What is a short sale and its consequences?
Short sales are back and are here to stay for at least two years. Sellers and Real Estate Brokers better get used to the term short sale, at least for the next two years, especially sellers who owe more than their property is worth. If you are a Real Estate agent, you need to have patience, persistence, and good problem-solving skills to develop a specialty in this field.
Once the listing contract has been secured by the seller and the real estate agent, it is recommended to confirm that there is enough proceeds to cover all existing liens on the property and the sale and escrow fees. If there is not enough proceeds based on on a careful CMA completed by the agent or broker, then a short sale is recommended. Better not get discouraged because this what it will be like for a while.
Why is it not enough proceeds? Because the seller/borrower owes more than what the property is worth. The bad part is that most properties are in this situation due to recent property devaluation and excess borrowing during the 2004 thru 2006 refinance and zero down boom compounded with the adjustable rates. the famous subprime loans.
Recent falling home prices, home-equity credit lines, 100-percent financing that sucked out equity, and spiking interest rates on adjustable mortgages are contributing to an alarming and expanding, specialty for real estate Brokers and agents: the short sale transaction. Not something to look forward to.
To help you the agent and the seller gain a better understanding of short sales and what it takes to specialize in this growing area, we took a look at some of the most common questions on this topic that agents and sellers likely will face today. Armed with this information, you the real estate agent can better decide whether short sales are revenue sources worth exploring for your business, and the seller may better understand the tax consequences of the short sale capital gain or loss.
What is a short sale?
A short sale occurs when the net proceeds from the sale of a home are not enough to cover the sellers’ mortgage obligations and closing costs, such as property taxes, transfer taxes, and the real estate brokerage fees. The seller is unwilling or unable to cover the difference.
Some sellers may also be in default on their mortgage loans and be headed for foreclosure. However, home owners who bought at the top of the market or who took out large amounts of equity with a refinance and who now need to sell because of divorce, job transfer, or other unforeseen circumstances may also find themselves upside down, owing more than the home is currently worth when closing costs are factored in.
Tip: Losing your home can be very emotional and most people don’t want to face up to the reality until foreclosure sets in. You have to have to be sensitive but still keep focused on all forms and paperwork required by the lender.
Some sellers simply don’t understand that if they have assets, such as stocks or a high-salaried job, a lender is not going to let them just walk away from a short sale without signing a note to repay what they owe, although some lenders make this an option and not mandatory. Seller should exercise caution to not sign alterations to existing notes and deeds of trust because of additional or reoccurring legal obligations to the bank and incurred income tax liabilities.
How do I know it’s short?
Starting with a CMA, complete the estimated closing statement as accurate as possible including all related fees and the most recent outstanding debt balance or pay off demand statement including 2nd loans if any. This will give you an estimate of the net proceeds that will be realized, often called the net sheet. This information can then be entered into a HUD-1 Settlement Statement to calculate out the final, negative result at closing. Some lenders also have their own forms. Sellers should understand that even though the lender will not allow them to keep any proceeds from the sale, the lender is absorbing most of the loan loss by discounting the note and the IRS looks it at as a loss to the lender and a gain to the seller. This is why a disclosure regarding potential capital gain and ordinary income from cancelation of debt is in order. The seller should be encouraged to obtain adequate information regarding short sales from a Registered Income Tax Professional and or a CPA.
Title companies and lenders are usually helpful in getting exact figures on closing costs and loan balances and to find out what procedures they have in place to make the transaction smoother. If they can afford it, sellers should also consider getting a home inspection to determine what repairs are needed on a home and how this might affect its value.
Tip: The seller should send a brief letter to all mortgage holders as soon as feasible, giving them permission to speak with you. Otherwise, privacy laws will prevent them from talking to you about the loans. Short-sale transactions require perseverance and discipline from the Real Estate Broker, so don’ be discourage if you need to fax authorization to communicate to more than one bank twice or more times. It’s also critical to build a relationship with the seller’s lender. Once you have credibility, the entire process becomes easier.
