Short Sales: When, and When Not, to Use Them

Homeowners who are contemplating short sales need to fully understand the potential risks and pitfalls of doing so because, in far too many instances, this option can have catastrophic consequences

Because the staggering downturn in real estate prices has left many homes over-encumbered, short sales have generated a substantial amount of publicity. When the owners of those homes need to sell them, either because they are seeking alternative housing or can no longer afford them, a short sale may be the only means by which that home can be sold. Not surprisingly, the ever growing number of short sales has led to confusion and misconceptions by homeowners, buyers, and their real estate agents. Until the last few years, short sales were rarely employed and, because they were so uncommon, most real estate professionals and lawyers do not understand them, nor can they identify when they are appropriate. As important, short sales have led to a variety of unintended consequences that may not be in the seller’s best interest.

This outline will describe short sales, explain when they should and should not be used, and also delineate some of the risks of utilizing them.

1. What Is a Short Sale?

A short sale is a sales transaction in which one or more of the secured creditors on real property permit the conveyance of the property without being paid in full. A short sale does not by its very nature address whether the underlying indebtedness is being released or satisfied. Instead, a short sale is separate and apart from the enforcement of the promissory note.

Lenders acquiesce to short sales when they realize that a short sale is the best means to maximize their recovery on the subject real property. In most situations involving short sales, the lenders understand that since the property is worth less than the indebtedness encumbering the property, a short sale allows lenders to realize the maximum amount from the sale of the property. Insightful lenders accept that their other means of recovery on the indebtedness is through foreclosure and, invariably, the amount the lenders net through foreclosure is substantially less than from a short sale. Therefore, from a lender’s perspective, a short sale is a means of making the best of what is oftentimes a very bad state of affairs.

For example, if a home is worth $200,000, but is encumbered by a first loan in the amount of $250,000 and a second loan for which $50,000 is owing, a short sale would allow the first lender to net $200,000 minus customary closing costs and commissions. Normally, to encourage the second lienholder to accept a short sale, it receives a minimal recovery with the consent of the first lienholder instead of nothing if the property were to be foreclosed upon. The second lienholder therefore receives something and the first lender can avoid the time and cost involved in completing a foreclosure which, in the case of a trustee’s sale, will require ninety (90) days once the process is initiated. More importantly, the price to be generated at the trustee’s sale is normally less than when the property is sold as part of a voluntary transaction. Along the same lines, if the lender is the successful bidder at the sale, which is commonly the case, the lender then finds itself burdened with a property it has to maintain and market and will ultimately incur selling costs. Though there is no magic formula as to how much better a lender will do with a short sale, it has been my experience that the difference can be significant.

So how does a seller and his or her agent actually effectuate a short sale?

2. The Short Sale Process

Even though lenders are modifying their policies even as this article is being drafted, the vast majority of lenders still follow the same practice. First of all, they require the seller to present a bona fide offer to it, along with a written explanation from the borrower as to why the short sale should be approved. Most lenders require an explanation of the conditions providing grounds for the lenders to approve the sale. In addition, most lenders request financial information as well, based on the often mistaken belief that a lender should not cooperate if the seller has the ability to either maintain the loan or cover any shortfall. If the lender then finds the offer acceptable, it will normally submit an addendum authorizing the short sale, whereas if it does not think the purchase price is adequate, it may summarily reject it.

Historically, the seller’s receipt of a rejection notice would leave the seller in an awkward position because the lender would not provide any guidance as to what price would be acceptable. This is now changing because lenders have finally discovered that failing to provide any parameters for sellers and their agents is counterproductive and detrimental to the lender. Now, even in situations in which the lender requires an initial offer, many lenders are now responding with an amount that the lender would accept as a minimum selling price.

At this point, you are probably wondering why sellers would not always resort to short sales instead of facing foreclosure. The following section outlines when short sales are appropriate, followed by a detailed explanation as to all the reasons why short sales can be problematic and, in some instances, actually be extremely risky and perilous for an unwary seller.

3. When a Short Sale Is Advantageous

At this time, notwithstanding rumors to the contrary, short sales are treated very similarly to foreclosures on your credit history. Nevertheless, a short sale is usually better than a foreclosure because, with a short sale, the number of months you are late with your mortgage payment is almost always less than if you endure a completed foreclosure. Therefore, this in itself is probably better for your credit. I have also been advised by credit experts that when you are trying to rationalize a poor credit score, you can procure a loan easier if your score has been impaired by a short sale versus a foreclosure since, at least in the case of a short sale, you took some steps to mitigate the lender’s losses.

A short sale is an appropriate vehicle to sell your house if you are not otherwise prejudicing yourself by completing the transaction. For example, if you are avoiding a foreclosure on your record and are desirous of minimizing your HOA fees, which are a personal obligation separate and apart from the foreclosure, a short sale permits you to terminate future fees because, once you no longer own the property, your obligation on those fees ceases as a matter of law. In many cases, this could save you hundreds if not thousands of dollars. But there is another reason why a short sale is preferable in certain situations.

Specifically, if the subject loans are recourse obligations and a short sale will reduce your obligation on any shortfall, utilizing a short sale makes sense and could save you tens of thousands of dollars if not more. That is because, as explained earlier, a short sale normally generates a far greater return for the lender than a foreclosure. Since, in the case of a recourse loan, the borrower is responsible for the difference between the amount owing and the amount realized from the sale and/or the foreclosure, reducing that number is of direct benefit to the borrower. It is a case of pure economics. The greater the amount generated from the sale of the property, the smaller the shortfall and the less the borrower may have to cover.

