency on the money they can’t pay. They also discuss the fact that the forgiven debt will be reported to the IRS on tax form 1099C. Sometimes these letters mention how the short sale will be reported on the borrower’s credit, such as paid via settlement or paid for less than amount owed, which is credit-speak for a completed short sale. In some cases, a 2nd mortgage company or a Private Mortgage Insurance Company (PMI) that insured one of the loans will require that a promissory note and a payment plan be agreed to in order for them to release their lien (Deed of Trust) so the property may be sold. The short sale success turns on this decision point. Example: A 2nd mortgage lender is owed $50,000 and that lender is receiving $3,000 as proceeds from the short sale and then requires that the borrowers sign a $7,000 unsecured promissory note at no interest payable at $100 per month for 70 months or the 2nd mortgage lender will not release their lien. So, a $50,000 debt gets settled for $7,000 … that is a good deal and one a borrower should consider agreeing to so the short sale can be completed.

A borrower who walks away from this type of settlement risks being sued for a deficiency judgment by the first and/or second mortgage. In a foreclosure, the 2nd lender gets wiped out and receives no money so they are often quite aggressive about pursuing the borrower … not right away, but several years later when the borrower is back on track financially. They can garnish wages and even seize bank accounts to recover their money. The same remedy is available to the first mortgage lender but cases of them pursuing and then suing borrowers are not as prevalent. Both situations are good reasons to consider a short sale. There is a written settlement agreement between the parties and the borrower knows what to expect. In the few cases where the 2nd mortgage company does not make it clear in their short sale approval letter if there will be a deficiency or not, the borrower can usually negotiate a settlement for pennies on the dollar if they are pursued at some time in the future. Most of these loans are charged off as a loss and may then be sold to collection companies for $.02 or $.03 per dollar. These collectors simply want to make a return on their investment.

If the borrower is an investor or a non-owner occupant of the property that is the subject of the short sale, they will have to pay tax on the forgiven debt because the IRS considers forgiven debt to be ordinary income. However, if the borrower is 1) an owner occupant and the loan(s) that are in default were used to 2) acquire or improve the property and the borrower 3) completes a short sale where there was forgiven debt, prior to December 31, 2012 there is a special moratorium in place so that forgiven debt will not be taxable, even if the IRS receives a 1099C from the lender stating there was forgiven debt. Borrowers who are considering a short sale should consult with a tax advisor to see if the tax moratorium will work for them. Another instance where the forgiven debt from a short sale is not taxable is if the mortgage debt was included in a Chapter 7 Bankruptcy proceeding. Generally, if the borrower is insolvent, there is a provision in the Bankruptcy Code that views the mortgage debt as extinguished, and not forgiven so there is no tax due to the IRS.

In order to be able to give free and clear title to the new buyer, the short sale mortgage lender will allow all outstanding property taxes to be paid from the sale at the closing of the transaction. Most lenders will allow outstanding HOA dues and/or liens to be paid at closing too. In many areas unpaid water and sewer bills can create a lien on the property and in those cases, lenders will allow those bills to be paid from the closing too. Gas and electric charges, however are the responsibility of the seller.

Most buyers want to see the short sale seller moved out by the day of closing or sooner. This minimizes any concerns about having to evict the seller who refuses to move out after the closing. It also allows the new buyer a chance to walk-through the property prior to the closing to make sure the property is in the same condition as when they agreed to purchase it.