Risks of Using a Short Sale to Avoid Foreclosure

The short sale process involves risks for both buyer and seller. Learn about them.

In a "short sale," a homeowner who's behind in loan payments sells their home for an amount that's less than their outstanding mortgage debt. While a short sale is one way to avoid a foreclosure, these sales have certain disadvantages and risks—legal, financial, and even emotional ones—for both the seller and the buyer.

Downsides of Using a Short Sale to Avoid a Foreclosure (Sellers)

While completing a short sale can be a good option for homeowners who want to avoid a foreclosure, short sales come with the following potential disadvantages and risks.

You Might Face a Deficiency Judgment

In a short sale, the sale price is short of the amount you owe on the mortgage. The difference between the sale price and the total debt is called the "deficiency." Because the sale price doesn't fully satisfy the debt, the lender might be able to sue you (the homeowner who's selling the property) to recover the deficiency after the short sale.

Whether the lender will file a suit to get a deficiency judgment largely depends on the terms of the short sale agreement and, in some cases, on state law. If the short sale agreement states that the transaction is in satisfaction of the debt, or if state law, as is the case in California, prohibits deficiency judgments after a short sale, then the lender can't get a deficiency judgment.

While many states have anti-deficiency laws pertaining to foreclosures, not many states have a law prohibiting deficiency judgments after short sales.

Short Sale Tax Implications

After a short sale, the lender might decide to forgive the deficiency amount and issue a 1099-C (Cancellation of Debt) form to you.

Generally, a forgiven deficiency amount is considered taxable income, subject to some exceptions, like if you can prove that you were insolvent when the debt was forgiven or if the debt was nonrecourse. (A "nonrecourse debt" is a loan that the borrower isn't personally liable to repay the debt.)

You'll Hurt Your Credit Scores

A short sale will have a significant impact on your credit scores. How much of a negative impact? No one knows for sure.

Some say short sales have less of a negative effect on credit scores when compared to foreclosures, but this claim isn't necessarily true. Short sales, as well as deeds in lieu foreclosure, are pretty similar to foreclosures when it comes to damaging your credit scores.

Finding a New Home

Unlike other loss mitigation options, like a loan modification, with a short sale, the seller has to give up possession of the property. This sacrifice can take an emotional toll on the seller's family.

Also, you'll have to leave the home as soon as the sale closes, which might be much sooner than you'd have to move out if you stayed put during a foreclosure. Depending on the state where you live and the process the lender uses (judicial or nonjudicial), the foreclosure might happen fairly quickly, taking just a few weeks or months, or it might take several months or years.

Foreclosure Might Be a Better Option

Not only might you get some extra time to live in the home if you simply let the foreclosure happen, but you could possibly also avoid being held liable for a deficiency judgment. Often, state law prevents a bank from getting a deficiency judgment after a foreclosure, but not a short sale.

If the bank can't get a deficiency judgment against you after a foreclosure, but it can after a short sale, you might be better off going through a foreclosure rather than completing a short sale that leaves you on the hook for a deficiency.

For specific advice about what to do in your particular situation, talk to a local foreclosure lawyer

Downsides of Buying a Short Sale Home

Short sales also have drawbacks for buyers looking to purchase a home.

Slow Process

Short sales can potentially take a significant amount of time to negotiate. A short sale buyer must be willing to wait to find out if the lender will accept the offer.

Moreover, lenders often rejects the first offer, especially if the offer is lower than the short sale listing price. Having to negotiate multiple counteroffers can draw out the process.

Lowball Listing Prices

The seller's real estate agent, rather than the lender, might have set the listing price. So, even if the buyer offers the asking price, the lender could come back with a higher, perhaps much higher, counteroffer.

Real estate agents sometimes intentionally set a low listing price to attract offers. When this happens, the lender isn't likely to accept the first offer. Instead, it will most likely come back with a notably higher counteroffer.

Moreover, a house that has a below-market asking price often attracts multiple offers from different buyers, which can lead to a bidding war between potential buyers.

Property Condition

Short sale properties are usually sold as is, which means that the seller and lender won't make any repairs to the home, even if an inspection indicates major problems. And the general condition of the property might be poor as sellers might not be especially motivated or financially able to provide upkeep before selling.

Why Choose a Short Sale?

With all these downsides, why would anyone want to do a short sale? If both buyer and seller are able to be patient through the process and negotiate as favorable terms as possible, then a short sale can work out in the best interests of all parties.

In the best-case scenario, the buyer gets a great home for a very reasonable price and the seller is released from making unaffordable mortgage payments, prevents a foreclosure, and hopefully avoids a deficiency judgment as well.

Talk to a Lawyer

To get help working out a short sale with your lender or if you have questions about buying a home in a short sale, consider talking to a lawyer. If you're facing a foreclosure, a lawyer can represent you in negotiating a short sale with the lender, as well as provide advice about other ways to avoid foreclosure.

Even if you decide not to hire an attorney to represent you throughout the short sale, you might want to consider scheduling a consultation with a qualified attorney who can answer any legal questions that you have about the transaction.

A HUD-approved housing counselor is also a good resource if you want to learn about different ways to avoid a foreclosure.

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