The housing market and mortgage industry, like the economy, rise and fall. This is normal and consistent with U.S. economics principles. No offense to major media outlets, but these are normal times. As I write this article, interest rates continue to hold steady at historic lows and housing inventories are at their highest levels in years. This is good news for buyers, not such good news for sellers.
Homeowners purchasing property in recent years may have bought properties priced higher than their current value, and financed those properties at high interest rates or via adjustable rate mortgages. This might explain why there's been a sharp rise in potential short sales listed in Massachusetts this year. Between January and August this year, 287 homes were listed by their owners through MLS (a real-estate listing service) as potential short sales, up from 51 last year. And many experts expect this number to increase in the coming months.
The Long and Short of Short Sales & Foreclosure
Short sales, like foreclosures, fall into the real estate category of arrangements called 'distressed sales,' but short sales differ from foreclosures and other kinds of distressed sales in many respects. For one thing, homeowners do not have to be behind in mortgage payments to venture into the short sales market. They merely have to demonstrate their homes can't be sold for what is owed on them. A short sale is an "arrangement" between the current owner of a home and the lender, where the lender accepts an offer less than the total amount owed on the mortgage. The "deficiency" is the difference between the amount owed, and what is collected at a short sale closing. It is important to note if a bank sells a house (most likely at auction) it is not a short sale. A seller deciding to lower the price and take less profit is not a short sale. Someone who owns a home free and clear, who sells a $150,000 for $75,000 - is not a short sale. For it to be a short sale, there must be an outstanding mortgage on the home and either the seller or the lender must be getting "shorted."
Foreclosure occurs when a lender files a notice of intent to foreclose in the Massachusetts Land Court because of non-payment. This filing notifies the homeowner that unless payments are brought up to date, the home will be sold to the highest bidder. Not all homes that fall into foreclosure go to public sale. Owners have the right to cure, i.e., make up "back payments" up to a point. Pending legislation in Massachusetts, House No. 4085, proposed by the Governor in July of this year, gives homeowners up to 90 days to cure. The 90-day clock starts ticking from the date that the lender mails the notice.
Why Have a Short Sale Instead of Foreclosure?
Even though it is not necessary for homeowners to be in arrears on the mortgages to qualify for a short sale, a homeowner can't just wake up one morning and decide to sell the home in a short sale transaction. Short sales require the approval of the lender, and typically, lenders won't consider a short sale if payments are current. Lenders aren't in the business of buying or selling property and are certainly not interested in losing interest money from interest rates on financed homes. In approving short sales arrangements, lenders usually do diligence on the homeowner/seller, the buyer, and the party financing the buyer. While the kinds of evidence lenders require varies, in doing diligence, all lenders usually require sellers to submit a hardship letter which specifically details the seller's financial difficulties. The lender may also require pay stubs, copies of medical bills, credit reports, checking account statements and other proof of financial hardship. From the buyer or buyer's representative (attorney, broker or the like) the lender will require some kind of release, signed by the seller, authorizing the lender to talk to the buyer about the seller's mortgage. In general, a buyer's first interaction with the lender is through the lender's loss mitigation department. At or near the closing of the short sale, the mortgage lender will review the settlement statement, a contract between the buyer and the seller, containing a description of the source of the buyer's financing.
In making a decision whether to foreclose on a property or to accept a proposal from a homeowner/seller and buyer to enter into a short sale, lenders may consider the following factors, among others:
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whether the seller is deserving of a break
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whether it would be cheaper to simply repossess and sell
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how many other properties the lender currently has in default
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whether there are co-signers on the mortgage who can be held responsible for the balance owed on the mortgage
Loss mitigators are also part of the decision-making process. They work for lenders and sometimes receive bonuses based on how many defaulted loans they clear up efficiently and inexpensively. Loss mitigators might be more likely, especially during certain real estate markets, to accept a detailed, well-done short sale plan versus foreclosing on a property. Foreclosures in New England typically cost an average of $50,000 and are time consuming to the lender.
In conducting diligence, homeowners can expect lenders to order what's called a broker's price opinion, which will give the lender some idea of what the property is worth in the current market. Sellers can get their own opinion from an independent appraiser.
What Are the Credit or Other Related Consequences of Short Sales Transactions?
Sellers at short sales will take a hit on their credit score, but a short sale typically turns out better compared to foreclosure, especially if that seller wants to qualify for another mortgage. For example, if a seller's FICO score was 680 before a foreclosure, after foreclosure, the seller's score could dip as low as 400 and the seller may have to wait about 36 months before a lender will offer a reasonable interest rate.
