Short Selling a House: Last Resort for An Underwater Mortgage Holder

With the deterioration of the housing market, there's been an increased interest in ‘short selling' homes. I didn't know much about short selling, so I did a little research. I should say up front that I don't have any personal experience in this topic (thank goodness); here's what I learned, though.

What is a short sale?

I covered the definition of a short sale in a previous post, but this is a refresher. A short sale is the sale of a house that has a mortgage greater than the current market value of that property. The bank agrees to forgive the outstanding mortgage balance after the sale completes. Short sales aren't a given ‐ the borrower must negotiate with the lender the accept the short sale.

Why would the bank agree to a short sale?

A short sale is isn't so much a win/win as it is a lose less/lose less for both parties. The borrowers don't have a place to live anymore. The lender's don't get paid back all they're owed. On the other hand, the property doesn't go to foreclosure, which is good for both of them.

In a foreclosure situation, especially in a down market, the lender can expect to recover less than if the property is sold short. Maybe they'd recover 75% 50% in an auction, but 85% in a short sale. It's obviously not ideal for the lender, but at least they don't have to sell the property.

The drawbacks for a borrower

As you would expect, there are several drawbacks to short selling for the borrower. Perhaps the biggest one is that they no longer have a place to live and any money they did put into the house is gone. Also, a short sale is going to show up on their credit report. It's hard to say exactly what the effect will be on credit score, but anecdotally it's somewhere in the neighborhood of a 80-100 point drop. That's nowhere near the penalty for a foreclosure, but still significant.

There's also another pitfall – taxes. The IRS treats the forgiven mortgage amount as income, so you're going to pay taxes on that amount. When you're talking about mortgage-size amounts of money, this could be very significant.

Other things to note about short sales

There are several other points about short sales to note. First, a lender might balk at paying the commission for a broker, which could complicate things.

Second, it takes some work to convince the lender to accept a short sale. You'll have to be several months behind on payments and most likely have to show evidence of significant hardship that caused you to get so behind. Your mortgage resetting to a too-high-for-your-budget payment isn't good enough. If you've lost your job, divorced, or have medical bills, you're in a better negotiating position. Well… regarding the short sale, that is.