Beware of Short Sales

I've addressed this topic before, but a client's situation brings it to the fore again. If you are upside down in your mortgage and thinking about a short sale, BEWARE! My clients had a real estate agent negotiate a short sale with their lender, who holds both a first and a second mortgage on their property. The combined mortgages are about $185,000 and, according to the agent, the property is worth about $90,000. The agent has presented a buyer for $90,000 and the lender has agreed to a short sale. So everything is great, right?

Not really, because the short sale agreement (written by the lender, of course) starts out by saying that the lender reserves its right to seek a deficiency against the borrowers (my clients). My clients are expected to contribute $8,000 in cash at closing (above the sales price, so this comes out of their pockets) and must give the lender a promissory note for another $7,000, payable at zero per cent interest for five years. At a minimum the short sale is costing my clients $15,000.

What my clients, and what most people doing a short sale, thought they were getting is a release from all liability to the lender upon sale for $90,000, plus the promissory note. They didn't realize they had to pony up cash, nor did they realize that all the lender is agreeing to do is to release its mortgages. The lender can still seek a deficiency against my clients for $95,000, the difference between the two mortgages ($185,000) and the sales price ($90,000).

And here's one last kick in the head. If the lender agrees to release my clients from the deficiency, the lender will undoubtedly file a form 1099 with the IRS, miscellaneous income, and my clients will get a hefty tax bill for the forgiven debt. Debt that is forgiven is income and you can be taxed on it.

Before you agree to a short sale, make sure you understand all of the ramifications of the deal.