Short Sale Central

You’ve got a piece of property, whether it be a primary residence or an investment property, and cannot make the payments, or are at a minimum having trouble making payments. Other than a short sale, what are your other options? What are the pros and cons of each?

1. Short Sale - The focus of this blog. You can find information here regarding the documents and information necessary to complete (or even propose) a short sale. Collecting this information can be a lengthy, cumbersome and potentially expensive process. Plus, there is no guarantee that you will find a buyer - or that the buyer’s offer will be approved.

Tax implications: In a short sale, you will receive a 1099 (miscellaneous income tax form) for “cancellation of indebtedness income,” thanks to Internal Revenue Code section 61(a)(12). If you do not know what the term “deficiency” means, check the first post for a discussion of this term. The amount of the 1099 will be equal to the deficiency. If the property sold is your primary residence, then you have a tax break for tax years 2008 through 2012. If it is invesment property, you should begin gathering information to make your case for “insolvency” - assets less than debts (see another post on this blog titled “Making the Case for Insolvency”). This is measured at the time of the transaction. Otherwise, you will be taxed at ordinary income rates on the deficiency amount.

Credit Impact: In the spectrum of the three options presented here, the short sale has the smallest impact on your credit score. However, this has been described as the difference between “being hit by a truck and being hit by a train” - in the end, we’re really talking about distinctions that may have no practical difference.

2. Deed in Lieu of Foreclosure: You can ask the bank to consider taking title to your property without going through a formal foreclosure process. The requirements for this process are very similar to the requirements for a short sale (see “What is the Short Sale Process?” in this blog). So, you may have very similar costs, with no guarantee that the lender will approve the deed in lieu. From the lender’s perspecitve, they want to intimidate you enough to make sure that if you have the money, you’re paying your loan - where I come from, they call this “trying to get blood from a turnip.” (I’m from Missouri, by the way) In my experience, the lender may also ask you for either a cash contribution or to sign a promissory note. Now, the terms on the promissory note are very favorable, and it is unsecured, but it sure doesn’t provide much inceitive to go this route.

Tax implications: Lenders will provide you with a 1099 (see above) for the difference between the amount of the mortgage and their own estimate of value (established bya BPO - see previous posts for explanation of this acronym). Again, if this is a primary residence, you’re likely OK. If not, you need to get with your accountant before the transaction to tax plan for making the case for insolvency.

Credit Impact: In the spectrum of the three options presented here, this is the middle ground. Not as significant of an impact as foreclosure, less than a short sale, but still pretty large.

3. Foreclosure: This might be the simplest, most straight-forward and least labor-intensive option available. You stop paying your loan, the bank sends a multitude of nasty letters demanding that you pay the amounts owed, and eventually they turn the file over to an attorney to foreclose. In this environment, I have worked with clients who are over 120 days delinquent on their mortgage, and foreclosure has still not started. The length of the foreclosure process will depend completely on your own unique state laws. In Colorado, the lender has to wait approximately 120 days after filing foreclosure to execute a “foreclosure sale.” The sale consummates the foreclosure, and typically (if there are no 3rd party bidders), the bank buys the property at the sale. You will likely want to move out before foreclosure. If you do not, the bank will have to file another action to evict you.

Tax implications: Same as the above 2, except that you will receive a 1099 for the entire amount of your mortgage.

Credit Implications: The worst of the three here. This is not as bad as bankruptcy, but you should expect to recover in no shorter time than 3 to 5 years.

Depending on your specific circumstances, one of these options is likely best.

All right, you know you’re in short sale territory. You have a piece of real property, you owe more than you will generate from the sale, and you’re actively trying to sell the property. What information do you need to begin generating? What will be asked of you? What will the bank be doing to consider an offer?

First, the bank will ask you for a whole host of information. This information includes:

1. Your Listing Agreement with your realtor: The lender wants to make sure you have listed the property, and have an active listing. Your realtor should be able to provide this document, since you likely signed it at the time you first listed the property.

2. Financial Information: The lender wants to know what your financial condition looks like. So, they will ask for income information (see below) and expense information. You must be able to provide information indicating how much you spend on things like insurance, utilities, groceries, gas, phone service, child care and any other recurring cost you typically pay in a given month. They will take this information and generate a predicition of your “discretionary income” - i.e. the amount of money you have left over at the end of a month.

3. W-2’s from prior years: To verify the information in #2 above.

4. Prior year Tax Returns: To verify the information in #2 above.

5. 2 Previous Months’ Bank Statements: To verify that you are not hiding cash (no, seriously, if you have $50,000 in the bank, you can bet they will ask you to PAY any deficiency - and will deny any short sale).

Second, once you find a prospective Buyer, the lender will require that you provide:

6. A fully-executed purchase agreement: To verify that the contract actually exists. As a short sale applicant, you tend to become an incidental party to the transaction - meaning, there is little reason to negotiate specific terms that will improve your position. You know, as the seller, that you will walk away with no cash (in most instances), so there is little reason to negotiate terms. HOWEVER, you should carefully consider the contract terms to address your specific circumstances. Items such as move-out dates and dealing with tenants (if this is a rental or investment property) can become very important matters in the short sale area.

