Short Sales: What happens when the seller’s lender doesn’t provide a forgiveness letter for the deficiency?

A word from The Tim: This post is from long-time Seattle Bubble participant Tim Kane (a.k.a. “S-Crow”). With short sales becoming more common every month in the Seattle area, I think Tim has struck on an interesting topic that not many other people are talking about. We already know what a hassle short sales can be for the buyer, but what about the potential mess the seller could find themselves in after the sale closes?


Note: The opinions expressed in this post are in no way legal advice nor should anyone take any commentary on this topic through this or any other blog as a substitution for legal advice. Sellers who are considering or currently engaging in a short sale should consult with an attorney.

If a lender refuses to forgive a deficiency in a short sale (will not provide letter of forgiveness), can the seller file bankruptcy and name the lender even if the lender does not pursue the deficiency?

Some thoughts:

  • Let’s face it: Many sellers file bankruptcy after a short sale is completed to be rid of their debts and start with a clean slate. Can the seller list the “deficiency” as part of their bankruptcy even if the lender is not pursuing the debt? I think many would like to know.
  • The banks that are not providing forgiveness of debt letters as part of a routine short sale are in effect reserving the right to pursue the deficiency at some time in the future.
  • Would it be prudent for the seller to file bankruptcy right after the short sale when they don’t have assets or wait until they are pursued for the debt (if they ever are)?

About S-Crow

"S-Crow" (Tim Kane) is co-owner (with spouse Lynlee, LPO-Designated escrow Officer) of Legacy Escrow Service, Inc., an authentic independent escrow firm closing residential purchase/sale and refinance transactions.

67 comments:

  1. 1
    Kary L. Krismer says:

    That the entity isn’t pursuing you, or that you think the entity might not have a claim against you, does not prevent you from listing a creditor on your bankruptcy. Lots of creditors are listed as “notice only,” meaning the debtor doesn’t think there’s a claim, but they are giving the creditor notice of the bankruptcy just in case. Even without notice, most claims would likely be discharged.

    The timing of a bankruptcy has to do with many things.

  2. 2
    Ryan says:

    Great post and I am looking forward to reading the comments. This is a concern of mine as I visited Seattle Bubble long ago, talked shit, bought a house anyway, and now have been eating crow every night for dinner.

    My big concern/issue is my 2nd is with a credit union…I wish it was with a big bank b/c I wouldn’t feel bad about not repaying it and it looks like any type of mortgage help/settlement will somehow involve restructuring these 2nds. Credit unions are going to be left out and I am really worried I will be screwed.

    Question: Do banks focus on assets when debating whether to pursue or are they looking instead at your monthly income? What about people who just refuse to pay rather than are unable to pay?

    Question: Because of paperwork snafu’s, has anyone successfully argued that a 2nd lender may move to 1st in line on collecting b/c the holder of the 1st improperly filed/completed/transferred/assigned note?

    Note: Just b/c you do a short sale doesn’t mean you qualify for bankruptcy (duh).

    Sorry if I hijacked this topic with irrelevant questions…feel free to tell me to take a hike.

  3. 3

    As noted by the author, if you’re thinking of a short sale and/or bankruptcy, you need to consult an attorney, not a blog. This comment is not legal advice.

    The problem with waiting to file bankruptcy, until the lender actually seeks to collect on the debt, is that very few people have a five year plan that sees themselves broker then than they are today. Rather, everyone hopes that they’ll be better off. As noted by Ryan, its not the short sale that qualifies you for bankruptcy; its your solvency. So, if you “wait” to file bankrupcy, and if your life plan goes as hoped, you might not even be insolvent when that bill comes due. And if you’re not insolvent, then you won’t be able to file bankruptcy and discharge the debt. Rather, you’ll have to pay it.

    The better question to ask is, “What is it going to take to resolve this debt so it does not come back to bite me in the a**?” Don’t just accept the short sale approval letter, close the sale, and ignore reality. Talk to the lender and make an offer. The lender should be willing to consider something less than full repayment because the lender’s alternative for a non-performing debt is to sell it to a collection agent for pennies on the dollar. If you can beat that price, you should be able to resolve the debt. Then you don’t have to worry about bankruptcy in the future.

    Ryan, I’ve never worked in a bank so I don’t know what their analysis might be. That said, my understanding is that bank is unlikely to sue you on the debt. Rather, they’ll likely sell it. And once somebody pays for it, you better believe they will make an effort to collect. And I’ve never heard anyone make the “jump in priority due to lost note” argument, and off the cuff I doubt if it would work (the legal basis for such an argument is unclear to me).

  4. 4
    S-Crow says:

    RE: Ryan @ 2 – Ryan, when a short sale is opened for consideration at the bank or credit union they typically ask for documentation regarding income and assets. The second lien holder (Bank or Credit Union) does not “move” into 1st position if I understand you correctly.

    One thing to consider is that the 1st lien holder can be short as well, not just the 2nd. From my perspective from the short sale transactions our office closes the 2nd lien holder receives very little or nothing at all. Yes, some of the losses are substantial.

  5. 5
    Ryan says:

    S-crow, just to clarify some….I was brainstorming about how I could satisfy my heloc holder and still default without recourse…it would be interesting to see if the argument could be made that b/c the bank who holds the 1st never properly assigned/recorded the note that this note is in fact invalid and because of this does not retain it’s right as the primary creditor. Does that make sense?

    Why can’t I just tell my credit union that I am going to default and they will be receiving nothing…unless of course they agree to provide me with a letter of forgiveness? If I stopped paying, my first would likely not collect 100% of what is owed…guaranteed that credit union will receive 0. So, why not tell credit union that you will pay them something (pick a number) if they agree to release you…otherwise, they won’t be getting anything?

