In the most basic definition, a short sale is the process of selling a primary residence for less than what is owed with the approval from the current loan company.
In other words, if you must sell your home that you owe $500,000 on but the home is only worth $400,000 – the bank may approve a “short sale” and allow you to sell the home for a lower amount. However, this article is going to go into a lot more depth than just the basic definition. Below, you’ll learn (click to jump to the section:)
- Short Sale Basics
- Short Sale Eligibility
- Alternatives to a Short Sale
- The Short Sale Process
- Short Sale Pros and Cons
- Tax Consequences of a Short Sale
Short Sale Basics
How long does a Short Sale take?
The length of time a short sale can take greatly depends on a number of factors, especially who the lender is. Some lenders can approve a short sale in as little as two weeks, where other lenders can take a year or longer. However, most short sales can be completed in a three to five month time period.
Why do people sell with a Short Sale?
If a home is currently “underwater,” which means the owner owes more than the property is worth, a property cannot be sold on the open market without the homeowner having to pay the difference. If the new purchase price can’t pay off the old loans and the homeowner can’t come up with the shortfall – everyone is stuck. This is when a short sale comes into play.
Why Would a Bank Agree to a Short Sale?
Typically, a homeowner will choose to sell their home via a short sale in order to avoid a foreclosure. If the foreclosure is completed, it allows the lender or a cash buyer to take possession of the home. However, this process can be tremendously time consuming and costly for lenders. The length of time and type of foreclosure process the Lenders can pursue depends on the state the home resides in; each state is different. The foreclosure process can range from several months to several years, and thus cost the lender tens of thousands of dollars in legal fees and holding costs. Additionally, the lender would need to place the home on the market to sell as a foreclosure (see my other article, How to Buy a Foreclosure, for more information on this process), which involves even more time and costs. This is typically known as “REO,” meaning, Real Estate Owned by the Lender.
Therefore, many lenders choose to accept a loss from a short sale to save the time and fees that a foreclosure would take. Essentially – a bank will agree to a short sale if it’s in the bank’s best interest to accept a short sale. Although there is no guarantee a Lender will complete a short sale, even if it seems to be everyone’s interest, it is typically advisable for the homeowner to pursue the short sale in good faith. Lender guidelines change often so it’s important to set expectations going in.
Who is responsible for the remaining balance on the loan?
This depends entirely on the agreement made between the lender and the homeowner, so it is important to get this important detail spelled out in writing before completing a short sale in the Short Sale Approval Letter. Unless the lender explicitly waives their ability to pursue the homeowner at a later date, the borrower (seller) may be on the hook for the difference of what the home sold for vs what hey owed. A few select states have Anti-deficiency statutes that offer additional protection to homeowners, but every situation is still a case by case basis. This is critical component of a short sale where Borrowers are encouraged to seek legal council if they are unsure if they will be responsible for any forgiven debt.
Short Sale Eligibility
Homeowners pursuing the traditional short sale are not always approved. Certain qualifications have to be met in order for a short sale to be considered or approved. While each bank will have different requirements for short sale approval, typically a bank will want to see:
- Homeowner is behind on payments
- Property is underwater
- Homeowner is experiencing financial hard times and does not have significant assets
Again, these are not hard and fast rules. Some short sales do not require the homeowner to be behind on payments or to be in significant financial trouble, but these do help qualify a home for a short sale. Again, it largely comes back to the simple truth that a bank will want to do what’s in a bank’s best interest.
Alternatives to a Short Sale
A short sale is simply one option of many that a homeowner can use if they are experiencing trouble with their home mortgage. This section is going to look at ___ other options a homeowner may have instead of a short sale, and explain some of the pros and cons of those options.
A loan modification happens when a lender changes the terms of the loan to make the loan more affordable for the homeowner, or as the US Department of Housing and Urban Development defines it, a “ Loan Modification is a permanent change in one or more of the terms of a Borrower’s loan, allows the loan to be reinstated, and results in a payment the Borrower can afford.”
While some banks will do this on their own initiative, most lenders will look at a loan modification under a program known as the Home Affordable Modification Program, also known as HAMP. Created in 2009 to help struggling homeowners, HAMP is a government program that requires lenders, in certain cases, to modify the terms of a mortgage to make it more affordable for homeowners. The HAMP program typically will enable lenders to re-spread out the loan over thirty years and drop the payment to a maximum of 31% of the homeowner’s gross income.
For more information on the HAMP program, see MakingHomeAffordable.gov
(Statistically, loan modifications have not proved as a permanent solution for distressed homeowners. Although there are short-term benefits for both parties, Loan Modifications can still heavily affect your credit and very rarely erase inequity on the property.)
Deed in Lieu of Foreclosure
A deed in lieu of foreclosure, also known as a “mortgage release” is a sort-of halfway point between a short sale and a foreclosure, in which the homeowner gives the property’s legal title back to the lender. Most lenders will want to see that attempts have been made to sell with a real estate agent for at least 90 days before allowing a deed in lieu of foreclosure.
