The Real Estate Short Sale Dilemma
Castle Rock, CO - 7/2/2009
Unless you've been shipwrecked on a desert island, you are aware that the housing market is in the doldrums. Even though the Denver market is faring better than other areas, the average price of an existing home keeps sinking. However, one part of the real estate market has recently swelled:
The Short Sale market.
In a Short Sale, the existing lender agrees to take less than the amount owed and then releases the mortgage lien so the house can be sold. If a homeowner falls behind in his mortgage payments, the idea of a Short Sale can seem pretty attractive. The homeowner sells his house and the new buyer gets a house at a discounted price. But, if it seems too good to be true - like the ship coming to rescue you from that desert island - it probably is.
When you get a mortgage, your lender has two available paths to secure his mortgage. The first path is the mortgage lien and foreclosure power of sale on the house itself. The lender can take back the house, sell it in a foreclosure sale, and pocket the proceeds.
The second path is the personal mortgage obligation of the homeowner. In the promissory note and deed of trust, the homeowner personally guarantees the repayment of the mortgage. If the lender doesn't get what he is owed, a deficiency occurs. A deficiency judgment is a judgment lien against a debtor, defendant, or borrower whose foreclosure sale did not produce sufficient funds to pay the mortgage in full.
Previously, when a deficiency occurred, the lender was satisfied by writing off the loss. The lender would simply send the homeowner an I.R.S. Form 1099, thereby characterizing the amount of the deficiency as a 'gift' from the lender to the homeowner. This gave the lender a tax deduction, but for the foreclosed homeowner it became taxable as income.
This all changed in December 2007. The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for this relief. This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million for taxpayers who are married filing separately).
What happens now that there is no longer this relation of tax deduction and tax payment? Can the lender choose to sue the homeowner for a deficiency judgment, i.e., the amount the lender lost? There is a certain amount of confusion on this issue among real estate professionals.
* The first confusion concerns whether a lender can get a deficiency judgment in Colorado. The answer is yes, it can. Not all states allow deficiency cases, but Colorado does. A number of states, including California, Oregon and Washington, have laws which restrict deficiency judgments - it is easy to see why this confusion exists. Colorado decided to clear things up.
In December 11, 2008, the Colorado Division of Real Estate issued a Revised Position Statement concerning Loan Modifications in general and Short Sales in particular:
" The Director of the Division of Real Estate finds that a position statement regarding loan modifications is necessary in order to provide clarity to the industry. . . The purpose of this position statement is to clearly notify loan modifiers (those who engage in the act of directly or indirectly negotiating a loan modification) of the applicability of Colorado mortgage broker law.. . . Short sale - A short sale is the sale of a real property for less than the mortgage loan balance. In the settlement of the short sale transaction the existing mortgage is extinguished. Any deficiency created from the settlement of the transaction may be transformed into a promissory note, charged off, forgiven, or pursued as a judgment against the previous owner." (emphasis added) .
* The second confusion is a misunderstood belief that the federal government passed a law that did away with deficiency cases. This refers to the Mortgage Forgiveness Debt Relief Act of 2007. This act lifted the homeowner's tax burden but did nothing to stop deficiency cases from being filed.
A Short Sale creates a deficiency just like a foreclosure does. So what is a homeowner to do?
**- First, if the parties choose a Short Sale, the homeowner must make sure that there is a specific clause in the documents stating the lender will not pursue the homeowner for any deficiency. One example is the clause of "payment in full without pursuit of any deficiency judgment." Unfortunately, in most Short Sale situations, the parties are all so eager for the sale to go through that most attention is paid to the release of the mortgage lien on the property instead of any protection for the seller.
**- Second, the homeowner should explore whether the house can be sold without the mortgage lien being affected, thereby avoiding any possibility of a deficiency. This can be done with an Installment Land Contract, Wraparound Financing or our firm's Bankless Financing Program (BFP). With no deficiency, there is no deficiency judgment.
**- Finally, if the foreclosure or Short Sale has already been done and the lender seeks a deficiency judgment, the homeowner can explore discharging the judgment in bankruptcy.
Short Sales have both good and bad characteristics. The goal of all homeowners in this situation is to stay afloat.
Mike Robinson is Senior Partner at Robinson & Henry P.C., a Castle Rock, CO Law Firm. He was assisted in writing this story by Ryan Wood, an Associate with the firm.