Now that you understand why short sales can make sense, I will devote attention to why in all too many cases short sales are not a panacea, they are a potential nightmare.

4. The Problems with Short Sales

A. Does a Short Sale Provide Anti-Deficiency Protection?

Purchase money loans on qualified property are non-recourse under Arizona law. This includes first, second, and third loans as long as they were utilized to purchase the subject property. Consequently, lenders cannot pursue recourse directly against the borrower even by suing directly on the note. This leaves junior lienholders unable to recover anything if the property is worth less than the amount owing on a senior loan.

If the seller consents to a short sale, is the seller protected by the anti-deficiency statutes [see A.R.S. §§ 33-729(A) and 33-814(G)]? Normally at the closing the lender asks the seller to sign documentation reflecting that the lender retains whatever rights it may have against the seller under state law regarding any shortfall. This open-ended provision could present an argument for an aggressive lender that, since the Arizona anti-deficiency statutes refer to foreclosures, etc., such protections are not available to a seller who voluntarily transfers his or her property. Interestingly enough, I believe that the only way to avoid this potential complication is if the lender incorporates into the agreement specific verbiage acknowledging that under Arizona law it has no recourse and, furthermore, will not be issuing a 1099 on the basis that the debt has been forgiven.

B. Acknowledgement of a Non-Recourse Debt

Many times, the lender specifically requires that the seller acknowledge that the seller is responsible for the remaining balance on the subject loan. If the loan is a recourse one, signing such a provision is probably meaningless, but in situations in which the debt would be non-recourse, acknowledging the enforceability of the debt will probably create a fully enforceable obligation. This scenario normally occurs when a seller is handed documentation at the closing and does not closely read the short sale provisions. Because the subject documentation may not be shown to the seller until right before the closing itself, an unknowing seller could easily find himself creating an obligation where one did not exist prior.

C. Triggering Tax Liability Where None Existed

When debt is forgiven, this forgiveness can trigger tax liability which is assessed at ordinary income rates. Consequently, if the lender sends out a 1099 for the difference between the indebtedness and the amount being paid, the seller may be facing a challenge by the Internal Revenue Service that forgiven short sale debt is taxable. While such an argument would probably fail in the case of the foreclosure of a non-recourse loan, sufficient uncertainty exists regarding the tax impact of a short sale, that a seller would need to consult with independent tax counsel before completing the transaction.

A similar scenario develops in cases in which the seller may have inadvertently ratified a debt that would otherwise be unenforceable. If the seller ratifies the indebtedness by signing an agreement at the closing and then convinces the lender to not pursue recourse, a strong argument exists that the forgiven ratified debt would lead to tax liability. What is especially devastating about this type of indebtedness is, whereas the underlying debt itself would be dischargeable in bankruptcy, the tax that results would not be.

D. The Seller Loses the Benefit of a Foreclosure

Separate and apart from the issue as to whether the seller may accidentally be converting a non-recourse debt into a recourse one is the economic reality of many individuals facing the loss of their homes. If that individual has nowhere else to go and will not benefit from a short sale, why should the seller relinquish title to the house and be forced to seek alternative housing until absolutely necessary? In many cases, remaining in the house just a few more months without having to make payments can provide the seller with an opportunity to put aside enough money to avoid becoming homeless. That same individual could find himself homeless by completing a short sale prior to having sufficient funds to move.

5. Interplay of Bankruptcy and Short Sales

In the last few years, I have been asked on innumerable occasions whether a seller who is contemplating bankruptcy should file for bankruptcy prior to completing a short sale or even allowing a foreclosure to be completed. I have concluded that the only time it makes sense to complete the foreclosure or short sale pre-bankruptcy is in situations in which a client is seeking eligibility for Chapter 7 by permitting the foreclosure to be completed, therefore reducing consumer debt. If the house is sold or foreclosed upon, that debt is normally extinguished and, in some cases, a debtor could then proceed under Chapter 7 if eliminating the house mortgage tips the scales in favor of business debt.

Separate and apart from that example, I otherwise cannot see a benefit in permitting the short sale and/or foreclosure to be completed prior to the bankruptcy filing. If the bankruptcy is filed first, the indebtedness will normally be discharged. By discharging the indebtedness in bankruptcy, you should eliminate any argument as to a 1099, forgiven debt, or tax liability. If a lender or lenders are not willing to then complete a short sale because of the bankruptcy, such is simply a risk that the seller should accept.

There is a side benefit of filing for bankruptcy prior to the completion of a short sale or foreclosure. Once the seller files for bankruptcy, whatever money the seller accumulates in not having to make house payments is free and clear of the bankruptcy estate. This is in marked contrast to a situation in which a seller quits making payments, delays the bankruptcy, and then finds himself with a surplus of cash and nothing to do with that money prior to bankruptcy. Though the benefit of filing for bankruptcy fairly early in the process is not truly a pure short sale issue, it is a practice tip that practitioners should consider in strategizing with clients.

6. Summary

Without question, some short sales are preferable to foreclosures and should be pursued. Nevertheless, clients who are contemplating short sales need to fully understand the potential risks and pitfalls of doing so because, in far too many instances, this option can have catastrophic consequences.

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