While it’s not the best alternative, it is still a choice made by the majority of struggling homeowners. Depending on the state the home is in, it can go through a Judicial Foreclosure or Non-Judicial foreclosure. Either way, if the foreclosure is completed, the home can revert back to the Lender or sold to a 3rd party. Whoever holds legal title to the property at that point will have the ability to re-sell the property. If the homeowner is still living in the property, they can be evicted, although many lenders/new owner may try to negotiate “Cash For Keys” to facilitate a cleaner transition. In some cases, a foreclosure may be better for the borrower than a short sale, but overall it is recommended only allowing a foreclosure if all other options are exhausted.
If the property is not upside down (more is owed than it’s worth) then simply selling the home may be a good option. This would be the best case scenario for the homeowner. However, selling a property can be difficult if the home is not in a great condition or if there is not enough equity to pay for a real estate agent to sell the home. Additionally, any late payments missed will already be affecting the homeowners credit, but avoiding the impact of a short sale or foreclosure on the credit report would be ideal.
The Short Sale Process
The short sale process is not always the most enjoyable event, but by following the proper steps and keeping excellent records the short sale process can be navigated. The following section will detail the short sale process, but keep in mind that different lenders may have a slightly different process, so use this as a general guideline but don’t bet your life on this information.
NOTE: Before you start the Short Sale Process, you may want to talk to a real estate Attorney in your area to review your situation. Although Agents will be involved to facilitate your sale, they cannot provide nor should you rely on any legal or tax advise they offer. Each case is different and with the legal and tax challenges, it’s important you understand your options and consequences.
Step One: Find an Agent
Homeowner chooses an experienced real estate agent to deal with. Short sales are complicated events that should be assisted along with an agent who specializes in working with short sales. To find good short sale agents, make sure you do your research and ask the proper questions to narrow down someone who will understands the caveats of pre-foreclosure and can steer the homeowner clear of potential pitfalls.
Here are a few questions to start:
- How long have you been doing short sales? (at LEAST 3 years experience should be a requirement)
- How many short sales have you been involved in? What is your success rate?
If they advertise 100% success rate, run for the hills. Unless they’ve only done 1 short sale, no one is hitting that average. Plus, there are times when a short sale is not the best option for the homeowner. This is where “knowledgeable” vs “just earning a commission and advertising how awesome I am” vary greatly.
- What makes you able to be the best short sale specialist for me?
You are looking for feedback like accreditations, experienced team in place, can point to additional resources, has worked with your lenders, can point out pitfalls, can negotiate effectively on your behalf, and overall, are upfront and realistic. You can also check the BBB, local Realtor board, and online reviews for complaints and feedback as well.
NOTE: This is not the time to use your cousin Susie SmileyAgent because she just got her license and would like to earn an easy commission. It is imperative to align with a trusted company that has proven their short sale expertise in your marketplace.
Step Two: A Buyer is Found
Before negotiating with a bank, a lender will typically want to see that there is an accepted offer on the property. This can be done in one of several ways. A real estate investor may be working with a homeowner directly and offer on the property, at which point Step One and Step Two would be reversed. However, it’s more typical for the homeowner to list the home with the short sale agent, explaining to potential buyers that this is a short sale, and wait for an offer to be accepted.
Step Three: Turn in Offer and Paperwork
After there has been a signed “purchase and sale” agreement between the buyer and the seller, the homeowner will need to begin dealing with the bank. Luckily, the homeowner typically needs to simply give the bank permission to deal with the real estate agent directly, so the homeowner won’t need to be involved in every step. The bank will typically have a significant amount of paperwork that must be completely promptly and returned to the bank. To shorten the waiting time, it is important that all necessary requirements are included. This paperwork might include (but not limited to:)
- Cover Letter
- Authorization to Release Information
- Seller’s Hardship Letter
- Seller’s Financial information
- 2 years w2′s
- 2 months pay stubs
- 2 months bank statements
- Supporting Hardship Info – HOA liens, medical/disability statements etc.
- Repair Estimate for the property
- Comparable sales for the property
- Net Sheet
- First mortgage holder may ask for a payoff amount from the 2nd
- Second mortgage holder may ask for a payoff amount from the 1st
- Lender may ask for an Initial Title Report
Perhaps the most important piece of documentation on this list is the “Seller’s Hardship Letter” and Financial information. The hardship letter is exactly what it sounds like: a letter written from the seller to explain why they are having trouble. This letter should be written by the struggling homeowner and:
- apologize for not being able to make the payments
- explain how things changed between when the loan was taken and now
- explain what you’ve done to try and keep up payments
- other attempted avenues taken (loan modifications, sale, etc)
- detail what the offer received on the property was and why the bank should accept it
- be cordial, polite, and detailed.
