Traditional Short Sales: What To Consider
If you are not able to save your property(s) through loan modification or Chapter 13—or you’re not interested in doing so, then you will be considering a short sale.
This firm negotiates traditional short sales and facilitates a strategy we have termed “Cooperative Short Sale.” In either case, the following are the key issuesto consider: tax liability, credit rating, and deficiency judgments.
Short Sales: Tax Implications
A short sale is where the lender agrees to sale the distressed property for less than the borrower owes on the mortgage. If the lender accepts the short sale net proceeds as full satisfaction of the mortgage, the borrower is “forgiven” the difference between what was owed on the mortgage and the net proceeds of the short sale. That difference will be considered income by the IRS and taxed accordingly unless an exception applies.
Under the Mortgage Forgiveness Debt Relief Act, taxpayers who were forgiven part of their mortgage on their primary residence can avoid tax liability by including Form 982 with their tax return. But, beware this act is set to expire on December 31, 2012.
Short Sales: Effect on Credit Rating
Contrary to popular belief, the effect of a short sale on the homeowner’s credit is virtually identical to that of a foreclosure—a dip of 200 to 300 points. There is a notable difference, however. The owner who goes through a short sale may qualify to purchase a subsequent home in less time than someone who goes through a foreclosure. The waiting period after a foreclosure is 24 – 72 months, whereas the wait after a short sale is about 24 months. Also, in the case of a short sale, there may be fewer months of non-payment on the mortgage, which will result in less damage to the homeowner’s credit score.
There is no empirical data, but it does make sense that a creditor reviewing someone’s credit history would tend to look more favorably on a short sale than a foreclosure. Admittedly, this is just speculation, though.
Short Sales: Deficiency Judgments
Where a home is sold for less than what is owed on the mortgage, there is the potential that the borrower will be liable for the deficient amount. In Florida, the lender is entitled to petition for a deficiency judgment if the sale of the home does not cover the balance due on the mortgage.
The lender may choose to request a deficiency judgment unless the discrepancy is relatively minimal or the homeowner’s attorney is able to negotiate a deficiency waiver.
Be aware, when it comes to these issues, state laws vary in fundamental ways, so be sure to consult with an HLA attorney before making a final decision.
COOPERATIVE SHORT SALE: A NEW SOLUTION
After four years with no meaningful assistance from the banks or the government, homeowners may at long last have a workable solution to their mortgage problems.
The concept of a cooperative short sale is straightforward. The homeowner with an upside-down property finds an investor with which to collaborate towards bringing about a short sale of the property. Once the short sale is consummated, the former homeowner signs an agreement with the new owner to lease the property, obtain an option to repurchase, and/or whatever else the parties negotiate.
If the cooperative short sale is successful, the participant gets out of the mortgage(s) and has a chance to get the property back at market value—a true principal reduction.
The effect of the program is that the participant gets out from under an inflated mortgage and has an opportunity to keep the property at market value.
I. Comparison with Other Loss Mitigation Options
At the moment, none of the options available to homeowners in distress are particularly desirable. There is foreclosure defense, which is a necessary and effective measure in most scenarios. After all, unless the homeowner puts up some resistance to the foreclosure proceedings, the lender will simply foreclose on the property and eject the homeowner. For the homeowner who has no interest in retaining the property—even at market value—defending against foreclosure for as long as possible can make good economic sense. The downside, however, is severe damage to credit rating and, depending on the jurisdiction, exposure to deficiency judgments. Also, for the homeowner who really wants to keep the home, and could do so if it were not so upside-down, foreclosure defense alone is not a long-term solution. It’s a strategic means of delaying the inevitable.
Loan modifications are very difficult to accomplish and never reduce principal. There is a small percentage of homeowners who can make use of loan modifications in their current form, such as homeowners whose properties are not terribly upside-down and who may have fallen behind on payments but can actually afford the existing mortgage on a foregoing basis.
Unfortunately, loan modifications have failed to provide the majority of homeowners with any meaningful relief.
