What is a Short Sale?

A short sale is the sale of real estate in which the sale proceeds fall short of the balance owed on the property.

It generally occurs when a borrower cannot pay the mortgage loan on their property, but the lender decides that selling the property at a loss is better than foreclosure.

Both parties must consent to the short sale process, it allows them to avoid foreclosure, which involves hefty fees for the bank and poorer credit report outcomes for the borrower. It is becoming a common practice as so many home owners owe more than their house is worth.

In a short sale without recourse, the lender does NOT pursue the home owner (borrower) for the forgiven debt.  Otherwise the lender may sue the home seller for the difference between the sales price of the home and the remaining loan balance.

Example Short Sale:

Steve bought a house for $320,000 and financed the property with an 80/20 loan.  He got a loan for 80% ($256,000) from one lender, and a second loan for 20% ($64,000) from another lender in order to 100% finance the property.

A year later Steve has lost his job and can no longer afford his house payments.  He’s 3 payments behind and is headed towards foreclosure.

Steve decides to sell his house and downsize.  Unfortunately, property values have fallen in his area and the real estate market is slow. He receives an offer for $205,000 to buy his home.

Since Steve still owes $320,000 on his house, he must either come up with the difference ($115,000) in order to sell the home, or request his lenders accept a short sale.

Because he is behind in his payments and the lender does not want to foreclose, the first lender (the 80% lien holder) might agree to discount their loan to $202,000 (a $54,000 discount) and the second lender  (the 20% lien holder) might agree to discount their loan to $3,000 (a $61,000 discount).  The second lien holder typically gives a much larger discount because if the first lender forecloses on the property, the second lender gets nothing, while the first lender gets the property.

With both lenders agreeing to discount their loans, the house is sold for $205,000 and foreclosure is avoided.  The home sellers will not receive any funds from the sale, and typically must prove a hardship (lost job, divorce, etc) for the lenders to agree to a short sale.

In general the IRS does not tax forgiven debt from a short sale (contrary to many reports).  See the IRS Home Foreclosure & Debt Cancellation site.

As long as the short sale is without recourse, the lender does not pursue the borrower for the difference between the original loan amount and the discount and the debt is forgiven.

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