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What is a Short Sale - Click HERE to view actual short sale approval letters

Home sellers should consider a Short Sale when the value of their home is LESS than the amount of their outstanding loans. For example, if your home is worth $250,000 but you have a loan of $260,000 then a short sale is a consideration. Obviously, if you do not have to sell your home, you could wait out the market and hope for a turnaround in real estate values.

However, if you do have to sell your home you basically have three options. First, you can bring cash to the table. In the example above you would sell your home for $250,000 and pay another $10,000 to the lender out of your pocket to pay off the loan on your property. Second, you could let the home go into foreclosure. The lender will go through the foreclosure process, force you out of your home and then auction it off to the highest bidder at a foreclosure or Trustee's auction. The third option is to pursue a short sale. You contact the lender, explain the circumstances and convince them to take less than full value of their loan.

In the case above you may tell them you have a buyer for $250,000 and it's very unlikely there will be a buyer at a higher price. If they will accept $250,000 for their $260,000 loan then you can proceed with a short sale. Sometimes the lender will consider a short sale before you have a buyer and you can market your property and, if you find a buyer, take their offer to the lender for consideration. The lender may or may not accept the offer.

Short Sale Process

Short sales are not necessarily complicated but do require some work on your part and your agent's part if one is involved.

  • Figure out the true value of your property. Many times a real estate agent can provide a market analysis and give you a good idea of what your home might sell for. You can also use Zillow or other real estate related sites to determine the rough value of your home. If the market is moving down keep in mind that your homes value may be moving down as well and estimated valuations may be valid for only a short time.
  • You also need to calculate your estimated closing costs. Items such as a title report, escrow, appraisal, attorney fees, agent commissions, unpaid property taxes etc. may add up to a substantial amount of money.
  • You’ll need to know how much you owe on your property. Include all loans on the property in your calculation.
  • Calculate your equity. Normally the value of your home is more than the total of the loans and closing costs. If your closing cost estimate plus your loan amounts are higher than the value of your property then a short sale is a possibility.
  • You’ll need to contact your lender and explain your situation. Be sure you talk to someone who has the authority to make the required decisions. Usually lenders have a loss mitigation department that you can contact. Lenders are under no obligation to accept a short sale but many times it is in their best interests to do so. Some lenders will not consider a short sale until you have missed a payment or two. Some will not accept short sales at all. You’ll need to know where your lender stands with regard to short sales so contact them as soon as possible.
  • Consider your tax obligations! Do not underestimate this! Many times there can be a substantial tax obligation after a short sale has occurred. Be sure to talk with an accountant or tax attorney to figure out how much money you may owe the IRS if you proceed with a short sale.
  • Find a buyer and sell your property. The lender will still have to approve the buyer’s offer but once they do you can sell your property.

Why A Lender Might Accept A Short Sale

While most lenders will not be thrilled at the prospect of a short sale they are acutely aware that a foreclosure is usually a far more time consuming and costly option. In a real estate market where housing values are going down it is in the best interests of the lender to liquidate their problem loans as quickly as possible.

With a short sale a property can be sold and the loan taken off their books fairly quickly. If they pursue a foreclosure they run the risk of the process taking a substantial amount of time during which the value of the property is depreciating. Also, buyers will tend to write low ball offers when they know that a bank or lending institution owns the property. The property will also be left vacant which can result in vandalism and deterioration. Some owners will even gut the house just before the foreclosure sale as a way to 'get back' at the lender. This is illegal but nonetheless happens on occasion. So, you can see why a lender might want to go the short sale route and get the loan off of their books with minimal hassle.

The Short Sale Package

All of the documentation needed to start a short sale is commonly called a "Short Sale Package" and is usually submitted by the investor interested in the property, the agent representing the seller, or the seller of the property. The package usually includes the following items:

Sample Short Sale Package (items may vary depending upon the lender):

  • Cover Letter
  • Authorization to Release Information
  • Sellers Hardship Letter
  • Seller's Financial information
  • 2 years w2's
  • 2 months pay stubs
  • 2 months bank statements
  • Supporting Hardship Info - HOA liens, medical/disability statements etc.
  • Repair Estimate for the property
  • Comparable sales for the property
  • Contract
  • Net Sheet
  • First mortgage holder may ask for a payoff amount from the 2nd
  • Second mortgage holder may ask for a payoff amount from the 1st
  • Lender may ask for an Initial Title Report
  • FHA and VA may have their own forms and special requirements as well

Beware The IRS!

Many homeowners do not realize that they may be in store for a large tax bill from the IRS after the short sale of their home. Every situation is different and you should absolutely contact an accountant or tax advisor before conducting a short sale to determine your potential liability.

