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The Two Most Important Concerns of any Short Sale Seller: Deficiency Judgments and Taxes

Unlike Nevada, California is a Non-recourse state for residential loans originated. When a property is foreclosed upon, or when a short sale closes, the lender (bank) has the right to pursue the monies owed to them that were not covered by the proceeds from the sale. In the case of a foreclosure, lenders have the right to sue the borrower for the difference between what they received at the trustee sale and the total amount of the debt owed (plus interest) for up to 6 months after the Trustee Sale.

As for short sales, the bottom line is the lender has the right to pursue the amounts owed to them for up to 6 years after the closing, unless the agent you hired or the negotiator you are using is able to obtain a “release” of the deficiency. What is a release? Basically the negotiator is able to have language inserted in the written short sale approval that states the debt is considered paid in full; or that the lender will not pursue any deficiency. Do banks agree to release deficiencies owed? Yes! However, this does not happen in every case and short sales are often as unique as the clients looking to do them. One of the big factors in obtaining a release is if the property is a principal residence and of course the actual hardship that caused the problem. We have had occasions whereby we are able to negotiate for sellers that do have substantial assets and are able to obtain a “lump sum” settlement for a portion of the debt; or some banks may require the seller to sign a note (or a promise to pay) for a portion of the debt interest free over a specified time. I’m hoping you can see where this is one of the really big advantages of the short sale: the ability to negotiate the debt with your lender directly vs. walking away from the home and having to deal with all the negative issues of a foreclosure plus having to face the possibility of being sued for a deficiency after the foreclosure. By the way, those that do get foreclosed upon will almost certainly have a larger deficiency to deal with due to the lack of maintenance of the property, possible vandalism, and prolonged missed payments that get added into the mix.

Let me begin by stating that I am NOT a tax professional nor an accountant. That said, there are some unique tax consequences that have to be considered when doing a short sale. In the past the IRS has always considered forgiven mortgage debt as income to the person that borrowed the money. You can therefore see how this may affect a seller closing a short sale. Let’s say you are closing a short sale and the debt forgiven s $150,000. Imagine your surprise when the following tax year you receive a 1099 for $150,000 and the IRS is expecting you to pay taxes on that sum at your current tax rate! The good news is that in December of 2007, President Bush passed a law known as the The Mortgage Forgiveness Debt Relief Act . This law allows exclusions to paying taxes on the type of debt described above, but there are provisions that must be met. The main thresholds that have to be met are:

  1. The property has to be your principal residence
  2. The loan that is being paid off (or the debt that is forgiven) has to be qualified as acquisition debt. What is that? The tax classifies mortgage loans into two categories:
  • acquisition debt: a loan that was obtained to buy, build, or substantially improve a principal residence. Ex: a pool loan
  • home equity debt: a loan obtained to be used for some other purpose other than to buy, build or improve a principal residence. Ex: used to purchase a car or payoff credit cards

Acquisition debt meets the threshold to qualify for the Mortgage Forgiveness Debt Relief Act, home equity debt does not and cannot be excluded under this law.

** Home equity debt may qualify under the insolvency or bankruptcy exclusions.

  1.  The exclusion only applies to indebtedness forgiven in tax years 2007-2012.
  2. The exclusion is limited to $2 million for married and single filers, and $1 million for a married person who files separately

We highly recommend candidates for short sales consult a tax specialist and/or attorney regarding these points PRIOR to listing a property as a short sale.