  6. 6
    S-Crow says:

    RE: Craig Blackmon @ 3 – with regards to the selling of the debt to debt collectors…..I think that in a few years time it is feasible that these debt collection companies will pop up in peoples lives.

    That raises another larger question: should sellers sell short without a letter of debt forgiveness and take their chances that the debt won’t be sought.

  7. 7

    I Found a Good Website Explaining Short Sales in Laymans’ Terms

    Article in part:

    “…Except for certain conditions pursuant to the Mortgage Forgiveness Debt Relief Act of 2007, be aware the I.R.S. could consider debt forgiveness as income, and there is no guarantee that a lender who accepts a short sale will not legally pursue a borrower for the difference between the amount owed and the amount paid. In some states, this amount is known as a deficiency. A lawyer can determine whether your loan qualifies for a deficiency judgment or claim….”

    http://homebuying.about.com/od/4closureshortsales/a/shortsalebasics.htm

    LOL…the IRS gets involved too, sellers are shafted then IMO, the IRS has RIGID rules that apply to all short sales sellers and telling them your RE attorney says you’re possibly immune, RE: this new found income, may work for a bank, but you’ll need an IRS attorney too, to fight this more “slamdunk” IRS contingency. Good luck….LOL

    IMO, just hand the keys back to the bank, if it comes to a short sale decision…LOL

  8. 8
    david losh says:

    This is timely to the radio spot Tim posted yesterday where he made the comment that a short sale may show you have worked with the bank.

    A short sale has always been an option. The thing is you need to demonstrate a financial or medical need. Many people are doing “liar” short sales when it is actually a strategic default.

    Even if you get a letter from a lender stating you owe them nothing you need an attorney to read it. You are in very, very deep water. You may have made representation about your finances on the advice of a Real Estate agent.

    You need legal advice. You need an attorney. A short sale is no easy solution. You need to show cause.

    I’m not an attorney, and this is not a legal opinion.

  9. 9
    Dweezil says:

    It seems that the system is really set up to encourage owners to choose foreclosure over short sales.
    Free rent and no ghosts coming back to haunt you. Except for the credit score hit.

    I guess for me, foreclosures mean cheaper houses, but it sure doesn’t make much sense for banks.

  10. 10
    Julie Lyda says:

    For those that are truly in financial straits I would recommend checking out the HAFA program. This is a government program and once approved you will NOT be liable for any remaining balance.

    “If your mortgage payment is unaffordable and you are interested in transitioning to more affordable housing, you may be eligible for a short sale or deed-in-lieu of foreclosure through HAFA.

    The benefit of a HAFA short sale is that you are no longer responsible for the difference between what you owe on your mortgage and the amount that your home sells for.

    You will also receive $3,000 in relocation assistance upon successful closing of your short saleIn a short sale, the servicer allows you to list and sell the mortgaged property with the understanding that the net proceeds from the sale may be less than the total amount due on the first mortgage. or deed-in-lieu of foreclosureWith a deed-in-lieu of foreclosure, you voluntarily transfer ownership of your property to the servicer— provided the title is free and clear of mortgages, liens, and encumbrances.

    Generally, if you make a good faith effort to sell your property but are not successful, a servicer may consider a deed-in-lieu of foreclosure.”

    Eligibility*

    You may be eligible to apply if you meet all of the following:

    •You live in the home or have lived there in the last 12 months.
    •You have a documented financial hardship.
    •You have not purchased a new house within the last 12 months.
    •Your first mortgage is less than $729,750.
    •You obtained your mortgage on or before January 1, 2009.
    •You must not have been convicted within the last 10 years of felony larceny, theft, fraud or forgery, money laundering or tax evasion, in connection with a mortgage or real estate transaction.

    http://www.makinghomeaffordable.gov/programs/exit-gracefully/Pages/hafa.aspx

    It is always recommended to seek legal counsel regarding other recourses, however becoming educated on available programs is a good first step.

  11. 11
    Kary L. Krismer says:

    By S-Crow @ 6:

    RE: Craig Blackmon @ 3 – with regards to the selling of the debt to debt collectors…..I think that in a few years time it is feasible that these debt collection companies will pop up in peoples lives.That raises another larger question: should sellers sell short without a letter of debt forgiveness and take their chances that the debt won’t be sought.

    One other issue I’d raise (but not answer) is tax consequences. [Note: I see now that Scotsman raised it in the 7th post.] It may be that short selling now, with or without a bankruptcy, would have different tax consequences than if you sell now and then the statute of limitations runs on the second debt in six years.

    And yes, I suspect that we will be seeing a lot of collection agencies pop up in a few years and that many of those pursued will claim (rightly or wrongly) that their real estate agent told them the debt was being discharged by the short sale.

  12. 12
    Kary L. Krismer says:

    By Julie Lyda @ 10:

    For those that are truly in financial straits I would recommend checking out the HAFA program. This is a government program and once approved you will NOT be liable for any remaining balance.

    I believe that’s only on the first mortgage, not any junior liens, but I’m not 100% certain of that.

  13. 13
    Kary L. Krismer says:

    By Craig Blackmon @ 3:

    A
    The problem with waiting to file bankruptcy, until the lender actually seeks to collect on the debt, is that very few people have a five year plan that sees themselves broker then than they are today. Rather, everyone hopes that they’ll be better off. As noted by Ryan, its not the short sale that qualifies you for bankruptcy; its your solvency. So, if you “wait” to file bankrupcy, and if your life plan goes as hoped, you might not even be insolvent when that bill comes due. And if you’re not insolvent, then you won’t be able to file bankruptcy and discharge the debt. Rather, you’ll have to pay it..

