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Brad comments today: short sales vs. foreclosures.

Some people use the terms “short sale” and “foreclosure” in the same breath. But really, they have little in common.

True, in both cases, the homeowner will not be able to keep the house for very long. But the similarities stop there.

One illustrative way to think about the differences would be this: Think of your car, running out of gas (means, you are unable or unwilling to make your mortgage payments). If you are able to safely steer your car over to the side of the road, that’s a short sale. If you crash, that’s a foreclosure.

Let’s talk about the difference in how your credit score can be affected. If you are already experiencing charge-offs, repossessions, collections, etc, the difference might not be significant. But assuming that your credit is not already trashed, then a short sale typically reduces your FICO score by approximately 100 points, while a foreclosure cuts it by about 250 points (on average).

Taxes? When your home goes to foreclosure, the lender might choose to issue a 1099 form, which means that the lender has written off the debt, and it is now taxable income to you. You might be liable for the income taxes due on the entire amount of the write-off. In a short sale, the lender may also choose to issue a 1099 for the balance between the short sale payoff proceeds and the outstanding mortgage balance. But if the home was your primary residence, then an IRS form 982 should waive tax liability on the deficiency.

Another difference: the amount of time that a lender can legally pursue a former homeowner for any unpaid balance. If the home was foreclosed, then the time period is six months for the first lien holder, six years for the second lien holder. But if the home was sold short, then it is six years.

That’s why, when choosing a real estate professional to list and handle your short sale, it is imperative that they do everything in their power to negotiate “full satisfaction” as part of the short sale approval. This is becoming increasingly difficult, by my observation. But it can still happen. Another way to ensure that a lender will not pursue a short seller is to negotiate some sort of financial contribution to the short sale. This could include a small amount of cash at close of escrow, but more commonly, a small promissory note. Sometimes, we can successfully negotiate a promissory note for a tiny fraction of the mortgage balance, with zero percent interest, no money up front, and small payments spread out over several years (typically up to six). If a lender agrees to accept a note of this sort, then a combination of the short sale proceeds along with that note constitute settlement in full, and no further pursuit of the former homeowner would occur.

Another benefit of doing a short sale is that the homeowner can have some control as to when he moves out. It is typical that during the time a short sale is being processed and negotiated, the lender will halt any foreclosure proceedings, or at least suspend them pending the result of the negotiations. Short sale negotiations might continue for several months, while the lender requests and reviews numerous pertinent documents, orders a BPO (broker price opinion) and/or an appraisal, processes the short sale package, and negotiates the approval. Once the approval is granted and accepted, close of escrow normally occurs in 30-45 days. And during this whole time, the homeowner can stay in the house without making any mortgage payments, largely uninterrupted, and with peace of mind.

A factor with varying degrees of importance is also embarrassment. With a short sale, it looks to most neighbors and friends as if you are simply selling your house. But if you allow your house to go through pre-foreclosure, and ultimately, foreclosure, the process could involve visits to your home by representatives of the lender, notices taped to your door, and possibly, even an indiscrete eviction process.

Another consideration when deciding between a short sale and foreclosure is the fact that in two to three years, if you sold your property with a short payoff, you might be able to obtain another mortgage. If you have a foreclosure on your record, it will remain there for at least seven years, and very few lenders will consider your mortgage application with a foreclosure on your credit report, for all intents and purposes preventing you from buying another property with a mortgage for at least five to seven years.

Completing a foreclosure is very expensive for the lender, which could result in the lender pursing the former homeowner not only for the unpaid debt, but significant legal costs and fees, as well.

All things considered, foreclosure is really the worst option of all when a homeowner is not making his mortgage payments, and it should be avoided. Some folks complain that the paperwork and complications of a short sale seem overwhelming. But considering how long they will suffer after a foreclosure, the short sale is clearly the better option: a controlled stop vs. a crash.

Regardless of which option you may choose, I highly recommend that all concerned parties check with an attorney and/or a tax professional, to see how their personal situation may be affected by their decision.

TR Realty has a notably high percentage of success conducting short sales on behalf of our clients, and we welcome inquires in this regard.

Date posted: December 17, 2010