April 3, 2013 Paul A. Sarcona, Esq.
How did this happen?
The real estate market runs in cycles. Presently, we are in an economic period in which mortgage delinquencies are on the rise. Some of the causes of the increased foreclosure rates are higher interest rates on mortgages making payment unaffordable and the declining value of homes. Some homeowners with adjustable interest rates are particularly stressed as their payment amounts increase, stretching their budgets to the limit. Others see the value of their homes are less than the amount owed on the mortgage and make a business decision to not make payments. The information herein will help you understand the short sale and how you can prepare for a short sale transaction.
What is a mortgage foreclosure?
Foreclosure is the legal proceeding in which a mortgagee, or other lienholder, usually a lender, obtains a court ordered termination of a borrower’s interest. A lender obtains a security interest from a borrower who mortgages or pledges an asset like a house to secure the loan. If the borrower defaults, the lender may has the right to repossess the property through this legal proceeding.
What is a short sale?
A short sale means the seller’s lender is accepting a discounted payoff to release an existing mortgage.
Why would a lender allow a short sale?
Lenders benefit because it can avoid the substantial expense and time of a foreclosure proceeding. Most lenders do not want to own the properties used as collateral for its loans, because the maintenance costs and taxes add to their cost and decrease profitability. Additionally, it will have instant liquidity once the sale occurs.
Do I need a realtor?
Although a realtor does not have to be involved in this transaction (remember it is the borrower that is requesting that the bank accepts less than the amount of the mortgage payoff), lenders usually want a realtor involved in the transaction. The existence of a realtor gives the appearance that this is a bona fide transaction.
What is the process of a short sale?
Typically, an attorney or authorized representative of the seller may start the process by obtaining a borrower’s authorization to request information from the lender, which allows the authorized agent to act on behalf of the seller in order to discuss terms with the mortgage company.
The lender will usually require a laundry list of items that must be presented to it such that it may make a decision. The following items are generally required:
- Signed listing agreement;
- Sales contract and pre-approval letter or proof of funds to close;
- Preliminary HUD 1 (net sheet) of proposed sale (this should include all fees, transfer taxes, outstanding water and sewer charges, attorneys fees, realtor’s commissions, outstanding real property taxes);
- Hardship letter from seller explaining why payments have not been made;
- Proof of income of seller;
- Three months’ bank statements of seller;
- Two years’ tax returns of seller;
- List of all monthly expenses of seller;
- Contractor’s proposal of needed repairs;
- Title work on property; and
- Signed short sale request document provided by lender
The lending institution usually orders a BPO (a broker’s price opinion) and/or an appraisal. Depending on whether the lender accepts the offer, the lender may then counter offer the purchase price listed in the contract of sale. The realtor or attorney will then need to negotiate with the buyer to see if the buyer is willing to pay an increase purchased price. Obviously, there is no obligation on the part of the purchaser to increase his/her offer.
Wait for the decision. This can generally take up to 30-90 days after all of the above have been provided to the mortgage company.
Why start a short sale versus allowing the bank to take the house in a foreclosure sale?
- The borrower does no longer have to deal with the long drawn out process and generally can walk away from the home without owing any more monies.
- Remember that in a foreclosure if the amount of monies secured at the auction are less that the amount owed, the lender could seek and attempt to enforce a deficiency judgment against the borrower. If a borrower defaults he/she runs risk of loss of his property by foreclosure and possibility of deficiency judgment if the value of land at time of sale is less than amount of obligation.
So, is the borrower off the hook?
Not necessarily. The lender still has options to try to collect the shortfall. As a condition of the short sale the lender may require borrowers to sign a note to repay the shortfall. It may also file a collection or a judgment for the amount of the shortage. Usually, debt forgiveness is granted.
Are there any tax consequences?
The answer may be yes depending on whether the home is an investment property or a principal residence and the amount of the shortfall. The IRS recognizes capital gains on the forgiveness of debt (see the attachment).
What if there are multiple lenders?