    If the worst thing that happens to you down the road is you’re no longer insolvent, great! I really doubt that will apply to very many people.

    As I mentioned, many factors affect the timing of a bankruptcy, and they are very specific so I don’t really want to go into them. I will note though that there are some disadvantages to waiting, such as possible changes in laws and the fact that X years from your bankruptcy filing will be later the longer you wait to file. That doesn’t mean though that filing earlier is always better.

  14. 14
    DavidB says:

    Forgiveness of debt is considered taxable income by the IRS Not much is written on this subject but this may be a big surprise to people facing foreclosure or short sales.

    I remember reading that legislation was passed during the financial meltdown to exempt forgiveness of debt from taxable income until 2012 for primary residences but not homes that were investment properties, vaction homes, etc. Many sellers are in for big surprises next year when this legislation expires and they short sell or have their house foreclosed.

    A bankruptcy filing won’t eliminate federal taxes or student loans so those would still have to be paid.

    I wonder if we’ll see a spike in short sales towards the end of the year as people try to get their debt forgiven before this legislation expires.

  15. 15
    Kary L. Krismer says:

    RE: Ryan @ 2 – Credit unions are reportedly extremely difficult to deal with on short sales when they are in second position. And that doesn’t surprise be because they were always difficult to deal with when I had to deal with them on my consumer bankruptcy cases.

    I’ve seen a lot of recent bankruptcy filings where BECU is in second position. I suspect they will be taking a lot of losses.

  16. 16
    Kary L. Krismer says:

    RE: DavidB @ 14 – That was the tax issue I was raising.

    Bankruptcies will discharge some taxes–it depends on the type and the age, and some other factors (e.g. was their fraudulent tax evasion involved). It’s a rather complicated topic and I would typically refer such matters out to a bankruptcy tax attorney so as to reduce my malpractice risk. Also, there may be a hardship discharge for student loans–I don’t remember exactly what they did there with the new law.

  17. 17
    Kary L. Krismer says:

    BTW, I should mention that if you have a second loan that is completely underwater (e.g. a $300,000 first and a $60,000 second on a house worth only $275,000), that you can typically file a Chapter 13 and treat the second position loan as unsecured debt. It’s an exception to the exception that prevents so-called “cramdown” in Chapter 13. Also, if the house is a rental, you may have even more ability to do a “cramdown” on the rental house.

    This is one of the reasons why people in financial trouble should see an attorney. The problem is though that attorneys that might know about loan modifications or short sales might not know about bankruptcy options.

  18. 18

    RE: Kary L. Krismer @ 16 – Kary, I think its safe to say that any legal advice dispensed via a blog is per se malpractice. The key is to make sure that nobody believes there is an attorney/client relationship.

    This comment is not legal advice. Kary, consult a malpractice attorney to identify your potential exposure. ;-)

  19. 19

    RE: DavidB @ 14 – Here’s the quick-n-dirty on tax liability for forgiven or extinguished debt. But first…

    This comment is not legal advice. Consult an attorney.

    Forgiven or extinguished debt is considered income subject to the income tax IF the debt was “recourse.” Recourse debt exists where the creditor can realize on collateral (i.e. force the sale and apply proceeds to the debt) AND pursue the debtor personally. Here in WA, a non-juidicial foreclosure extinguished the debt. Therefore there is no tax liability following a non-judicial foreclosure.

    On the other hand, if the lender voluntarily waives the difference in a short sale — and yes, anybody who is counseled to accept a short sale without also being informed of this issue probably has a claim — then the debt was recourse because at that time the lender had the option of foreclosing judicially, which results in a judgment against the debtor as well as sale of the collateral. So this is a powerful incentive to simply let the bank have the home — no risk of tax liability.

    That said, if the debt is forgiven anytime until the end of 2012, and if the property was your principal residence, then you are exempt from income tax liability.

    When I said “quick-n-dirty” I meant it — there are many other aspects of these issues I have not addressed.

  20. 20
    Scotsman says:

    RE: Craig Blackmon @ 18

    “consult a malpractice attorney”

    Malpractice attorney? Are you serious? Oh, the irony. This society has truly jumped the shark, as they say.

    How many malpractice attorneys does it take to finally get it right?

  21. 21

    RE: Scotsman @ 20 – Maybe its the lawyer in me, but I don’t appreciate the irony. Lawyers are subject to professional liability, just like doctors, accountants, real estate brokers, etc. We all have an obligation to provide appropirate professional services, and if we fail to do so we are liable for the harm we cause. Legal malpractice claims are their own breed because its really two claims in one: You must prove that the attorney was negligent, AND you have to prove that you were harmed as a result, which generally means you need to prove you would have prevailed on the claim for which you hired the attorney but for his malpractice. So yes, “legal malpractice” is a niche as much as “medical malpractice” — the other varieties of professional negligence are less lucrative and therefore less specialized.

  22. 22
    Ryan says:

    Good info guys, thanks. It’s tough to find an attorney who can comprehend both the bankruptcy side of things AND the foreclosure/housing side of things. So far, I have had no luck in finding someone competent.

  23. 23
    Kary L. Krismer says:

    By Craig Blackmon @ 19:

    RE: DavidB @ 14
    Forgiven or extinguished debt is considered income subject to the income tax IF the debt was “recourse.” Recourse debt exists where the creditor can realize on collateral (i.e. force the sale and apply proceeds to the debt) AND pursue the debtor personally. Here in WA, a non-juidicial foreclosure extinguished the debt. Therefore there is no tax liability following a non-judicial foreclosure..

    Craig, I don’t think that is correct. Just because the creditor elects to use a non-recourse method, that doesn’t mean the debt is non-recourse. Do you have a citation for that position? Or are you just dealing with discharge of indebtedness income resulting from a non-judicial foreclosure?