Who do I and the seller need to talk to about the problem?
If there are a first and second mortgage or a home equity line of credit, you may have to talk to more than one lender to get approval for a short sale. In addition, you may also need approval from the entity that holds the pool of loans if the mortgage has been securitized. Most lenders have their own Loss Mitigation Department. Try talking directly with that department to obtain the authorized instructions sooner. During your conversations with the lenders, it is a good idea to keep a log sheet of all conversations including those with the seller.
When two lenders are involved, the a short sale gets more complicated since it’s often the lender holding the second, or junior, mortgage that has to absorb most of the loss. Some times this 2nd loan may be a non-recourse or a secured loan which may have different tax consequences for the seller trying to do the Short Sale. Non- recourse loans are generally secured by the property only but the borrower is not personally liable for the outstanding balance forgiven. This type of loans is typical in the State of
Some times is not a good idea to try to get a head start by notifying the lender that you have listed the property and that you need assistance to complete a short sale because they are not going to do any thing any ways until you have obtained a willing and able buyer with all the supporting documentation.
Tax Tip: Contrary to popular belief, most short sales are not taxable. Notice the word most but not all. Fact. The majority of sellers that find themselves forced to foreclose or short-sell the property are financial insolvent and the IRS does not recognize a capital gain nor ordinary income when the borrower is financial insolvent, source IRS pub 906. Fact. The sale of a personal residence falls under IRS code 121 and the gain, if any, may be excluded up to $250,000.00 if single, and up to $500,000.00 filing married. Fact. the capital gain on personal property is prorated so you don't have to have lived in the home for the full two years if you have an unforeseen circumstance that is acceptable to the IRS. Some of the most common unforeseen circumstances are; divorce, job loss, job transfer, health loss, multiple births from same pregnancy, but these are not limited. Source, IRS pub 544. and pub 523. Short sales, Forgiveness of Debt, Foreclosures, Repossessions, and Conventional sales are all treated the same for tax purposes. It is the nature of the loan that determines how the gain, if any is taxed. The nature of the loan meaning non-recourse loan and recourse loan.
Non recourse loans are secured by the home and the borrower does not have any additional obligation to the bank after the house is repossessed or foreclosed or sold. This type of loans do not have ordinary income from canceled debt or forgiveness of debt. They may however have taxable capital gain if the main residence and or financial insolvency tests are not met. Call me for details. A recourse loan, however not only would it have ordinary income from canceled debt, but in addition to ordinary income, it may have capital gain from a realized sale. Keep in mind that short sales, foreclosures, repossessions and involuntary transfers are all treated as sales. See short sale gain calculator.
TAX TIP: While losses on sales of personal properties are not deductible, you may consider turning your house into a rental property if you anticipate a loss instead of a gain. The loss of the rental property or business property may be deductible.
Tip: Be sure you contact the bank’s loss mitigation department, which will be the group to decide whether to accept a short sale, rather than the collection or customer service department, which is only interested in recouping past due loan payments. Going directly to the decision maker is often one of the biggest initial challenges in a short sale. The loss mitigation department is also more knowledgeable of the nature of the loan, whether is non-recourse or recourse.
TAX TIP: Contrary to popular belief, the seller of a personal residence does not have to buy another home in order to avoid taxes. This IRS regulation was repealed over ten years ago.
So you can do with your profit whatever you wish as long as it is less than $250,000.00 if you are filing single or less than $500,000.00 if filing married. See IRS pub 523
What information will the bank need to decide whether to accept a short sale?
The sellers’ submission package should include W-2 forms from employers (or a letter explaining the seller is unemployed), bank statements, two years of tax returns, and other financial documents outlining income and debt obligations. The bank will also need comps or a broker’s price opinion showing your estimate of value.
In addition, the sellers should submit a “hardship letter,” explaining the circumstances that make it impossible for them to pay the full amount of the loan. The seller needs to be able to show true financial hardship. Someone with the assets or the income to pay is unlikely to be considered regardless of their hardship.