On the other hand, if a seller with the same number of points entered into a short sale transaction, the FICO score will only fall about 80 to 100 points, i.e. to about 580 to 600, and in about 18 months, the seller can buy another home with financing at a good interest rate. As part of the negotiation, sellers (or representatives) might ask the lender not to make an adverse report to credit reporting agencies. Lenders are under no obligation to accommodate this request. In fact, some companies require them to report as part of their policy.
Lenders are likewise under no obligation to "write off" the loan. Sellers may still be legally obligated to pay the difference between the loan amount and the amount that the buyer paid for the property if at least one of the following is true:
(1) the terms of the loan agreement make the homeowner personally liable; and/or
(2) state law requires lenders collect loan deficiencies from homeowners/sellers.
In Massachusetts the current law in this area permits with little restriction, the loan agreement to govern. Thus, it is important sellers review loan documents with an attorney to make an informed decision. Attorneys can advise sellers on legal options or obligations and whether they will be subject to the possibility of a deficiency judgment for the "loss" to the lender who permits them to "sell short."
What About Income Tax?
Sellers might think that they are fine when it comes to taxes from selling a home less than its value. The IRS sees it differently. The deficiency the sellers paid in a short sale transaction is taxed as ordinary income. Short sale sellers can expect to receive a 1099 for debt cancellation from the IRS. In the case where a seller is found to be liable for and has paid a deficiency judgment, that amount can be counted as a loss for tax purposes. For sellers with capital gains, short sale losses can be subtracted from capital gains. For those without capital gains, the law presently allows them to deduct up to $3,000 for the year. Additional losses have to be carried forward to later years at the rate of $3,000 per year. Each seller should be certain to get individual tax advice for specific transactions from an attorney, CPA or other similar professional as part of the process of considering a short sale.
Pending Federal Law and New Massachusetts Regulations
Representatives advising sellers should, in addition to advising on existing tax law, be aware of pending federal law that could potentially affect taxation on short sales (if enacted) as well as new Massachusetts regulations currently in effect. On October 4 of this year, the House passed the Mortgage Forgiveness Debt Relief Act of 2007. In sum, should this piece of legislation pass in the Senate, it will amend the Internal Revenue Code to exclude amounts attributable to a discharge of indebtedness incurred on a principal residence. There are limits on the amount that can be discharged, among other provisions of the bill. Attorneys or others representing sellers in a short sale transaction should keep an eye on this bill and, for now, make their clients aware of it as a future possibility.
Currently Massachusetts has promulgated regulations to protect and help sellers in a different way from the pending federal legislation. New regulations apply to what they call "foreclosure rescue transactions" and "foreclosure-related services." The regulations took effect this September and are intended primarily to protect sellers from charlatans in the foreclosure world who prey on sellers in danger of losing their homes. Here's how scam foreclosure rescue schemes typically work. Businesses or professionals claim to assist consumers who are facing foreclosure by convincing them to convey their property to straw purchasers. The straw purchasers then obtain mortgage loans, permitting the individuals facing foreclosure to continue living in their property for a limited time, and promising the individuals they will be able to later reacquire their homes. The promises of maintaining home ownership are illusory and homeowners lose their home to the so-called "rescuer." These new regulations underscore the need for attorneys zealously representing their clients in Massachusetts and thoroughly investigate the buyers in a transaction.
Selling Short in Short
In the world of investment, securities stocks are often sold short; meaning that an investor sells borrowed securities in anticipation that the price will plummet and the stock can be paid back at a lower price. This is called "covering" a sale of shorted stock.
A short sale in the real estate world is fairly similar. A homeowner who does not yet own the home (i.e., the home is mortgaged) can sell it to a third party to "cover" the mortgage. Short sales in the mortgage world therefore, amount to an accommodation by a lender who hopes to avoid or at least mitigate an impending loss by permitting a homeowner/seller to "short" the property - selling it below the value of the mortgage to a buyer who is not the lender.
As previously mentioned, it is not necessary for homeowners to be behind on their mortgage in order to enter into a short sale transaction. If that is the case for a particular homeowner, it might be important for the homeowner to know a short sale or foreclosure are not the only options. Even though this article is limited to discussion of options to short sales and foreclosures, these are not always the best solutions for every homeowner with an "upside down mortgage." Attorneys or other representatives would be well-advised to have homeowners consider workouts or restructuring of loans, voluntarily offering the lender the deed in lieu of foreclosure or inquiring if mortgage insurance will cover the deficiency. Short sales can be risky, somewhat intrusive and involve a long, frustrating process, but could be worthwhile, provided homeowners and their representatives work together to choose and negotiate the right solution for the right client.
