How Does a Short Sale Help?

A short sale can stop a foreclosure and save your credit score.

When you can no longer make the payments on your mortgage and are facing the possibility of a foreclosure, a short sale may be able to stop foreclosure altogether. Although it's not a quick solution, a short sale can help you to avoid a ruined credit score and the embarrassment that comes from having a foreclosure on your record.

Function

The term "short sale" means that something is being sold for less than what it's worth. Usually this is done to get rid of an item (in this case, a house) quickly. An owner who realizes that he can't meet the monthly mortgage payments anymore may have an opportunity to sell the home short before the foreclosure process is initiated.

Features

A short sale is approved and controlled by the lender, not by the seller. For this reason, any transaction must be sent to the lender, who will approve or disapprove of any possible sale. Because the lender is the one who will lose money in the transaction, it's the lender that has the final say. The homeowner isn't allowed to receive any money from a short sale.

A lender may be interested in selling a home for less than what the house is worth, rather than going through the foreclosure process, partly because of the cost of a foreclosure. According to the U.S. Congress Joint Economic Committee, it can cost up to $50,000 for an average foreclosure, marketing a house and getting it sold again.

Considerations

For a short sale to be helpful to a homeowner trying to break free from the burdens of a particular house, the homeowner needs to start early on the short-sale process. This should occur before late payments are being reported and the homeowner's credit score begins to slide. A lender will be more interested in going through with a short sale if it can recover as much as possible from the sale of the house.

To start the process, the homeowner first has to talk to the lender to see if it's interested. According to Tamara E. Holmes of Bankrate.com, it's probably not likely that a short sale will be approved if there's a second mortgage on the home, because this would mean that the lender would not be paid---or paid very little.

Once the homeowner is given the green light to submit the paperwork, she will need to submit a formal application to the lender with several documents. These documents will include a letter of authorization (which will allow the homeowner's real estate agent to talk to the bank); a preliminary net sheet that shows the homeowner's assets; a completed financial statement, two years' worth of W-2 forms and tax returns; recent payroll stubs, the past two months of bank statements; and a comparative market analysis. The homeowner will also have to detail her hardship case as to why she can't make the payments anymore.

Time Frame

Because the owner is selling the home for less than what it's worth, the home may be more attractive to potential buyers. The approval process does take longer than it would for a regular home sale, and buyers often get discouraged and quit. Selling a house through a short sale can take as long as six months.

Warning

While a short sale may prevent a foreclosure, it's still possible to be stuck with a large bill. The Bank of America, for instance, according to the "Palm Beach Post" in Florida, says that the bank has decided that if the sellers can afford to pay the difference between the sale price and the amount still owed, or part of it, that they will have to do so at closing. Even in cases already completed, lenders have up to 20 years to collect.

Sellers may find themselves with a large tax debt, too. This can happen two ways. First, a lender can send a Form 1099 to the IRS, which declares the amount of debt forgiveness and which you must report on your taxes as income. If the 1099 says you were forgiven a debt of $50,000, you'll then owe taxes on the $50,000.

The exception to this rule, however, may come under the Mortgage Forgiveness Debt Relief Act of 2007. This law states that debt forgiveness on a primary residence may not be subject to federal tax (you may still have to pay state tax), if the transaction takes place between 2007 and 2012. Other than that, words in the agreement with the lender may prevent you from being liable for the balance (make sure you understand what the lender intends to do before signing).

A second way to be held liable for the difference is that the lender can send the balance owed to collections if they think you have the assets to pay for it.

References

• WSJ: Short Sale Versus Foreclosure
• MoneyCentral.MSN: Use a Short Sale to Escape Foreclosure
• IRS: Mortgage Workouts, Now Tax-Free for Many Homeowners; Claim Relief on Newly Revised IRS Form
• Palm Beach Post: Bank of America Wants to Reduce Short Sale Gambles for Itself and Borrowers
• Nolo: Short Sales and Deeds in Lieu of Foreclosure