Tip: In preparing the package, be careful about discrepancies between the seller’s income and the income used to obtain the loan. Keep in mind that the reason of the short sale proposition is due to decrease of income due to a hardship such as job transfer, loss of income, health expenses, divorce loss of income, etc. Sellers are reminded that the banks are in it to help them avoid a foreclosure, and not trick them into additional loan obligations or income tax liabilities. The lenders are also benefited from avoiding the foreclosure so they, as well as the sellers have an incentive to complete the short sale.
What are the options besides a short sale? opinions and don’t be shy to ask for credentials.rd and 3rd predator lenders and confirm their credentials and always get at least two additional opinions. In the mid 1990’s many desperate sellers were fooled into granting their real estate interest in their properties to “rescue lenders” and or “dummy buyers” thinking they had landed a legitimate refinance with lower monthly payments or thinking that they had a legitimate buyer but the escrow never closed after they had already signed and recorded the grant deed. If you are a seller, always get 2.
There are programs such as those proposed by Fannie Mae and Freddie Mac to assist sub-prime borrowers, to assist borrowers with lenders that are more willing to offer loan modification options. This option can extend the term of the loan, add on delinquent payments to the loan principal, and/or reduce the interest rate to make the loan more manageable for the home owner. At the time this article was being written the president was contemplating the amending of some lending regulations to assist borrowers in need of financial relief. Don't count on this financial rescue soon because it is being carefully analyzed so that lenders and investors don't abuse the flexibility of liberal financing. Two million adjustable mortgages are expected to reset by the end of 2008 which will increase the number of defaults and foreclosures due to lack of equity and some credit tightening from the lenders that will become more conservative about subprime loans and easy qualifying loans.
Another option is a repayment plan that requires home owners to increase their monthly payments until the loan is current. Not the best option but it may work for some buyers. A word of caution is in place here for all desperate sellers to exercise due diligence with
Tip: The ideal candidate for a short sale is still making loan payments and has a credit rating worth preserving. Otherwise, it may not be worth going through the complicated process. If the credit is already shot, there is no incentive for the seller to complete the short sale, although delinquencies are not as bad as foreclosures.
How should I price a short sale property?
In general, most short sale experts say to price the property at or near fair market value, although a few will begin with the total payoff amount owned by the seller. How frequently prices are dropped will depend in part on whether the property is in pre-foreclosure. Most banks have a formula for what percentage under market value they will accept relatively to what they will loose if it forecloses but is hard to know this formula because they are not going to tell you both scenarios.
I try to price it 20 percent lower than comparable to peak buyer interest and initiate buyer activity. Not more than that because both, the lender and the potential buyers will not look at it as a realistic price and often time think is too good to be true. In the event the seller and the lender agree to discount the loan there will be tax consequences for the seller due to cancelation of debt ordinary income, and or capital gain taxable income depending on the nature of the loan if it is a resource loan or a non recourse. Most loans in the state of
I know. It’s not fair that the seller is already loosing his property and top he may have taxable income. Unfortunately, the I.R.S looks at it as a loss to the lender because they are the one discounting the note and a gain to the seller. In this case the existing borrower, even though they did not receive any income, he kept the forgiven principal amount and the interest that by contractual right should have been paid to the lender.
Even though the seller did not physically see that income, it is borrowed money they used to purchase the home or refinance it, and it is money that he is now not able to pay back. This is why the I.R.S. looks at it as loss to the lender and a gain to the seller.
There is a silver lining however to this. Fortunately, most short sales may not be not taxable because the seller in most cases is financial insolvent and or his property may qualify as his main residence and may fall within the two year exclusion allowed. Other special circumstances to avoid capital gain taxes and or ordinary income tax from the canceled debt or forgiven loan, may apply to the seller due to; divorce, jog transfer, jog loss, multiple births from same pregnancy, involuntary transfer or sales, condemnation of property, and to her special circumstances that the IRS fortunately is not very specific on these yet.