At this point, it’s time to wait. While some lenders will respond within weeks, other lenders still take months and months to respond, and there is no guarantee that the response will be helpful or positive. Patience is key during this stage! During this waiting time, the bank will typically assign one of their employees to be the “negotiator” in the transaction followed by the ordering of the valuation – which is step four.
Step Four: Bank Valuation
Before a lender will be willing to negotiate with the new buyer over price, the lender needs to understand what the value of the property is (after all, the lender is probably located thousands of miles away in a skyscraper in a large city, and doesn’t know anything about the property’s value.) Therefore, the lender will order a valuation to determine the price.
Typically, this valuation is determined through a Broker’s Price Opinion (BPO) or an Appraisal. A BPO is a semi-formal opinion from a licensed real estate broker of the value of a property, whereas an appraisal is a more thorough opinion. Each lender will have an independent valuation done, and they typically will need to be updated every 90 days. Once the bank has a good idea on how much the property is worth, they will either either accept (skip to step six), deny (go back to step 3 with a new offer or quit), or negotiate (go on to step five.)
Step Five: Negotiation with the Bank
If the bank decides to negotiate, understand that the bank is not negotiating with the distressed homeowner but with the buyer. At this point, the homeowner simply is nothing more than a signature on the page, but they can reject to close the sale if the Approval letter is not in their best interest. As in any negotiation, though, the buyer will submit an offer and it will be either rejected, accepted, or changed. However, unlike typical real estate negotiations, this process can take a long time. Finally, when you have mutual acceptance between the bank and the buyer, the transaction can move forward.
Step Six: Make the Sale Happen
Finally, when the bank has fully approved the home to be short sold, and the paperwork has been fully signed by all parties, the sale can move on to the Title and Escrow company (or the attorney’s office, if your state closes real estate transactions using attorneys.) The transaction will typically close just like any other transaction. You will wire money or bring a cashier’s check to closing (or have your lender send loan docs), legal title will transfer, and the property will become yours.
Short Sale Pros and Cons
For the Lender
Pros: A lender who agrees to a short sale is doing so to lessen the financial blow that a foreclosure may cost them. A short sale also gives the lender a better public image, as they are seen as helping rather than hurting.
Cons: Besides the obvious loss in the note value that the lender will face, a short sale still takes a lot of time and fees for a lender, so a short sale is not without financial cons for the lender.
For the Seller
Pros: A seller who chooses to sell with a short sale can get out from an underwater mortgage, thus reducing their debt load. The seller also has the more “dignified” approach of selling the home rather than being legally evicted in a public manner. Additionally, a short sale may look better on a credit report than a foreclosure and the seller may be able to purchase a home sooner than if they had allowed the home to be foreclosed upon.
Cons: A short sale does reflect negatively on the seller’s credit report, and any money paid to acquire the home (such as a down payment, closing costs, etc) will be lost forever. Additionally, there is no guarantee that the bank will accept a short sale, so all the work may be for nothing.
For the Buyer
Pros: A buyer may be able to get a significant price reduction when buying a short sale. Additionally, because of the hassle, there may be less competition for a property listed as a short sale as well.
Cons: Short sales can take many months to complete, with no guarantee that the bank will even approve the sale – thus a buyer may waste a lot of time for no result. Also, a home that is going through a short sale may have significant deferred maintenance and problems.
Tax Consequences of a Short Sale
After a short sale has been completed – there still may be additional charges for the home seller in the way of taxes. You see, the IRS considers any debt forgiven to be income, and thus taxable. In other words – if you borrowed $50,000 and the lender forgave $40,000 of that loan, the IRS may tax you on that $40,000.
In 2006, the US Government passed the Mortgage Forgiveness Debt Relief Act, which gave an exclusion to the above “forgiven debt tax” when that debt was tied to the person’s primary residence and if the forgiveness amount was less than $2 million dollars for a married couple filing jointly. However, this exclusion ONLY applied to debt forgiveness that took place between 2007 and 2012, but was extended for the 2013 year, so if you are looking to do a short sale… you better hurry!
If you are considering pursuing a short sale at this point, it’s advisable to talk to a qualified professional to see if you may be liable for taxes if the sale is completed in 2014.
Short sales have been a significant player in the real estate world over the past several years and continue to be such, so it’s important for a real estate investor or homeowner to truly understand the short sale concept and process. If this article wasn’t the most definitive article on Short Sales … well, I don’t know what is! (Seriously, I checked. Wikipedia only had 1043 words!) Hopefully this article has helped clear up any questions you may have had about short sales, but if not – I invite you to leave a comment or question below and hopefully we can sort through the issue together!
Special thanks to Tracy Royce, a Short Sale Arizona specialist, for her assistance in writing this post. Without her help, this epic post would still be sitting in the shelves for months to come! Also – if you want to learn more about the short sale process from a short sale agent’s perspective, don’t miss the interview we did with Tracy Royce on the BiggerPockets Podcast.What is a Short Sale? The Definitive Guide by Brandon Turner