As an example assume you purchased your home for $400,000 in 2003. Since that time it has appreciated to $500,000 and you refinanced and now owe $450,000. You need to sell your home now but due to the bad market you can only get $400,000 for it. Your lender accepts a short sale since you owe them $450,000 but they are accepting only $400,000. The IRS considers the $50,000 that was "forgiven" by the lender as "debt relief" income.

Your lender will probably send you a 1099-C in the amount of $50,000 and the IRS will want you to pay taxes on that amount. What are the odds that you have that kind of money laying around after you just went through a short sale on your home? Be very careful regarding your tax obligations BEFORE you consider a short sale, deed-in-lieu-of-foreclosure or foreclosure.

The IRS will use your tax basis on your property to determine your tax obligations so you must be able to figure this amount out.

See our article on IRS Form 982. The form is used to request a "reduction in tax attributes" due to insolvency. This may allow you to avoid having to pay taxes on the debt relief you experience with a short sale. Definitely worth talking to a tax attorney or accountant about!

IRS Form 982 - Avoid Debt-Relief Taxes

We are not tax experts so what we've written here is only for informational purposes and should be used as a starting point to further investigate the potential tax savings involved. It is absolutely worth your time and money to consult with an expert in these matters as it could save you thousands of dollars.

As we mentioned in another article, 'Beware The IRS', you could be in for a large tax bill if you utilize a short sale, foreclosure, or deed in lieu of foreclosure. The IRS may view the amount of debt that is ‘forgiven’ by your lender as income for that tax year. If you owed $450,000 on your home and you received an offer for $400,000 and your lender accepted the offer (a short sale) then the IRS would view the $50,000 difference as ordinary income in that tax year. So, you would owe taxes on $50,000. This is a simplistic example and most cases are more complex but the bottom line is that you need to be aware of the potential tax liabilities involved in a short sale.

Is there a way to avoid paying that tax? Possibly. IRS form 982 says, "Generally, the amount by which you benefit from the discharge of indebtedness is included in your gross income. However, under certain circumstances described in section 108, you may exclude the amount of discharged indebtedness from your gross income". The specific instructions are contained in section 108 of the Internal Revenue Code.

One of the 'circumstances' they are referring to is that if you are insolvent before you conduct a short sale then you may be able to 'exclude' the forgiven indebtedness (the amount the lender forgave on the loan) from being added to your gross income for that year. Here are some questions you will need to ask an expert:

  • Can I avoid paying taxes on the forgiven debt if I was insolvent at the time of the short sale?
  • Do I have to file bankruptcy to be considered insolvent?
  • If you already used a short sale and paid taxes can you file an amended return and get a refund?
  • Does your real estate agent understand any of this?
  • Do you have to surrender your property in bankruptcy to be eligible for relief?
  • Does a form 982 have to be filed in order to be eligible for tax relief?
  • These are just a few of the questions that should be asked. But, it may very well be worth it.

The BPO (Broker Price Opinion)

The Lender will want to see a Broker's Price Opinion (BPO) to get an idea of what the property is worth. The BPO is usually produced by either the agent for the seller or sometimes by an agent or appraiser working for the lender. The BPO will contain comparable sales of similar houses in the neighborhood, with adjustments made for condition and attributes, to determine what the market value of the subject property is.

The Hardship Letter

The Hardship Letter is usually part of the short sale package and is written by the seller or their representative. It is used to explain to the lender the reasons for the borrower's need for a short sale. Reasons such as divorce, job loss, medical issues, etc. can and should be included. Usually just a one-page letter with the pertinent information will suffice.

A simple letter in the following form should suffice:

  • Date
  • Lender Name
  • Address
  • Loan Number

Dear Sir/Madam,
{In this section explain your hardship and why you must utilize a short sale - some example hardship reasons are listed below}

  • Unemployment
  • Reduced Income
  • Divorce
  • Separation
  • Medical Bills
  • Too Much Debt
  • Death of my Spouse
  • Death of a family member
  • Payment Increase
  • Business Failure
  • Job Relocation
  • Illness
  • Damage to Property
  • Military Service
  • Incarceration
  • Other(Please Specify)

Borrower's Signature Date:
Co-Borrower's Signature Date:

The Credit Consequences of a Short Sale

The credit consequences of a short sale and foreclosure vary slightly. The general consensus is that a short sale will show up on your credit report as a 'settlement', 'settlement for less than owed' or a "pre-foreclosure in redemption". Also, since most lenders will not consider allowing a short sale until a few payments have actually been missed you may also have a few 'lates' on your credit report. Neither of these marks is a good thing to have but it's possible to get them off of your credit report within a few years or less. A short sale can drop your credit score by 80-100 points. There is also the possibility that through negotiation with the lender you can avoid having the short sale reported to a credit agency. A foreclosure on your credit report can take 7-10 years to remove and can cost your credit rating (FICO) up to 200-280 points which is a very big hit. So, if you have no better alternatives, pursue a short sale aggressively and avoid foreclosure.