  24. 24
    Scotsman says:

    RE: Craig Blackmon @ 21

    Stop it! Did I read that correctly? You’re saying legal malpractice is one of the better paid specialties? How comforting. I’m going to start drinking again.

    But wait- this is even “better”- a congressman who’s “tired of reading the constitution.” And You’ll never guess who it is. Hint: yup, it’s one of ours. . .

    http://hotair.com/archives/2011/03/31/outrage-du-jour-dem-rep-says-hes-tired-of-reading-the-constitution/

    OK, I’m done- bye.

  25. 25
    Kary L. Krismer says:

    By Ryan @ 22:

    Good info guys, thanks. It’s tough to find an attorney who can comprehend both the bankruptcy side of things AND the foreclosure/housing side of things. So far, I have had no luck in finding someone competent.

    Part of the problem is many attorneys, and most that do bankruptcy work, think that loan modifications are a total waste of time because of early results. And given the fact that they are all over-worked doing bankruptcy, they have no motivation at all to even try to determine if things have changed.

  26. 26
    Kary L. Krismer says:

    By Craig Blackmon @ 18:

    RE: Kary L. Krismer @ 16 – Kary, I think its safe to say that any legal advice dispensed via a blog is per se malpractice. The key is to make sure that nobody believes there is an attorney/client relationship.

    What I was saying is that when practicing law I would refer those tax discharge matters out to another attorney. The fee for doing the case was not enough to justify the malpractice risk. IMHO, bankruptcy tax discharge is an area where the attorney should specialize to make it cost effective.

  27. 27

    RE: Kary L. Krismer @ 23 – The comment was addressing only the potential tax liability for debt extinguished via non-judicial foreclosure. I did not intend to imply anything beyond that.

  28. 28
    Pegasus says:

    RE: Craig Blackmon @ 19 – A couple of points. You would have to be a moron to do a short sale without having at least the first mortgage holder agree to forgive otherwise what would be the purpose? Second, I believe the tax law exempts taxes only on the purchase money portion of the loan. If you refied and yanked $100,000 to blow on toys and trips and the bank forgives 150,000, you have to pay taxes on that $100,000. Those with helocs that actually forgive the debt would have to pay taxes on the loan amount unless maybe improvements were made with the money. Sadly big screen TV’s don’t count as home improvement neither does that Porche glittering in the driveway.

  29. 29
    Pegasus says:

    By Craig Blackmon @ 27:

    RE: Kary L. Krismer @ 23 – The comment was addressing only the potential tax liability for debt extinguished via non-judicial foreclosure. I did not intend to imply anything beyond that.

    Those seconds and helocs that don’t get paid off in a foreclosure still have recourse although now unsecured and will pursue it eventually or sell the liability to a bill collector who will.

  30. 30
    Kary L. Krismer says:

    By Craig Blackmon @ 27:

    RE: Kary L. Krismer @ 23 – The comment was addressing only the potential tax liability for debt extinguished via non-judicial foreclosure. I did not intend to imply anything beyond that.

    Maybe I need to ask more directly, with an example.

    Fred buys a house in Washington with a note and deed of trust for $300,000. The bank non-judicially forecloses at a point in time where the property is only worth $220,000, and when Fred still owes $320,000 (accrued interest).

    If the note is expressly non-recourse (very rare on personal home debt), I don’t believe there would be any discharge of indebtedness income. But I don’t think the bank non-judicially foreclosing converts the status of the debt for IRS purposes. I think it’s still recourse debt, and that the non-judicial foreclosure would result in $100,000 of potential discharge of indebtedness income (subject to possible exclusions). Do you have authority otherwise?

  31. 31
    Kary L. Krismer says:

    By Pegasus @ 28:

    RE: Craig Blackmon @ 19 – A couple of points. You would have to be a moron to do a short sale without having at least the first mortgage holder agree to forgive otherwise what would be the purpose?

    To avoid a foreclosure. There are difference consequences to shorts sales and foreclosures. I’m not certain this is correct because the rules change at times and I don’t track them:

    http://massrealestatenews.com/buying-a-home-after-short-sale-or-foreclosure/

    Also, I believe the standard loan application asks have you ever had a property foreclosed or returned in a deed in lieu transaction. I don’t think they ask the same question about short sales (although they may start).

    Finally, it is possible that they are planning on doing a bankruptcy in any event to deal with other debt, and don’t care at all about whether the bank waives the debt.

  32. 32
    Pegasus says:

    RE: Kary L. Krismer @ 31 – What would be the point of wasting time doing a short sale if you are going to declare bankruptcy anyhow? Does not compute. Your credit will be hammered whether you do a short sale, foreclosure or bankruptcy. Foreclosure gets rid of the first mortgage liability if it goes non-judicial. It also gives you over a year maybe two now of living rent free. The IRS tax exemption depends on the usage of the debt.

  33. 33
    Pegasus says:

    RE: Kary L. Krismer @ 30 – In a non-judicial foreclosure up until recently the bank would place a bid at the auction that amounted to all the debt owed, fees etc. They would then normally win the auction since it is far more than the home is normally worth.The bank files that all obligations are satisfied with the county. The bank was the buyer and takes all the liability away from the defaulting home owner by purchasing at the price to satisfy all outstanding obligations for the first mortgage, unpaid taxes, late fees, attorney fees, inspection fees, etc. The former owner is now free of any of those obligations. HELOC’s and seconds are a different story unless there was enough equity to satisfy all of them. Big dream there. Now I think the banks are less inclined to bid full price at the auction but the non-judicial rule of no deficiency judgments still applies.

