Some of my clients are in the unfortunate position of facing the prospect of foreclosure, as so many are right now in Michigan. Some have asked me what the options are for them and I’ve had a discussion about doing a short sale with them. For those not familiar with short sales, here’s a quick tutorial.
A short sale is an arrangement with your lender in which it allows you to sell the property for less than you owe. This is a method of disposing of your home without having the lender foreclose on you. Not all lenders will agree to short sales, so you’ll need to check with yours. Unfortunately, most lenders won’t agree to a short sale unless you’re already in the pre-foreclosure process – you have missed payments and received notices from the lender that you are in default and that they are about to begin foreclosure proceedings. While that seems like waiting until the horses are out to shut the barn door, lenders don’t want to offer short sale deals to those who still appear to have the wherewithal to pay.
Here’s an example: Joe and Robin both worked at good paying jobs and bought a house three years ago for $400,000, foolishly taking advantage of the mortgage broker's sales pitch and obtaining a 100 percent loan. Joe lost his job with one of the big three auto makers ands now works at a supplier for about half what he used to make. Joe and Robin cannot afford to continue with the monthly mortgage payments on their new, combined salary. With what has happened in the market, the house is now only worth only $350,000, so they’ve discovered that they can’t even refinance. They are, unfortunately, what lenders call "upside down."
They have hired a good Realtor and have discussed the situation with their financial advisor and maybe even their lawyer and understand the risks involved and the impact upon their credit rating if they do a short sale verses a foreclosure (about 50 points off their credit score for a short sale vs. 200 points off for a foreclosure). Recent changes in tax law (or policy) have removed one stopping point for many people, when the IRS said it would no longer tax as ordinary income any difference between what was owed and what the sale price is. Now it’s time to ask the bank to participate in a short sale.
Joe and Robin must make sure to ask, should the lender approve the short sale, if they will still be obligated to make up this difference, which is called a deficiency. Unfortunately, most lenders will not put their agreement in writing, so your legal advisers will have to satisfy themselves -- and you -- on this matter. In fact, many lenders have been known to use this "forgiveness of debt" issue to dissuade their borrowers from pursuing a short sale. It is possible that their lender will accept a short sale and then turn over the deficiency balance to a debt collection agency to hound them for that difference. Make sure that you understand the position of your bank on this issue before proceeding.
After Joe and Robin are satisfied that they understand the concept and are prepared to move forward, then they should contact their lender. They should ask to speak to the manager of the short-sale department. Typically, a lender has a "loss remediation" department that handles these matters. The lender will need a letter of authorization for their real estate agent to work on their behalf. Privacy laws prohibit lenders from discussing personal and financial information with a third party without such written permission. This letter will include their name, property address and loan number. And it will clearly identify the Realtor who will be representing them in the process.
Then Joe and Robin, working with their agent, should prepare a comprehensive letter explaining why they are requesting the short sale. They should emphasize the hardship, without turning it into a sob story. A market analysis by the Realtor showing what houses in your area are selling for will also help. Finally, they should spell out the request in detail: the price they are asking the lender to approve, the commission the real estate agent can accept and the closing costs associated with the settlement. Keep in mind that in Michigan, there are recording fees and transfer taxes, which are typically paid by the seller, in addition to the commission and the owners title insurance policy. Their Realtor can help with detailing all of that.
The proposal should be as specific as possible, including in this case a letter supporting the loss of Joe’s job. The more documentation they can provide the lender, the faster the decision will be. However, lenders are swamped with these requests; Joe and Robin aren’t the only one facing a possible foreclosure. The earlier one can start the process, the better the chance of getting the short sale approved.
But the lender's approval to proceed with a short sale does not end the process. The listing must include a notice that the transaction is “Subject to Bank Approval” and when the real estate agent finds a prospective buyer, the Purchase Agreement must also state that it is contingent on lender's approval. They’ll have to send the contract to the lender; it would help to include an accounting of all expenses that they will have to pay at settlement, as well as the final number that the lender would receive at settlement.
A HUD-1 settlement statement would expedite the process. The lender will then review the documentation and may reject certain expenses. For example, if the contract provides that Joe and Robin will give the buyer money toward closing costs, or that they’ll pay some items that are traditionally the buyer's obligation, such as title search and survey, the lender may not allow such payments. Joe and Robin will want to go to settlement knowing all of the terms and conditions on which the lender will accept the short sale, including whether they’ll have to come up with money at the settlement table.
The short-sale process works; but is complicated, time-consuming and uncertain. If you can start before you are in default, you will be ahead of the game. The key to success is getting help from people who can guide your through the process – a good Realtor and you lawyer. Taking the smaller hit to your credit score from a short sale will make it much easier to get back into a home, once things stabilize in your life.
Portions of this post were taken from, or inspired by, an article by Benny L. Kass that first appeared in August, 2007. Since that time the IRS view of the taxability of the deficiency on a short sale have changed, so the example was updated to reflect those changes.