Short sale approval is required from each lender. The first lien holder usually offers the subsequent lien holders as little money as possible in order to achieve the sale. Typically, subordinate mortgage holders do not have much leverage to negotiate with the borrower and accept much less monies from the first lien holder in the short sale process (sometimes as little as $500.00). Do not forget that subordinate lienholders’ interests may be wiped out in a foreclosure sale and they may receive nothing. Some subordinate lien holders will refuse to negotiate.
What should I look out for if I represent the buyer in a short sale transaction?
One of the biggest hesitations that a buyer has is entering into an agreement that is contingent on the approval from the seller’s lending institution. The expenses of a home inspection, lender application fees and appraisals, and attorney’s fees generally turn people away from the process. Additionally, time is a major factor as the decision to purchase a short sale home is usually a time consuming process. It is very difficult to coordinate a purchase of a home with a purchaser who has already contracted to sell his/her home.
What should I look out for if I represent the seller in a short sale transaction?
- Try to obtain all the necessary information from the seller, i.e., ask the client the following:
- how many mortgages exist against the house;
- are there any additional judgments or liens; and
- can he/she make payment arrangements (or work it out with the bank in a modification).
- Assess the value of the home. Lenders will not just accept any offer that is presented. The value being offered should be reasonable.
- It is really important to explain to the seller that the lender will not allow the seller to make any money from the sale of the home.
- Explain that he/she should seek advice from an accountant to see if there are any tax consequences.
- Explain that there may be legal consequences. Some lenders require that the seller sign a deficiency note.
- See what assets the borrower’s possess. If the borrower owns multiple properties, just because one is a bad investment, does not mean that they can simply get rid of the property in a short sale. Remember the lender will ask for a financial breakdown of assets and may seek the recovery of the deficiency from the other assets.
Excerpt from the IRS website relating to the Mortgage Forgiveness Debt Relief Act of 2007
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
What does that mean?
Usually, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. The Mortgage Forgiveness Debt Relief Act of 2007 allows you to exclude certain cancelled debt on your principal residence from income.
Does the Mortgage Forgiveness Debt Relief Act of 2007 apply to all forgiven or cancelled debts?
No, the Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes.
What about refinanced homes?
Debt used to refinance your home qualifies for this exclusion, but only up to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified.
Does this provision apply for the 2007 tax year only?
It applies to qualified debt forgiven in 2007, 2008 or 2009.
If the forgiven debt is excluded from income, do I have to report it on my tax return?
Yes. The amount of debt forgiven must be reported on Form 982 and the Form 982 must be attached to your tax return.
Do I have to complete the entire Form 982?
Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), is used for other purposes in addition to reporting the exclusion of forgiveness of qualified principal residence indebtedness. If you are using the form only to report the exclusion of forgiveness of qualified principal residence indebtedness as the result of foreclosure on your principal residence, you only need to complete lines 1e and 2. If you kept ownership of your home and modification of the terms of your mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete lines 1e, 2, and 10b. Attach the Form 982 to your tax return.
How do I know or find out how much was forgiven?
Your lender should send a Form 1099-C, Cancellation of Debt, by January 31, 2008. The amount of debt forgiven or cancelled will be shown in box 2. If this debt is all qualified principal residence indebtedness, the amount shown in box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.
Can I exclude debt forgiven on my second home, credit card or car loans?
Not under this provision. Only cancelled debt used to buy, build or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion.
If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Yes. The forgiven debt may qualify under the “insolvency” exclusion. Normally, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent. A taxpayer is insolvent when his or her total liabilities exceed his or her total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982.
Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?
There is no dollar limit if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven. If the balance was greater, see the instructions to Form 982, page 4.
Is there anything else I need to know before filing?
Yes. Because the Mortgage Forgiveness Debt Relief Act of 2007 was passed so late in the year, the software systems used by tax preparers and at the Internal Revenue Service need to be updated to accept the revised Form 982. The IRS expects to be able to process the new Form 982 electronically on March 3, 2008
Filed Under: Real Estate