One can do a short sale and, perhaps, negotiate away the deficiency judgment. This is an acceptable outcome for some homeowners but not for those who want to keep their homes. After all, most homeowners have something invested in the property (i.e. money, time, energy, affection, etc.) and giving it up is usually painful.
Bankruptcy under Chapter 13 should be a better solution than it sometimes turns out to be. First, there are unfortunate limitations to what can be done with a primary residence. That fact alone takes reorganization off the table for many homeowners. As for the investment properties, which are subject to cram down under the bankruptcy code, there is the hassle to consider. Under the best of scenarios, reorganizing under the bankruptcy code means submitting to the scrutiny of the trustee and creditors and living under that scrutiny for three to five years. Even if everything goes as smoothly as possible, the debtor’s credit rating will be severely damaged by the process. Moreover, for homeowners who have significant assets, bankruptcy under any chapter is usually not a good option. Reorganizing under the bankruptcy code looks good on paper and is an option homeowners should consider, but it does leave a lot to be desired.
The cooperative short sale addresses many of the above shortcomings. It offers a permanent solution to the mortgage problem without filing for bankruptcy and without losing the property. To be fair, a cooperative short sale may not resolve the issue of deficiency judgments. However, asset protection planning and/or negotiations with the lender can mitigate this problem.
II. Legal Implications of Cooperative Short Sales
The banking industry has done a good job of convincing realtors and homeowners that anything along the lines of a cooperative short sale amounts to fraud. The argument, presumably, is that such a sale is not an arm’s length transaction. There is only one scenario where this might be true.
There are a few homeowners who have enough cash to purchase their own property through short sale and who create a trust or Delaware company for this purpose. Even though there might be some validity to the non-arms-length-transaction argument in this scenario, there is still very little downside to taking this approach, and the benefits far outweigh any possible detriments. Nonetheless, even with the current depressed home values, this option is still unrealistic for most homeowners.
With the cooperative short sale, however, the purchaser is in fact a legitimate third party. The argument that a bona fide purchaser of real property cannot enter into a lease agreement with the former owner of the property—or do whatever else it pleases with the property—flies in the face of one of the most fundamental doctrines of American law. A cooperative short sale is an arm’s length transaction, and any contract language that attempts to bar the same would likely be struck down by the court.
Even if we take the worst case scenario, where a local judge finds the sale is not arm’s-length or that cooperation between the purchaser and former homeowner somehow contravenes contract language or doctrine of law, what would be the lender’s damages?
If the property was sold for the current market value, what difference does it make to the lender who purchased it? And, the fact that the lender approved the short sale makes it pretty hard to argue that the sale price was unfair. There simply are no damages.
III. Good Candidates and Factors for Success
The cooperative short sale is a welcome new alternative, but it will not work for everyone. Ultimately, investment companies have to make money and minimize risk, so they have to consider both the homeowner’s financial circumstances and the value of the property. That reality, unfortunately, will eliminate this alternative for a certain percentage of homeowners. Good candidates for this kind of program are those who can make regular payments based on market value and whose properties are valuable enough to mitigate the company’s risk.
The financial assessment can be done early on and the parameters are predictable. What is not predicable is the lender’s willingness to approve a short sale with terms acceptable to the investment company and/or the homeowner. Implementation of the government’s HAFA program has made getting short sales approved a bit easier, which is encouraging. Perhaps a more powerful incentive is the difficulty lenders have had finalizing their foreclosures due to effective defense attorneys and the over-burdened court system.
In reality, all the affected parties’ interests seem to align pretty well. After all, short sales are one way for lenders to get non-performing assets off their books while receiving the benefits of mortgage insurance and/or governmental incentives.
Notwithstanding, experience teaches us to be conservative in setting expectations of bank decision-makers, so consider approval of the short sale an unknown factor.
Also, there are some parties whose interests may not fully align, such as homeowner associations and junior lien holders. Handling those negotiations is more art than science, and may require a good deal of persistence.
Accordingly, the cooperative short sale is not a panacea, but it is a very interesting alternative for homeowners to consider.