A Short Sale From The Seller's Point Of View

Short sales, when considered through the eyes of the seller are, by far, more complex than the issues faced by the buyer. Each situation is different and will turn on its own facts. The purpose of this discussion is to highlight a few of the areas of concern where the seller should obtain professional legal, tax, and/or credit advice. The law is constantly changing and the reader is warned not to rely on this discussion as anything other than a description of issues to be researched.

The notation C.C.P. refers to the California Code of Civil Procedure and the notation C.C. refers to the California Civil Code.


Foreclosure:
In the event a borrower defaults on a loan, the lender may foreclose on the borrower's real property which secures the loan. A foreclosure may take the form of a Trustee Sale Foreclosure, or a Judicial Foreclosure resulting in a deficiency judgment. A foreclosure poses a number of threats to a borrower: (a) loss of the borrower's home; (b) a foreclosure on the borrower's credit report; and, (c) a potential deficiency judgment.


Deficiency Judgment:
A deficiency judgement is a court judgment obtained by the lender, in a judicial forclosure, against the borrower for the difference between the unpaid balance of the secured debt and the amount produced by sale or the fair market value of the property, whichever is greater (C.C.P. § 726(b).) A lender may obtain a deficiency judgment only with a judicial foreclosure. With a trustee's sale foreclosure, the lender cannot go after a deficiency judgment.


When Deficiency Judgments Are Not Available:
Under certain circumstances, in California, a deficiency judgement may not be available to a lender:

a. Purchase Money. If the loan was obtained to purchase an owner occupied residence (1-4 units) and the loan is secured by that property, the lender may not obtain a deficiency judgment against the defaulting borrower. The loan is entitled to "purchase money" protection (C.C.P. § 580b.). However, if the loan is the result of a refinance the new loan is no longer "purchase money" and is not entitled to protection.

b. Seller Carryback. If the purchase money loan for any type of real estate is financed by the seller and secured by that same property, the lender/seller may not obtain a deficiency judgment against the defaulting borrower. (C.C.P. § 580b)

c. Trustee's Sale. A lender may not pursue a deficiency judgment against the borrower if the lender opts to foreclose by a trustee's sale foreclosure (a non-judicial action). (C.C.P. § 580d.)

d. 3 Month Time Limit. An action for a deficiency judgment must be brought within 3 months from the time of a judicially-ordered sale. (C.C.P. § 580a.)

e. Fair Value Limitations. A deficiency judgement is limited to the difference between the unpaid balance of the secured debt and either the amount produced by judicial sale or the fair market value of the property, whichever is greater, in a judicial foreclosure (C.C.P. § 726(b).)


Junior Deeds of Trust:
If a junior deed of trust is not purchase money or seller carryback, then the junior lien holder may sue on the note and the borrower on the junior loan may be presonally liable.


Exception To The One Action Rule:
Typically a lender may not sue on a debt secured by a mortgage, except by judicial foreclosure (C.C.P. §726). An exception to this is if the property has become valueless after the lender's security interest was recorded. In this case, the lender may sue directly on the debt, unless the borrower's loan is either a purchase money or a seller carryback loan.


Risk of Deficiency Judgment and/or Direct Suit:
Seller is warned to consider carefully the risks of a deficiency judgment and/or a direct suit on the debt.


Other Lender Options:
Borrowers should understand that lenders will sometimes consider solutions other than a foreclosure. These solutions might include:

a. Loan Workout: A loan workout is a resolution of the problem between the borrower and the lender which modifies the original loan agreement. Some of these options include forbearance (e.g. forgiving a portion of the debt or late charges); deferment; renegotiating interest rate, monthly payment amount, principal amount, maturity date; or the enforcement of an acceleration clause in the loan.

b. Deed in Lieu of Foreclosure: After the borrower is in default, the borrower voluntarily delivers title to the lender for consideration and the lender accepts the conveyance of the property in full satisfaction of the mortgage debt.

c. Short Sale: A short sale is a transaction in which a lender allows the real property securing the loan to be sold for less than the remaining mortgage amount due and accepts the proceeds as full payment of the loan. This is generally the result of the borrower's inability to make the mortgage payments and a property value which is less than the total amount owed on the mortgage(s). Typically, a lender will not consider a short sale unless the borrower has stopped making payments on their loan and has in hand an actual offer to purchase the subject property.


New Loan:
Sometimes it is possible to refinance Borrower/Seller's existing loans and thereby obtain an affordable monthly payment. Borrower/Seller is encouraged to explore the possibility of refinancing the existing mortgage debt.


Debt Counseling:
If borrower/seller's inability to make the existing loan payments is due to other unsecured debt (e.g. charge cards etc) the seller may benefit from the advice of a professional debt counselor.

Advice Of Counsel: The Borrower/Seller is encouraged to seek the advice of an attorney as to the most appropriate course of action to be taken.


Effect Of A Short Sale On Credit Rating:
A lender will likely report a short sale to credit bureaus as being "settled" for less than the full balance. This type of report will show up on the borrower's credit report as a negative mark for seven to ten years (C.C. §1785.13). Even so, the effect of this negative mark is generally perceived to be less damaging than a reported foreclosure. Typically lenders will not negotiate how they report a short sale.


Tax Effects Of A Short Sale:
The tax implications for the borrower can be significant and are relatively complex. In very general terms mortgage relief (i.e. a discount on the amount owed) will be reported to the IRS by the lender, and must be included in the borrower's gross income.

On December 20, 2007 President Bush signed into law a measure giving tax breaks to homeowners who have mortgage debt forgiven. With the passage of the "Mortgage Forgiveness Debt Relief Act of 2007", a taxpayer does not have to pay federal income tax on debt forgiven for a loan secured by a qualified principal residence. This tax break applies to debts discharged from January 1, 2007 to December 31, 2009. Qualified principal residence indebtedness is debt incurred in acquiring, constructing, or substantially improving the residence (up to $2 million for refinances).

Before a short sale is contemplated, it is strongly recommended that the borrower seek the advice of a professional tax advisor. To determine if there will be taxable income credited to the seller. "Insolvency" under the Internal Revenue Code is an issue not discussed here, but certainly one which the seller should explore with a tax advisor.


Lender Not Required To Approve Short Sale:
Sellers need to understand that lenders are not required to agree to a short sale and may refuse to proceed with a short sale even though a conditional approval has been issued. A lender may resort to a foreclosure all the way up until the actual close of escrow.


Lender Not Required To Respond To Approval Request:
There is no requirement that a lender respond to a request for approval of a short sale/payoff.


Effects Of Late Payments:
If borrower stops making payments and the lender begins the foreclosure process by filing a notice of default and then the borrower pays what is owed under the note, these activities may appear on the borrower's credit report. The lender can report to a credit bureau receipts of any payments made 30 or more days after their due date. This may appear as a "foreclosure in process," etc. and will harm the borrower's credit rating. Before stopping payments on a mortgage, it is strongly recommended that the borrower seek the advice of a professional tax advisor.

It bears repeating that lenders are not obligated to accept a short-payoff and that Sellers and Real Estate Brokers have no control over whether Short-Pay Lenders will consent to a short-payoff.

A short sale may create credit or legal problems or may result in taxable income. Seller should always seek advice from an attorney, certified public accountant or other expert regarding such potential consequences of a short-payoff.