Beleaguered property owners all too frequently wonder: Should I let the bank foreclose my loan or should I try to complete a short sale? In many cases, borrowers will be better served by a short sale than a foreclosure.
When real property is secured by a loan that has more due on it than the market value of the property, the property is described as being “underwater.” When the borrower wants to sell such a property, he or she may try for a short sale on the market, i.e., a sale in which the lender(s) agree to execute a deed of reconveyance for each deed of trust in return for less than the full balance due on the loan. It’s called a short sale because the selling price is short of the amount required to pay the liens on the property.
An owner can pursue a short sale either before or after defaulting on the loan, but the owner definitely has more leverage if there hasn’t been a default yet.
When a short sale is successful, the property owner can avoid foreclosure proceedings and stay in the property until the transaction is completed. Unlike a foreclosure, a short sale may have little or no effect on the owner’s credit, depending on whether the lender reports the short sale to credit reporting bureaus as loan losses and whether the borrower defaulted on the loan before the sale.
On the downside, a short sale may result in taxable income to the borrower. The difference between the property’s value and the balance on the mortgage is considered a forgiveness of debt and this amount may be considered taxable income in certain circumstances. The tax consequence may be forgiven if the borrower can prove financial insolvency, or if the transaction falls into one of the tax law exceptions.
Even if the short sale is a taxable event, the borrower may want to avoid foreclosure unless the borrower has no need for future credit. A foreclosure is considered a major credit infraction that can severely damage the owner’s credit for years.
Borrowers in default who have substantial assets and who fear that applying for a short sale will tempt a lender to foreclose judicially or nonjudicially may choose to roll the dice on a foreclosure, but they should stand ready to reinstate the loan if the lender decides to pursue a deficiency judgment.
For a complete discussion of this crucial question, check out the featured articles in the November 2011 and January 2011 issues of CEB’s Real Property Law Reporter. Also check out coverage of this issue in CEB’s California Real Estate Brokers: Law and Litigation, chap 2, California Mortgages, Deeds of Trust, and Foreclosure Litigation, chap 7, and California Real Property Sales Transactions, chap 6.
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