    I don’t think the IRS makes a distinction between recourse and non-recourse mortgages. Just that the mortgage must be secured by the principal residence and only the purchase money plus significant improvements amounts can be exempted

  34. 34
    David Losh says:

    To get more to the point about escrow is the example of if the lender refuses to fulfill the promise of a letter of deficiency.

    We had a listing of a property that was flooded. BECU had the first, and second on the property. Insurance paid a portion of the loss, the sale paid the first in full, and $600 of the second.

    BECU was thrilled with the offer, and terms. They promised a 6% commission, and a letter of deficiency. The day before closing the representative called to tell me that we got to keep the 6%, but BECU was retaining the right to pursue the deficiency.

    Well, what do you do? The seller had the means to pay, but with five kids, being behind six months on the mortgage, and given the fact the property had flooded once already within a year of purchase, the seller agreed to sign.

    In another sale Bank of America sent an addendum saying they did reserve the right to pursue a deficiency. What should the seller do? The buyer was threatening specific performance. The buyer’s agent was really aggressive. What does the seller do?

    Seriously the short sale process is a mine field. I know sellers who have good jobs, money in the bank,and yet a listing agent tells them to make up financial data to make it look like they have a hardship. Others give correct financial data, W2s, job history, and I can’t help but think the bank will just use that against them in the future.

    Is a short sale really something a Real Estate agent should be in charge of?

  35. 35
    Macro Investor says:

    The comments on this thread make the issues even muddier than before. Is there anyone who can actually express themselves in simple english sentences, and explain:

    When can a lender pursue recourse, and when can’t they? Bankers aren’t particularly smart, so this shouldn’t be so difficult.

  36. 36
    Pegasus says:

    RE: Macro Investor @ 35

    Wa. state non-judicial first mortgage foreclosure-normally no recourse

    Judicial foreclosure- can pursue deficiency judgement

    HELOC-can pursue judgement after foreclosure

    Second, third mortgages-can pursue judgement after foreclosure

    Of course there are exceptions

  37. 37
    Pegasus says:

    RE: David Losh @ 34 – I have heard several stories of the lender waiting until closing and pulling the deficiency stunt. Your input just adds to that. Must be a popular dirty trick. They are not pulling this stunt without someday pursuing the deficiency. Let them foreclose and enjoy the free rent as long as it lasts. You might save enough to pay off the deficiency of the second or be able to give them enough to forgive part of it.

  38. 38
    Kary L. Krismer says:

    By Pegasus @ 32:

    RE: Kary L. Krismer @ 31 – What would be the point of wasting time doing a short sale if you are going to declare bankruptcy anyhow? Does not compute. Your credit will be hammered whether you do a short sale, foreclosure or bankruptcy. Foreclosure gets rid of the first mortgage liability if it goes non-judicial. It also gives you over a year maybe two now of living rent free..

    Did you read the link? Short sales and foreclosures affect people differently going forward. You’re right they might give up some time of free rent, but that frequently happens with short sales too.

    But basically a foreclosure and bankruptcy can be seen as being worse than a short sale and bankruptcy.

  39. 39
    Kary L. Krismer says:

    By Pegasus @ 33:

    RE: Kary L. Krismer @ 30 – I don’t think the IRS makes a distinction between recourse and non-recourse mortgages. Just that the mortgage must be secured by the principal residence and only the purchase money plus significant improvements amounts can be exempted

    Recourse/non-recourse matters because of the possibility of discharge of debt issues. Absent the debt being recourse, there is no discharge of indebtedness.

    http://www.irs.gov/newsroom/article/0,,id=174034,00.html

    You can also read Publication 544 linked at the bottom of that link.

    What you are referencing in your last sentence pertains to exceptions to taxation if there would otherwise be liability for the foreclosure.

  40. 40
    Kary L. Krismer says:

    By Pegasus @ 33:

    RE: Kary L. Krismer @ 30 – In a non-judicial foreclosure up until recently the bank would place a bid at the auction that amounted to all the debt owed, fees etc

    The first might not necessarily bid in the entire amount they are owed. If they did, and it was clearly more than the amount the property was worth, I recall vaguely that the debtor can contest that if that would lead to more adverse tax consequences. For example, let’s say the debt is $2,000,000 because it includes a business loan, but the house is only worth $1,000,000, and the basis in the house is also $1,000,000. I don’t think the debtor is stuck with that being a sale for $2,000,000 with a gain of $1,000,000 (less perhaps the $500,000 exclusion). The balance couldn’t be excluded under the 2007 law for homeowners, because as you’ve pointed out that wouldn’t apply to the non-house related debt. But it’s possible the debtor would have an insolvency exception to the discharge of indebtedness claim, and could contest the sale price to get that exclusion. Again though, keep in mind that it’s been a long time since I’ve had to deal with these types of issues, and back when I did the issues were considerably different (typically debt over basis).

    I agree with you that the second is different.

  41. 41
    Kary L. Krismer says:

    By David Losh @ 34:

    Is a short sale really something a Real Estate agent should be in charge of?

    Many real estate offices require every seller considering a short sale to consult an attorney about whether to proceed, etc.

  42. 42
    Kary L. Krismer says:

    By Macro Investor @ 35:

    When can a lender pursue recourse, and when can’t they? Bankers aren’t particularly smart, so this shouldn’t be so difficult.

    That would depend on the state. In Washington the typical rule is that the foreclosing creditor using the non-judicial procedure cannot pursue a deficiency. There are some exceptions to that, but I don’t think they’re that likely to apply to the typical homeowner.

    In the context of a short sale, the bank would typically need to waive any claim to the balance owed, and if they don’t, they can collect. Signing a note or new agreement is not necessary because the old note is probably still valid. There may be exceptions to that too.