See short sale gain calculator included her as a convenience taxable gain consequences or a C.P.A. so they understand their professional tax preparer I as a Real Estate Broker am not the tax preparer of their preference I always recommend to the seller to consult a If
Tip: Most lenders will want to get a broker’s price opinion or even an appraisal to see what the property is worth before you and seller set a list price. One way to help ensure that the bank’s estimate of value is realistic is to offer comps of recent sales.
What and how should I disclose about the short-sale property to prospective buyers?
We as professionals should disclose that the property is a short sale in the comments section of the MLS listing as soon as possible before an offer is presented. This give the potential buyers enough warning that the short sale transaction may take longer than a conventional sale transaction. It is also a good idea to disclose it in a short sale addendum or rider made part of the offer. It is also a good idea to disclose to the seller as to the potential tax liability due to foreclosure and or repossession of the property.
Tip: Watch out for unethical investors who will try to convince an owner facing foreclosure to sign a quit-claim deed for the property, and then lease the property. In such cases, the former owners will still be liable for the mortgage payments and possible for capital gain taxes and ordinary income taxes. Even though they no longer own the house, the loan is still in their name and the IRS foreclosures and repossessions rules apply as if the seller was still the owner. Scams similar to this mushroomed in the mid 1990’s, when we experienced another wave of short sales and desperate sellers trying to sell were taken advantage of by unscrupulous investors.
How long does it take to complete a short sale?
Although response times vary from lender to lender, it can take two weeks or as long as 60 days to receive an approval of a short sale from a lender. That’s why it’s critical that buyers and their representative understand and accept that time frame before they make an offer.
An addendum to the California Association of REALTORS® purchase contract includes a provision allowing either party to cancel a short-sale contract within a set period if the seller hasn’t gotten the deal approved. Some require a longer time to get an approval of a short sale because of the possible need for approval from the entity holding the pool of securities.
Tip: Keep in mind that the purchase contract on a short-sale property is a legally binding agreement once the earnest money has been deposited. Without language in the contract stating that the lenders must approve the offer and release all liens on the property, the seller may face a legal problem for failing to execute the contract if the short sale is not approved.
What can the seller and I do to make a short sale more attractive to a lender?
Getting a lender to approve a short sale is primarily a question of economics. You have to provide hard numbers to show that the amount of money a bank will realize on the short sale is better than the amount it may recoup from foreclosing on the property and selling the property as an REO.
Tip: A buyer that is willing to close in 30 days and who can make a substantial down payment may make the deal more attractive than a buyer who wants 95 percent financing. It is always recommended that all buyers are pre-approved for a mortgage before submitting the offer.
However, to avoid unnecessary costs, buyers should wait on having a home inspection and an appraisal for the loan until after the bank has accepted the short sale proposition. Legitimate and realistic hardships, such as a lost job or high medical bills from an illness have influence over the approval.
What are the seller’s options if a short sale is rejected by the lender?
There are a variety of reasons a bank will reject a short sale — from too low a price to too many files on the loss mitigation’s desk. You can look for another buyer or even try resubmitting the same contract. Banks don’t want to take properties back in foreclosure, so they are going to do everything they can to make it work. You also need to prepare your seller in advance for the possibility of foreclosure if a short sale fails, says.
Tip: A short sale might be rejected if the loan is less than a year old. In such cases, the loan servicer that’s bought the loan can often require the original lender to buy it back.
What financial or credit liabilities will a seller have as a result of a short sale? The home with the short sale, adjusted basis if the amount of the canceled debt is larger than the capital gain taxable income of debt. They will however have cancelation from ordinary income. Sellers with non-recourse loans don’t have to worry about it.