7. A Buyer Prequalification Letter: Your lender doesn’t want to waste time considering a contract that won’t close. If the lender approves, they want to make sure that the buyer has the wherewithall to close.

8. A Proposed HUD-1 (Settlement Statement, etc.): To consider a short sale, the lender must know the net proceeds that will be applied against the outstanding principal balance of the loan. The proposed HUD provides this information.

Third, the lender will order what is called a “Broker Price Opinion” (”BPO”). This is like a mini-appraisal, performed by a realtor rather than a licensed appraiser. The lender must determine whether the offer price is reasonable - you will likely not get away with a complete “fire sale” price. In my experience, as long as the offer price is within about 10% of the BPO, the offer will be given serious consideration.

The BPO will be affected by the performing realtor’s subjective opinions regarding the marketplace and direction of prices. If the realtor is not conservative in their estimate, the offer may be dead on arrival. In my experience, the BPO makes or breaks the deal - which is frustrating since you have absolutely no control over this piece of the process.

If the BPO has only considered the exterior of the property, and the interior drastically impacts the valuation, then you should seriously (loudly and continuously) ask the lender to re-perform the BPO by going inside the property. Depending on the circumstances, you may be able to get some traction with this idea.

Fourth, and finally, the lender will provide approval or rejection. We will deal with approval here only. The lender will likely submit additional addendums to your existing purchase contract. These may include: (1) a Contract Addendum (re-establishing that this is an as-is sale), (2) a Closing Date addendum (requiring closing within a short timeframe), (3) a Listing Agreement Addendum (extending the listing agreement if necessary) and (4) an Arms-Length Transaction Addendum (stating that you are selling to a third party, not a related party. This one is designed to ferret out fraudulent transactions where you are receiving cash outside of closing, where you are essentially trying to perform a refinance in another’s name, where you are trying to get out from under onerous loan terms, or the like).

If you get this far, you’re ready to close. Just cross your fingers your Buyer has not gotten cold feet by now!

So you’ve heard of this fancy phrase “short sale” a lot more frequently lately, eh? Do you understand what the phrase means? Are you considering a short sale? Should you be? This blog is designed to provide exactly the kind of guidance for you to answer these questions appropriately.

First, let’s talk basics. A “short sale” is a sale of real property where the lender (i.e. the entity your mortgage checks go to) accepts less than is owed on your mortgage. So, for instance, let’s assume your mortgage balance right now is $300,000. If you sell your property for $300,000, you’ll most likely have closing costs of about $30,000 (or roughly 10% of the contract price). The left-over balance - in this case $270,000 (the $300,000 less the $30,000 in closing costs) - will be paid to the lender in complete satisfaction of your mortgage. Since this is LESS than you owe, the sale is called a “short sale.”

If you can fully satisfy the amounts owed on your mortgage, you do not have a short sale - a short sale only occurs when the lender accepts less than the amount owed.

Here’s a math equation describing the above:

Offer Price: $300,000
Closing Costs: $30,000
Net Proceeds: $270,000

You owe (your mortgage balance): $300,000
But you’re only going to give the bank: $270,000

Which means they’re losing: $30,000
(We call this a “DEFICIENCY“)

Since they’re accepting less than is owed, the sale is considered a “short sale.”

Is this a problem for the bank? Well, in reality, the bank has already created a “loss reserve” that projects what they expect to lose on this specific loan. The loss reserve will be based on all sorts of factors - and if you gave different banks the same loan details, they would likely generate different “loss reserves” for that same loan. The loss reserve offsets the value of their loan portfolio on their balance sheet, and attempts to create an honest prediction of the value of the loan.

Think of it this way: You have a friend Adam. Adam has a steady job, doesn’t spend excessively, but really wants to buy this spectacular new mountain bike that costs a whole bunch of money. You loan him $5,000. You ask him to repay it in 6 months. Your expectation is that Adam will repay the amount owed.

In contrast, your friend Billy works off-and-on, has a tendency to buy drinks for the entire bar on Friday night, and is generally unreliable. He asks for the same $5,000. You are kind-hearted, so you lend him the money, with a demand that he repay the amounts in 6 months. Do you expect to be repaid in full? Perhaps. But it’s fairly likely that you won’t be surprised when Billy comes to you and says he can’t make the payment. Or maybe he says he can pay $4,000. You have likely already adjusted your expectations for the possibility that Billy will not repay the entire amounts owed. The difference between the $5,000 and what you subjectively expect to receive is no different - in theory - as the bank’s “loss reserve.”

Loan losses are a cost of doing business to banks. When the risks look right (according to the bank’s actuarial specialists and risk-management people), and the bank’s loans are diversified amongst multiple risk “pools,” then the bank makes enough money to survive - to thrive even. But when the you-know-what hits the fan (like right now), and the bank’s projected losses pale in comparison to their actual losses, then the bank has a serious problem. A large number of short sales or foreclosures is a clear symptom of this problem.

Overwhelming loan losses can cripple banks, since they rely on monthly mortgage payments for their own operating capital. When you don’t pay your loan, this likely trickles down, leaving your lender in a troublesome spot to pay their own expenses.

Are you a candidate for a short sale? If so, keep reading the posts on this blog. We have helped multiple clients navigate these tricky waters.