Short Sales: A Viable Option to Foreclosure?

Short Sales were especially prevalent in California in the 80’s and early 90’s when the real estate market declined.  Although not as common here in Washington, most Short Sales occurred in the early 80’s.

A Short Sale can occur when a piece of real property has declined in value and the amount owed the bank/lender exceeds the value of the property. Instead of forcing a foreclosure, the bank may cooperate and agree to release its security interest in the property for less than what it is owed on the mortgage.  The lender will do so only to accommodate a sale of the property to a third-party buyer.  As most lenders are in the business of making money, they would rather not own real estate (which is expensive to own and maintain).  Many lenders realize that some money soon is better than less money later, as foreclosure auctions often bring below market prices.

A buyer in a Short Sale situation is subject to the terms and conditions set forth by any lender, as well as the seller.  Once buyer and seller come to mutual agreement, the bank or lender has the right to review the terms and conditions and modify them to meet certain guidelines depending upon the type of loan.  A potential buyer should discuss these specific guidelines with the lender.

The bank then has an appraisal done on the property to determine its value.  If the appraisal is below the loan balance, they may be forced to sell at the appraised value, which usually means taking a loss.  The bank may be willing to reduce the amount it is owned from the Seller to current market value less costs (which may or may not be higher than the appraised value).  Usually a bank will not accept a sales price less than current market value.  The bank usually requires a financial statement from the seller to determine if the seller is in serious financial hardship.  The bank reviews all these factors and then prepares a letter detailing what terms it will accept for the sale.  These terms may or may not be the same as those negotiated between buyer and seller.

The bank must also assess the condition of the property.  The bank can try and fix up the property if repairs are needed, or try and sell it “as is”.  The bank usually will also agree to pay a real estate commission (3-6%), excise tax, attorney fees, and any other fees related to the sale of the property.  Be advised the lender may try to negotiate reduction in these costs to reduce its losses.  Single-family residences must be in market condition.  This means repairing roofs, septic systems, electrical, etc., if necessary.  These fees will further compound the bank’s loss if the bank cannot get back all the fees it has paid.

A Short Sale can result in both capital gain or loss and relief of debt income.  When property is sold in a Short Sale, the property owner is liable for payment of income tax on the sale.  Prior to entering into a Short Sale or a Foreclosure action, a property owner should consult a CPA or tax adviser to assess the tax consequences, which may vary depending on the nature of the loan.  Many people are often shocked to find that they can owe tax in a Foreclosure or Short Sale situation.

Banks do not like to have losses from a Short Sale on their financial statements.  As an alternative, a bank may sell the Note, perhaps at a discount, to another lender or investor who takes their position and continues the foreclosure process.  This way, the bank does not have to fix up the property or pay any of the related fees.  The person buying the Note usually wants to own the property because there is still equity in it.  They may or may not sell the property at a later time, in an attempt to get their money back.

Each property sale is unique and banks deal with each potential Short Sale on a case-by-case basis.  If you or your clients are considering a Short Sale, it is a good idea to contact your tax advisor, your lender, and an attorney prior to entering into any agreements.

Published November, 2000

This article contains information of general interest, and is not intended to be, nor should it be relied upon as a substitute for specific legal advice.