    The exceptions are the reason why people in these sorts of issues should see an attorney! Just as an example of an exception, if second mortgage debt was signed by the husband prior to marriage, and the couple has been married close to three years, they may have less to worry about as far as collection is concerned. The tax ramifications could still be adverse. Again, the reason to see an attorney so that they can assess your specific situation.

  43. 43
    Kary L. Krismer says:

    By Pegasus @ 36:

    RE: Macro Investor @ 35 -Second, third mortgages-can pursue judgement after foreclosureOf course there are exceptions

    Most likely not if they are the ones non-judicially foreclosing (subject to the unlikely exceptions I just referred to). That doesn’t happen much today. It used to be common.

  44. 44
    Scott Weitz says:

    RE: Ryan @ 22

    I hate to promote myself on this blog, but I’d be happy to discuss the basics with you free of charge. (Make sure to remind me you found me on this blog).

    We do a ton of foreclosures, short sales, and BKs. You are exactly right, many attorneys are knowledgable in one area, but have no clue in the other arena.

  45. 45
    Scott Weitz says:

    RE: Macro Investor @ 35

    RCW 61.24.100(1) – (Washington Law)

    In plain language: FORECLOSING PARTY (typically first mortgage) cannot collect on a deficiency. All other junior liens can pursue the deficiency.

  46. 46
    Scott Weitz says:

    RE: Pegasus @ 33

    This is a tough issue for most to comprehend:

    Tax consequences of Foreclosure:

    1) Non-recourse loan – generally no COD/ 1099 income unless your ‘basis’ in the property is below the value of the property at the time of foreclosure (very rare).

    2) 2nd – either would fall under the exceptions for short sale below or debt would not be waived

    Short Sale – implicit 1099 if debt is waived – BUT 3 big exceptions

    1) Mortgage debt forgivness act – primary residence loan made to purchase or improve the property – more to this, so please review with Accountant (this is good through 2012, but I expect it to be extended)

    2) insolvency

    3) BK

  47. 47
    ray pepper says:

    I continue to see more and more of this each and every week here in Nevada and California. Soon to be in Washington as well. Homeowners making “arrangements” with 3rd party investors and buying their homes back for 1/3 of what they owed post Trustee sale.Don’t believe it? Its happening every week… everywhere. The homeowner doesn’t pay for 2-3 years. Saves up a tremendous amount of money and then buys their home back…

    Watch last 60 seconds: http://www.youtube.com/watch?v=qNOP59eXVmk&feature=related

  48. 48
    Pegasus says:

    By Kary L. Krismer @ 43:

    By Pegasus @ 36:

    RE: Macro Investor @ 35 -Second, third mortgages-can pursue judgement after foreclosureOf course there are exceptions

    Most likely not if they are the ones non-judicially foreclosing (subject to the unlikely exceptions I just referred to). That doesn’t happen much today. It used to be common.

    The reason it is not happening anymore is that the home is now likely to not be worth as much as the first mortgage. They would be cutting their own throat if they were still receiving payments from the home owner. If they were not receiving payments they would still incur the cost of the foreclosure and get nothing for their costs and troubles.

  49. 49
    Kary L. Krismer says:

    By Scott Weitz @ 45:

    RE: Macro Investor @ 35

    RCW 61.24.100(1) – (Washington Law)

    In plain language: FORECLOSING PARTY (typically first mortgage) cannot collect on a deficiency. All other junior liens can pursue the deficiency.

    I always thought the language was plain too, but then it required a state supreme court ruling a couple of years ago. There was a prior decision involving an IRS lien, or some such thing, that someone tried to stretch into a different result for junior deed of trust holders. Under their theory of the world, what a senior interest did would impact their ability to collect. There was more than one professional who posts here that subscribed to that theory.

    The decision is Beal vs. Sarich, 160 Wn.2nd 544 (2007). The debtor actually won at the superior court level, which I find a bit shocking.

  50. 50
    David Losh says:

    RE: Macro Investor @ 35

    The comments here are very, very murky, and misleading. It’s interesting that the attorneys are throwing around the phrase this is not legal advice while trying to explain a one size fits all set of rules. There are no rules.

    The conclusion that I came to three years ago is that banks are enjoying this cross talk about short sales. When Bank of America introduced the intent to pursue deficiency addendum, back then, I don’t know that they still do it, it was the end of the games.

    Prior to that all kinds of paper work including the 1099s could show up at escrow. Banks are the injured party and play that to the hilt. In my opinion there is a lot out there that has yet to be resolved so all of the banter about recourse, or non recourse, or tax consequence of forgiveness, is pure speculation.

    Your situation is unique. Before you consider short sale, bankruptcy, or foreclosure, you need to talk with an attorney, if one will talk with you, and an accountant.

    Real Estate is a business. It should be treated like that. That is why there are free legal counseling groups all over the country. You bought a house. If you want to walk away you need to cover your future liability with at least a show of good faith.

  51. 51
    Kary L. Krismer says:

    By David Losh @ 50:

    The comments here are very, very murky, and misleading. It’s interesting that the attorneys are throwing around the phrase this is not legal advice while trying to explain a one size fits all set of rules. There are no rules.

    Don’t assume there are no rules just because you don’t fully understand them. In the law small factual distinctions can lead to different results. I gave an example yesterday of the date of a hypothetical couple’s marriage. Also, I as just noted, in that Beal case the Superior Court made a rather absurd decision, so you also have that factor which affects things.

    When Bank of America introduced the intent to pursue deficiency addendum, back then, I don’t know that they still do it, it was the end of the games.

    You generally would need to have an express waiver of the debt, or at least you should have such an express waiver. Simply saying nothing as part of the short sale process wouldn’t likely make the debt go away. So the result would likely be the same with or without that addendum you refer to, unless there was other language that could be implied to be a waiver or some fact pattern that would lead to an equitable remedy against the bank.

