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.

Beware Short Sales

We hear a lot about short sales these days. A "short sale" is a term that generally means a lender accepts less than what is owed on a mortgage loan and in return releases its mortgage. There's a lot of confusion about the effect of a short sale. Is the borrower free and clear after a short sale, or can the mortgage company still sue her for what wasn't paid in the short sale?

To understand this, you have to know there are two parts to a mortgage loan. The first part is the promissory note. That evidences the debt that was created when the borrower borrowed money from the bank. The second part is the mortgage, or lien (pronounced "lean") on the borrower's house. That is the security for the loan and is what lets the bank foreclose and sell the house if the borrower doesn't pay.

Most borrowers think that when the bank releases its mortgage, which is the point of a short sale, the underlying debt is fully paid. In some cases this is true. But it is possible for the bank to agree to release its collateral (the house) without considering the loan to be fully paid. In that case, the borrower remains liable for the unpaid balance and can be sued.

The lesson is, if you're considering a short sale, make sure that the bank will accept the proceeds of the sale in full satisfaction of the loan.