Contra Costa, California Real Estate

Note:  This blog pertains to the state of California.  Lending laws and regulations may differ in other states.

Many sellers proceed with a short-sale prior to consulting a CPA and attorney.  Don't make this mistake! There is a significant amount of erroneous information about short-sales and the ultimate impact on you, the seller. 

There are three major items to consider before listing your home as a short-sale:

• Recourse or Non-Recourse mortgage(s)
• Income Tax Liability
• Personal Liability after the sale

Recourse or Non-Recourse mortgage -

Recourse is the lender's right to collect the mortgage deficiency for up to four years.  If your current mortgage(s) were the loans obtained when you purchased your home, then it is a Non-Recourse mortgage.  If you refinanced your original loan (even if you didn't take cash-out) or obtained a 2nd mortgage / Home Equity line of credit after the purchase, they are now Recourse loans.

Let me walk you through an example -

Mr. and Mrs. Seller purchased their home with a $600,000 original mortgage.  They later refinanced the mortgage and obtained a Home Equity Line of Credit for $150,000.  Total combined finanncing = $750,000.  The current fair market value of the home is $525,000.

In a typical short-sale transaction, the 1st lender pays the 2nd lender 10% of the 2nd lender's balance to release the lien and allow the sale to close.

Sales Price:     $525,000
Selling costs:   $ 32,970
Payoff to 1st lender:   $477,030 ($122,970 short)
Payoff to 2nd lender:   $15,000 ($135,000 short)

Since these are not the purchase loans, both lenders have the right to Recourse (the right to collect on the unpaid balance) for up to four years unless they waive that right.

Potential outcome #1:  Both lenders waive their right to Recourse

Each lender will send you a Form 1099 (Miscl Income) for the portion of the mortgage that was "forgiven" (i.e. unpaid).  In this case, the sellers will have an additional $257,970 "income" on which they will have to pay State and Federal income taxes.  Assume they are in a 25% effective Federal tax bracket, this will represent an additional Federal income tax bill of $64,500 +/- plus an additional State tax bill of $23,00- +/- for a total additional income tax liability of $87,500.

Important note:  the requirement for lenders to issue Form 1099 for the forgiven debt occurs whether the home is a short-sale or a foreclosure, but in the case of foreclosure the seller has no control over the price and ultimate loss.

I know of two methods allowed by the IRS (there could be more) to legally avoid paying Federal income tax on the forgiven debt:  if you are Insolvent at the time of the sale OR if you qualify under the Mortgage Forgiveness Debt Relief Act.  It is important to discuss your potential personal income tax liability with your CPA in advance.

Potential outcome #2: The 1st lender waives their right to Recourse but the 2nd lender doesn't.

The 1st lender will issue Form 1099 for $122,970.  Using the same effective tax bracket as the previous example, this will result in additional Federal taxes of $31,000 +/- plus an additional $11,000 +/- State taxes for a total additional tax liability of $42,000.

The 2nd lender retains their right to collect on the balance due of $120,000 ($135,000 less $15,000 paid from the short-sale).  Remember, unless the lender waivees their right to recourse, they retain that right and typically utlize the services of a collection agency or a deficiency judgment.

When faced with the potential post-sale Recourse, sellers have said, "If they try to collect the balance, I will file bankrutpcy." BUT due to changes in the bankruptcy laws, sellers may not have the option to file a Chapter 7 bankruptcy after selling the home because they no longer pass the "means test" and will be forced in to a Chapter 13 bankruptcy (5 year repayment plan).

There are numerous other "potential outcomes" but, in the end, this is the truth:  Regardless of our "short-sale expertise", Realtors' are not attorneys.  For some sellers already dealing with a serious financial hardship, a bankruptcy or foreclosure may be the better option than a short-sale.  The only individual qualified to help you evaluate your options is an attorney who specializes in Bankruptcy, Short-Sales and Foreclosures.  Many attorneys offer a free half-hour consultation. 

Please, take the time to meet with a CPA and attorney.  Learn your options and potential ramifications in order to make educated decisions for your future.