It might be better off letting the lender foreclose, he says. If you are working in a state in which mortgage loans are non-recourse, be sure and alert your seller-clients to this distinction. Non recourse loans are usually secured by the property only and not by the personal promise of the borrower. Sale short, in such states, the lender cannot pursue a deficiency judgment against a seller for any deficiencies after a property is foreclosed. Because of this distinction, sellers who are already in default on a mortgage and do not have the resources to pay off a separate promissory note after a non-recourse mortgages It’s particularly important to understand this distinction if you work in states such as California that have
See short sale calculator liabilities. taxable income. In such cases, the note gives lenders the right to sue a seller and attach other assets if the note is not paid when due. Most lenders make this note optional. Care must be exercised by the seller because of additional obligations to the seller including sale short and the debt obligation as a condition to a sale short. Many lenders ask sellers to sign a promissory note for all or part of the difference between the proceeds.
Tip: Having a portion of a loan forgiven may have an adverse affect on the seller’s credit as well as on their income tax return. Encourage your client to try and sign a lease on an apartment before credit is further damaged if they don’t already have a place to go after the short sale is closed.
What tax liabilities will a seller have as a result of a short sale? A seller must count any amount forgiven by the lender as income and pay taxes on that income, even if no actual money was received. The IRS requires lenders to submit a Form 1099-A or a 1099-C depending on the nature of the loan forgiven, stating the forgiven amount. Sellers who meet the Internal Revenue Service definition of insolvency (either in bankruptcy or with debts exceeding assets) will not have to pay taxes on the forgiven amount. Also seller that meet I.R.S. code 121 for sale of main residence may exclude up to $250,000.00 if you are single and up to $500,000.00 if you are married filing joint.
Tip: Most short sale transactions, is the main residence of the seller and may qualify as their main residence for purpose of the two year capital gain exclusion. See I.R.S. pub. 523 Tip: The U.S. House of Representatives has introduced the Mortgage Cancelation Tax Relief Act (H.R. 1876), which would eliminate taxes on any debt forgiven on a principal residence through either short sale or foreclosure. The NATIONAL ASSOCIATION OF REALTORS® has been working to support this bill.
What compensation will I receive as the real estate salesperson or broker in a short sale?
Banks are going to want you to discount your commission. If they are absorbing most of the loss, it is not uncommon for the bank to ask you, the real estate agent to discount your commission as well as the new lender to reduce its financing fees.
Tip: Instead of stating a specific percentage of compensation for buyers’ representatives when posting the listing in the MLS, offer a 50/50 split. This way, if the lender pressures for a lower commission, you can divide the fee, rather than give a stated percentage to the buyer’s representative. Many MLS's also require that you disclose a short sale in your listing.
Where can I find clients if I’m interested in specializing in short sales?
Word of mouth remains the biggest source of new business, experts say, but you can also promote your services to individuals attending credit counseling classes (now required prior to filing bankruptcy), to people who receive state notices of loan defaults, and to home owners named on lists of ARMs that will be resetting in the next few months. To find buyer clients, creativity is a plus. News letters, hot sheet, reports etc, are good tools to send to potential buyers and investors.
Tip: FSBOs are another good source since many upside-down sellers think they can’t afford to pay a commission and so try to sell on their own. Many don’t realize that in a short sale, the lender pays the broker’s commissions.
Good news! On December 20, 2007, the Mortgage Forgiveness Debt Relief Act of 2007 was signed into law to help most borrowers in foreclosure avoid capital gain and ordinary income taxes related to the forgiveness of debt on their residential mortgage. This new amendment to the IRS tax code will prevent taxpayers with foreclosed homes from paying ordinary income tax from the forgiveness of canceled debts by residential mortgages.
Are short sales for me? sales represent a growing sector of the market. However, because sales are time consuming, they aren’t for everyone. If you are interested in short sales you will need patience, perseverance, and problem solving skills. With many more adjustable rate mortgages ready to reset to higher loan amounts in the next couple of years,
Disclaimer: The above is basic and general information regarding short sales and it is not to be constructed as legal advice or representation of any form. Ace Tax and Realty is a Registered Tax Preparer, Real Estate Broker, and Notary Public, but not an attorney. Click here for most recent approved shortsale guidelines
