Making the choice between “Short Sale” & Foreclosure

By Joel Persinger
YourRealEstateDude.com

As the prices of San Diego County homes have come down and low introductory interest rates on many home loans have gone up, some San Diegans have found themselves owing more on their homes than the properties are worth. This has given rise to a sharp increase in foreclosures as home owners find it difficult to cope with the increase in their mortgage payments and see little incentive in holding on to homes that aren’t worth what’s owed on them. In addition to foreclosures, this has also brought about a rash of what are called, “Short sales”, and with them the age old question posed by sellers, “Should I try to sell it or just walk away?” While there is often no clear answer, the question did spark a debate among my agents during the weekly training meeting at my office this past week. But, before I share the highlights of that discussion, a short explanation of foreclosures and short sales is in order.

Foreclosure is the more commonly understood of the two terms. Essentially, it refers to the process by which a lender reclaims a property when a borrower has failed to make the required payments on the loan. The lender goes through “foreclosure” in order to sell the property for the purpose of recouping the money lent to the borrower.

By contrast, a short sale is an action taken by the borrower in order to avoid foreclosure. In this case, the borrower (or homeowner) attempts to sell the home in order to satisfy the loan. However, the value of the home has decreased to the point that the value is no longer sufficient to pay off the loan. If the homeowner places the property on the market and succeeds in finding a buyer at the home’s current market value, the lender will lose money on the deal. In this case, the lender would have to agree to take a loss for the difference between the amount of proceeds from the sale and the loan balance. If the lender accepts the deal, the property will have been sold “short” of the amount owed. Thus, it is called a “Short sale.”

The individual situation often dictates which option a homeowner will elect to take. It should be noted that there are pros and cons to each. In the case of short sales, while I have no way of confirming the assertion, I have heard many people claim that a short sale will not cause quite as great a ding on your credit report as will a foreclosure. This is often why homeowners will choose this path. However, a short sale requires a great deal of effort and significant disclosure of information. Among other things, the lender will require that the homeowner provide tax and financial records, draft a “hardship letter” explaining why the payments cannot be made and demonstrated a diligent effort to sell the property for the highest possible amount. By contrast, foreclosure is somewhat easier, in that you simply stop making payments and walk away from the property. Additionally, a foreclosure may not have the income tax ramifications of a short sale. In the case of a short sale, it is quite common for lenders to send the homeowner an IRS form 1099 for the amount of the lender’s loss. No such form is issued in the case of a foreclosure. However, as mentioned before, foreclosure may have a much worse effect upon the borrower’s credit rating.

If you find yourself in the unenviable position of having to choose between foreclosure and selling your home in a short sale, the best advice I can give is that you seek competent professional counsel prior to making any decision. At minimum, you should speak to both a tax advisor and an attorney. And make sure that both are knowledgeable and experienced.