What Comes First: Short Sale or Foreclosure in Real Estate Loans?

Forgiven debts resulting from a short sale or foreclosure must be reported to the IRS.

When you default on your real estate loan a short sale comes first. If the lender does not accept any buyer offers, foreclosure is the next step. A short sale occurs when the lender agrees to accept less than your loan balance, for the sale of your property. Foreclosure is the legal process by which the lender takes ownership and sells the property. Some lenders will consider a short sale ahead of foreclosure in real estate loans that have become delinquent.

Short Sale

A short sale is sometimes a better option than foreclosure for the homeowner, but not necessarily for the lender. You are more likely to avoid foreclosure and convince your lender to accept a short sale, if you find a buyer quickly. If the lender agrees to a short sale, typically most of the seller's costs get paid by the lender, including Realtor's fees, repair fees and escrow and title costs. The real benefit to you with a short sale is getting the lender to accept the selling price as payment in full and forgive any remaining balance.

Foreclosure

If a lender believes there is a better chance they can get closer to the loan balance on the property at a foreclosure auction or on the open market, they may opt to initiate foreclosure proceedings. Foreclosures are usually the least beneficial route for both parties. Lenders often end up buying the properties back at auction, due to a lack of qualified bids and then have to pay to maintain, insure and sell the properties on the open market. Although lenders often lose principal, interest and late fees in a foreclosure and sale, it is still favorable to many lenders over short sales or loan modifications.

Deficiency Judgment

When you complete a short sale or the lender forecloses and sells your property at auction, typically there is an outstanding balance left on the mortgage loan, which is known as a deficiency. If your lender does not agree to write off the deficiency amount, you are still responsible for the remaining debt, and the lender may be able to pursue a deficiency judgment through the court system. In essence, the lender sues you for any amount outstanding on the loan after the proceeds from the short sale or foreclosure auction, if it is determined that you have sufficient assets to pay the deficiency.

Tax Implications

Whether a lender decides to implement a short sale or foreclosure in real estate loans that have become delinquent, there may be tax implications for the homeowner. Up until 2007, any debt "forgiven" by a lender as a result of a short sale or foreclosure, could have resulted in a tax bill for you on the total amount of the forgiven debt. Thanks to the Mortgage Forgiveness Debt Relief Act of 2007, debt forgiven during 2007 through 2012 up to $2 million will generally be excluded if the income is a result of a loan modification -- short sale -- or foreclosure on your principal residence property.

References

• Homeowner Short Sale Information: Short Sale FAQs
• "Seeking Alpha"; Why Banks Prefer Foreclosure Over Mortgage Modifications; Ryan Avent; July 2009
• Judgment Deficiency Debt Relief & Negotiations: Deficiency Judgment
• "Real Estate Consumer News"; Will You Owe Taxes on a Short Sale or Foreclosure?; Dennis Norman; January 2010

Resources

• foreclosure university: Short Sales & Foreclosures
• "New York Times"; Program Will Pay Homeowners to Sell at a Loss; David Streitfeld; March 2010
• Thompson & Brown: Frequently Asked Questions - Short Sales
• TD Service Company: Foreclosure FAQs