This type of sale can only be accomplished if all lien holders agree to accept less than the amount owed on the debt. The concept of a short sale is based on two intrinsic and inseverable components: (1) a lien holder’s agreement to net less than the amount owed on the debt, and (2) an arm’s length sale at or below the appraised value of the property. It is important to note that a short sale is distinct from a short settlement, which occurs when a lien holder demands a greater selling price than the appraised value but less than the amount owed on the debt. Short sales have become a more common alternative to foreclosure in the United States since the 2007 real estate recession, and similar procedures exist in other countries, such as the UK’s Assisted Voluntary Sale (Spotblue.com).
Difference between Short Sale and Short Settlement
In real estate, a short sale and a short settlement are two distinct concepts that involve the sale of a property for less than the outstanding mortgage debt. A short sale occurs when the lien holder, typically a mortgage company, agrees to accept less than the amount owed on the debt and permits the sale of the property at or below its appraised value. This is possible when the lien holder believes that the mortgage will likely never be repaid and the property’s value will not regain equity to allow full payment of the mortgage. On the other hand, a short settlement refers to a situation where the lien holder demands a selling price greater than the appraised value but still less than the amount owed on the debt. In this case, a sale with a prudent arm’s length buyer is no longer a reasonable or attainable expectation, as neither the buyer nor the bank or finance company will provide a mortgage for greater than the appraised value. Thus, the key difference between a short sale and a short settlement lies in the lien holder’s agreement to accept a selling price at or below the appraised value in a short sale, while demanding a higher price in a short settlement (Cowan, 2012; Investopedia, 2021).
Reasons for a Short Sale
There are several reasons for a short sale in real estate, primarily stemming from financial hardship faced by the homeowner. One common reason is the inability to keep up with mortgage payments, which may result from job loss, reduced income, or increased expenses. Additionally, a decline in the property’s value due to market conditions or damage to the property can lead to a situation where the outstanding mortgage balance exceeds the current appraised value, making it difficult for the homeowner to sell the property and repay the loan in full. In such cases, lien holders, including primary mortgage lenders, second mortgage lenders, and other creditors, may agree to a short sale as it is often a more favorable alternative to foreclosure. This is because a short sale typically results in a smaller loss for the lien holders and less negative impact on the homeowner’s credit compared to a foreclosure (Investopedia, n.d.; NOLO, n.d.).
Lien Holders and Their Role in Short Sales
Lien holders play a crucial role in the short sale process, as they hold the authority to approve or reject a short sale proposal. In a short sale, the net proceeds from selling the property fall short of the debts secured by liens against the property. Lien holders, which may include primary mortgage lenders, second mortgage lenders, home equity line of credit (HELOC) providers, homeowner association liens, mechanics liens, and tax liens, must agree to accept less than the amount owed on the debt for a short sale to proceed. This agreement is essential because it allows the property to be sold at or below its appraised value, which is a key component of a successful short sale. Lien holders often opt for short sales over foreclosures, as they tend to result in a smaller financial loss and a more responsible resolution for the property owner. However, it is important to note that lien holders are not obligated to accept a short sale proposal and may instead demand a higher selling price, leading to a short settlement rather than a short sale (Harvard Business Review, 2017).
The Impact of Appraised Value on Short Sales
The appraised value of a property plays a crucial role in short sales, as it determines the maximum amount a buyer is willing to pay and the amount a lender is willing to finance. In a short sale, the lien holder (e.g., mortgage company) must agree to accept less than the amount owed on the debt, and the sale must be at or below the appraised value of the property. A prudent buyer will not pay more than the appraised value, and a bank or finance company will not provide a mortgage for more than the appraised value, thus limiting the short sale proceeds to a maximum gross yield of the property’s appraised value. If the lien holder demands a price greater than the appraised value, it is no longer considered a short sale but rather a short settlement, which is less likely to be successful. Therefore, the appraised value serves as a critical benchmark in determining the feasibility and success of a short sale transaction (Investopedia, n.d.; Wiki.Agency, n.d.).
- Wiki.Agency. (n.d.). Short sale (real estate). Retrieved from https://wiki.agency/index.php/Short_sale_(real_estate)
Alternatives to Short Sales: Foreclosure and Assisted Voluntary Sale
Alternatives to short sales include foreclosure and assisted voluntary sale. Foreclosure is a legal process in which a lender attempts to recover the balance of a loan from a borrower who has stopped making payments by forcing the sale of the property used as collateral for the loan. This process can be lengthy, costly, and damaging to the borrower’s credit. On the other hand, assisted voluntary sale is a more cooperative approach between the borrower and lender, where the lender agrees to accept a sale of the property at a reduced price, often below the outstanding loan balance, to avoid foreclosure. This option is more favorable for both parties, as it allows the borrower to avoid the negative credit impact of foreclosure and the lender to recover a portion of the loan amount without incurring the costs associated with foreclosure proceedings (UK Government, 2017).
Home Affordable Foreclosure Alternative Program
The Home Affordable Foreclosure Alternative Program (HAFA) was a U.S. government initiative introduced in 2009 as part of the Making Home Affordable Program (MHA) to address the real estate recession and assist homeowners in managing their mortgage debts. HAFA provided homeowners with the option to exit their homes through a short sale, relieving them of any remaining mortgage debt. Additionally, the program offered up to $10,000 in relocation assistance for homeowners or their tenants. Eligibility criteria for HAFA included financial hardship, delinquency or risk of falling behind on mortgage payments, obtaining the mortgage on or before January 1, 2009, and owing up to $729,750 on a primary residence or one-to-four unit rental property. Notably, the HAFA program expired on December 31, 2016 (Making Home Affordable, 2016).
