Why You Should be Reluctant About Short Sales

October 28, 2010

By: David M. Serafin

In an attempt to seemingly mitigate the harsh consequences of a foreclosure on their credit report, increasing numbers of homeowners in Colorado are surrendering their homes by engaging in a “short sale” of the home. This often occurs as a last resort when a mortgage lender rejects a proposed loan modification or when you cannot sell the home for anywhere close to its fair market value.

A “short sale” occurs when you sell your home for less than that owed on the overall mortgage balance, with the mortgage lender agreeing to accept this lesser amount. The specific drawback is that the mortgage lender will typically not agree to waive the deficiency balance on the mortgage (i.e. the balance between the amount owed on the overall mortgage balance and the lesser amount for which the home is later sold), or the contract will be silent as to the treatment of such deficiency balance.

For example, a house in Denver with a mortgage debt of $300,000 might sell in a “short sale” to a buyer for only $250,000 (with the mortgage lender agreeing to the reduced contract price), with the remaining $50,000 deficiency balance owed to the lender. When the selling homeowner is unable to pay the mortgage lender back $50,000 (plus accompanying late fees, inspection fees and/or foreclosure costs, if the process gets drawn out), the mortgage lender will seek legal recourse in the county court of the county in Colorado in which the home is situated, obtain a judgment, and then either garnish wages or levy a bank account. Pushed to the brink, the selling homeowner is often pushed into either a chapter 7 or chapter 13 bankruptcy in Colorado Bankruptcy Court.

Alternatively, the mortgage lender may agree to forego the deficiency balance. The problem here is that the lender will send to both the selling homeowner and the IRS (and the Colorado Department of Revenue) a Form 1099 COD regarding cancellation of indebtedness income. Put another way, the IRS and State treat the amount of the mortgage debt forgiven (in the tax year of the property sale) as gross income for taxable income purposes. Using the above example a $50,000 or more increase in gross income, combined with other unsecured debt such as from credit cards, medical bills or other unsecured debts, can also push the selling homeowner into chapter 7 or chapter 13 bankruptcy, as bankruptcy eliminates the adverse income tax consequences.

As a Denver foreclosure defense attorney, I believe that chapter 7 or chapter 13 are the best and only options for many who ‘short sell” a home as the bankruptcy discharge will replace the foreclosure recording on the selling homeowner’s credit report, not to mention simultaneously eliminating both the deficiency balance and any income tax consequences.