  52. 52
    David Losh says:

    RE: Kary L. Krismer @ 41

    You know that is as bogus a claim as the conflict of interest it represents. Many of these new law firm, “we can do escrow,” groups have sprung up all over the city.

    Real Estate agents steer clients, as do attorney’s, as did Tim in his radio interview into short sales. It just sounds good.

    What I think is that in the next five years law firms will be investigationg how much “legal” advice a buyer, or seller of a short sale actually got.

    Let’s say your client bought a short sale three years ago because it was a “screaming” deal? How would that play out today? How much a deal was that? Didn’t the bank do pretty darn good on that transaction?

    I don’t know what the answer is, but I do know this Real Estate market has been dead since the government intervened. We won’t know anything until after June of this year, after this selling season.

  53. 53
    Kary L. Krismer says:

    RE: David Losh @ 52 – You’re right there is a potential for abuse there, and beyond that there are a lot of attorneys that are not very good. So referring short sellers to an attorney isn’t a cure-all. Ideally the attorney giving the advice would not have any connection to the short sale negotiator, but firms that do that type of work also would be more likely to have current information as to the prospects.

    BTW, I don’t get your short sale buyer scenario. Buyers at short sales don’t go to attorneys to get advice about where the market is headed three years down the road.

  54. 54
    David Losh says:

    RE: Kary L. Krismer @ 51

    Well I do understand. I understand there are no rules by the very examples you just gave.

    The Superior Court makes decisions, your opinion of those decisions isn’t pertinent. The decision was made. As I always say you never know what will happen when you go to court.

    As to the Bank of American statements, those are masking the fact Bank of America declared an intent. Case by case in escrow you would have to look at all documents to see if that intent had always been there, or is there in other closing documents.

    Bank of America simply made a declaration. I think Real Estate agents should pay attention to that.

  55. 55
    Pegasus says:

    RE: Kary L. Krismer @ 38 – Yes I did read the linked material and I still find nothing logical for wasting one’s time doing a short sale without having the deficiency waived versus a foreclosure(non-judicial) that normally eliminates the liability. The hit on the credit report is about the same for short sales, foreclosure, bankruptcy, deed in-lieu of foreclosure.

  56. 56
    Kary L. Krismer says:

    RE: Pegasus @ 55 – The link doesn’t mention credit reports, but instead shows differences in getting financing down the road between the two.

    In any case though, I don’ think you base decisions like this primarily, or even significantly, on what the hit to the credit score might be. And again I’d note that many of these people will probably need a bankruptcy in any event, further impacting the credit score, and making the distinction between the effect of a foreclosure vs. short sale even less important.

  57. 57
    Pegasus says:

    By Kary L. Krismer @ 56:

    RE: Pegasus @ 55 – The link doesn’t mention credit reports, but instead shows differences in getting financing down the road between the two.

    In any case though, I don’ think you base decisions like this primarily, or even significantly, on what the hit to the credit score might be. And again I’d note that many of these people will probably need a bankruptcy in any event, further impacting the credit score, and making the distinction between the effect of a foreclosure vs. short sale even less important.

    I mentioned the credit reports because that is often an excuse given as to why you should do a deed in-lieu of foreclosure or a short sale instead of foreclosure or bankruptcy. It is a fallacy. The damage is about the same for all. Reality is a short sale without debt forgiveness or a deed in-lieu benefit the banks more the the other two options and is perhaps the reason the myth exists.

  58. 58
    David Losh says:

    RE: Pegasus @ 57

    That is an excellent point.

    I did a lot of short sales in the 1980s. As a patient advocate for the terminally ill there were many times the family home was used to secure debt for medical treatment. It was easier because there were compelling medical reasons to allow the short. You have to have a compelling reason to sell a property short.

    What I see today is Real Estate agents encouraging home sellers to use the short sale as a strategic default. They are fishing for commissions as both buyer, and seller agents. The short sale, in my opinion, is what has kept Real Estate agents in business these past few years.

    People should be very careful about how they proceed.

  59. 59
    Kary L. Krismer says:

    RE: Pegasus @ 57 – I’ve not heard that there is a significant difference. This link (the first on Google I found), gives conflicting information, but overall doesn’t indicate a difference.

    http://homebuying.about.com/od/4closureshortsales/qt/060907SScredit.htm

    The thing I don’t like about credit scores is they focus on the wrong thing. The focus should be on what you want to do in the future. Just as an example, Bank of America would not issue an Alaska Airlines rewards credit card until you were 10 years out of a bankruptcy. Their decision wasn’t credit score based (although you could have also been turned down due to the credit score). You really need to decide based on what you want to do in the future. Some people might decide to totally forgo credit in the future, and thus their credit score would be irrelevant to them.

  60. 60
    Ryan says:

    By Scott Weitz @ 44:

    RE: Ryan @ 22

    I hate to promote myself on this blog, but I’d be happy to discuss the basics with you free of charge. (Make sure to remind me you found me on this blog).

    We do a ton of foreclosures, short sales, and BKs. You are exactly right, many attorneys are knowledgable in one area, but have no clue in the other arena.

    Thanks Scott…I will follow up offline in the next few weeks. Cheers.

  61. 61
    Macro Investor says:

    By Pegasus @ 36:

    RE: Macro Investor @ 35 -Wa. state non-judicial first mortgage foreclosure-normally no recourseJudicial foreclosure- can pursue deficiency judgementHELOC-can pursue judgement after foreclosureSecond, third mortgages-can pursue judgement after foreclosureOf course there are exceptions

    Thanks to all who joined the discussion.