- Making Home Affordable. (2016). Home Affordable Foreclosure Alternatives (HAFA) Program. Retrieved from https://www.makinghomeaffordable.gov/pages/default.aspx
Eligibility Criteria for HAFA Short Sales
The Home Affordable Foreclosure Alternative Program (HAFA) was designed to provide homeowners with the opportunity to exit their homes through a short sale while being relieved of the remaining mortgage debt. To be eligible for HAFA, homeowners had to meet specific criteria: they must have been struggling to make mortgage payments due to financial hardship, either delinquent or in danger of falling behind on their mortgage, and have obtained their mortgage on or before January 1, 2009. Additionally, the property in question must not have been condemned, and the homeowner must have owed up to $729,750 on their primary residence or one-to-four unit rental property (with higher loan limits for two- to four-unit properties). Upon successful completion of a HAFA short sale, homeowners were granted a waiver of deficiency, releasing them from any remaining mortgage debt and potentially receiving up to $10,000 in relocation assistance (Making Home Affordable Program, 2009).
The Short Sale Process: Steps and Key Players
The short sale process involves several steps and key players to ensure a successful transaction. Initially, the homeowner contacts the primary lien holder to submit an application for a short sale, providing necessary documentation such as a hardship letter, financial statements, and tax returns. The lien holder then reviews the application and decides whether to approve the short sale. If approved, the homeowner works with a real estate agent to list the property and find a potential buyer. The buyer submits an offer, which the homeowner presents to the lien holder for approval. Lien holders, including primary and secondary mortgage holders, home equity line of credit (HELOC) providers, and other creditors, play a crucial role in the process as they must agree to accept less than the amount owed on the debt for the short sale to proceed. Once all lien holders approve the offer, the transaction moves forward to closing, where all parties sign the necessary documents to finalize the sale. Throughout the process, communication and collaboration among the homeowner, real estate agent, lien holders, and buyer are essential for a successful outcome (Wiki.Agency, n.d.).
Deficiency Judgments in Short Sales
Deficiency judgments arise in the context of short sales when the proceeds from the sale of a property are insufficient to cover the outstanding mortgage debt. In such cases, the lender may seek a deficiency judgment against the borrower to recover the remaining balance. This legal action allows the lender to pursue the borrower for the difference between the sale price and the total mortgage debt, potentially leading to wage garnishment, bank account levies, or property liens. However, not all states permit deficiency judgments, and some have specific laws governing their application in short sales. Additionally, certain lenders may agree to waive their right to pursue a deficiency judgment as part of the short sale negotiation process, providing the borrower with a release from any remaining mortgage debt (Harvard Law Review, 2010; Investopedia, 2021).
Credit and Tax Implications of Short Sales
The credit and tax implications of short sales can be significant for both homeowners and lenders. In terms of credit, a short sale can negatively impact a homeowner’s credit score, as it is reported as a “settled debt” on their credit report. This can lead to a lower credit score and potentially hinder their ability to secure loans or credit in the future. However, the impact on credit is generally less severe than that of a foreclosure, as the homeowner has proactively addressed their financial situation by opting for a short sale.
Regarding tax implications, the difference between the outstanding mortgage balance and the sale price in a short sale is considered “forgiven debt” by the Internal Revenue Service (IRS). This forgiven debt may be treated as taxable income, which could result in a higher tax liability for the homeowner. However, under the Mortgage Forgiveness Debt Relief Act of 2007, homeowners may be eligible for tax relief if the property was their primary residence and the mortgage debt was used to buy, build, or improve the property (IRS, 2021). It is essential for homeowners to consult with a tax professional to understand their specific tax implications and potential relief options in a short sale scenario.
- (IRS. (2021). Home Foreclosure and Debt Cancellation. Retrieved from https://www.irs.gov/newsroom/home-foreclosure-and-debt-cancellation)
Benefits and Drawbacks of Short Sales for Homeowners and Lenders
Short sales offer several benefits for homeowners, including avoiding foreclosure, mitigating the negative impact on credit scores, and potentially receiving relocation assistance through programs like the Home Affordable Foreclosure Alternative Program (HAFA) (Making Home Affordable Program, 2009). Additionally, short sales can provide a sense of control and proactive decision-making in a challenging financial situation.
Lenders also benefit from short sales as they can recover a portion of the outstanding loan amount without incurring the costs and time associated with foreclosure proceedings. Furthermore, short sales can result in a faster resolution, as foreclosed properties may remain unsold for extended periods, leading to additional maintenance costs and potential property value depreciation.
However, short sales also present drawbacks for both parties. Homeowners may still face deficiency judgments, wherein they are held responsible for the remaining loan balance after the sale. Moreover, the short sale process can be complex and time-consuming, requiring negotiations with multiple lien holders and extensive documentation.
For lenders, short sales may yield lower returns compared to the full repayment of the loan. Additionally, the negotiation process can be lengthy and resource-intensive, potentially straining the lender’s capacity to manage other assets and loans effectively.