    So why would a lender ever foreclose non-judicially if the alternative gives them the right to sue for more later? Especially nowadays with everybody talking about walking away and stiffing their banker.

  62. 62
    Pegasus says:

    Court cases especially if contested are much more expensive and is it worthwhile to spend the money on someone that will file bankruptcy or is already insolvent? Also if they can’t produce the docs to prove they have standing without forging them they will take their chances in the non-judicial system where they are not perpetrating a fraud upon the court. I imagine on a high priced home with a large mortgage where the occupants are doing a strategic default and the bank knows they are not broke they might go the judicial way.

  63. 63
    Scott Weitz says:

    RE: Kary L. Krismer @ 49

    Not sure what your point is. Beal had a bizzare fact pattern (subordination agreements in place, etc) Sure, there are some odd ball cases out there, but they don’t apply to a vast majority of folks.

  64. 64
    Kary L. Krismer says:

    By Macro Investor @ 61:

    So why would a lender ever foreclose non-judicially if the alternative gives them the right to sue for more later? Especially nowadays with everybody talking about walking away and stiffing their banker.

    First, they typically can get the property faster by non-judicial means. That’s one thing the legislature has to watch out for with these mediation provisions they are adding to the process. At some point it’s going to get banks to go judicial. That would be sort of like years ago when the prior morons on the Seattle City Council made it illegal to retain a security deposit if you stayed less than a year, so landlords went to one year leases. At the time they prevented the loss of maybe a $500 deposit and substituted that with a $5,000 liability on a lease. Brilliant!

    Second, most people are not worth squat and will file bankruptcy if pursued. I would guess that it’s typically only large loans over $500,000 that they even consider the option of going judicially.

  65. 65
    Kary L. Krismer says:

    By Scott Weitz @ 63:

    RE: Kary L. Krismer @ 49

    Not sure what your point is. Beal had a bizzare fact pattern (subordination agreements in place, etc) Sure, there are some odd ball cases out there, but they don’t apply to a vast majority of folks.

    My point is that prior to Beal, some people believed that non-judicial foreclosure of the first prevented the second from pursuing the debtor. I agree with you that the result should have been clear based on the statutory language, but the earlier WAMU vs. US case had some bad language in it, and should have been overruled by Beal. What’s odd is I don’t recall anyone ever raising WAMU v. US in a bankruptcy case, even though it had been around quite some time.

  66. 66
    Novice says:

    There are a couple of questions I have on this topic, being a novice I hope they don’t make me sound too ignorant:
    With all the short sales and foreclosures over the last couple of years, how come I have not heard of any actual cases of borrowers being sued for the deficiency? I am sure many of those properties had recourse seconds.
    If a property goes through foreclosure or short sale and has a recourse second, doesn’t the issuance of a 1099 for debt forgiven relieve the borrower of any further obligation? I don’t see how the lender could take the debt forgiven write off and continue to pursue the debt.

  67. 67
    The Good Egg says:

    I have followed with tremendous interest all of the responses to this posting and I would like to offer the following comments.

    Mostly I would suggest that many of these responses simply cannot be addressed without the specificity of a particular homeowner’s situation. Deficiency issues, tax consideration of debt forgiveness, short sale versus foreclosure cannot be answered without analyzing all of the dynamics of a particular set of circumstances. I have yet to see identical circumstances for any two clients.

    For example, the “simple” (oxymoron) issue of whether to go through the effort of a short sale versus simply allowing the home to be foreclosed upon can be summarized in part with the following chart.

    Beyond these issues though are a number of additional dynamics that frequently come into play, the biggest one being the value of the property relative to ALL of the mortgage indebtedness. If there is any hope of returning a material amount of money to the 2nd mortgage in a short sale then “generally” speaking it would be foolish to let that particular property go to foreclosure.

    This is explained best in the context that a short sale has the opportunity to become a “negotiated” transaction — meaning that with proper presentation we can frequently convince a 2nd lender to forgive the deficiency for some amount of money in a short sale as opposed to their becoming completely wiped out in a foreclosure. This is a win-win-win for everyone as the homeowner avoids a foreclosure on their record; the 2nd lender gets more money than they probably would if they are forced to chase after the full amount of their note after foreclosure AND the homeowner walks away not owing anything further. Note: The potential tax ramifications of this comment are beyond the scope of this response.

    Any of the issues surrounding the original title of this post are solved BEFORE the transaction actually closes and there is plenty of time to have these approval letters reviewed by the homeowner’s attorney if there is any doubt as to the clarity of the forgiveness of debt. These stories of homeowner’s being confronted with these issues at the 11th hour at signing are just not realistic as these documents have been produced usually at least 30 days prior to closing.

    Based on the experience of my firm, having negotiated literally hundreds of short sales, I can emphatically state that the better organized ALL of the parties to the transaction are BEFORE the home is even listed for sale the more likely a positive outcome can be delivered to the outgoing homeowner. Sometimes that can involve also seeking legal advice but more than that it is simply analyzing all of the components in such a way that there are no hidden “gotcha’s” which are easy to come upon in this environment.

    Another issue that has been discussed in part is the issue of needing to have a “hardship” in order to qualify for a short sale with the notion of a “strategic default” somehow being a morally improper thing to consider. I STRONGLY DISAGREE with this notion! Rather than attempting to articulate my position on this topic, I would suggest that anyone who has issue with this check out the following website: http://www.BrentWhite.com

    Brent White is an Associate Professor of Law at the University of Arizona and leading expert on the mortgage crisis. His academic work has been widely-covered in the national media, including 60 Minutes, the Wall Street Journal, and the New York Times. We recommend this book to all of our clients as it is quite simply the best written book about “Underwater Homes” I have seen to date.

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