Short-Sale, Foreclosure and Anti-Deficiency Information

I frequently receive inquiries from homeowners with underwater properties who want to know about their options. A short sale, deed-in-lieu or foreclosure are the 3 most common options for disposing of an underwater property. Each option is a unique process with its own set of challenges. Below is some general information about each, along with some other answers to common questions.

Short Sale

A short sale is a sale of real estate in which the proceeds from the sale amount to less than the total amount owed on the property. Although a short sale is like any other sale of real property (i.e., between a buyer and seller), because the lender is in effect “writing off” a portion of the loan on the property, approval of the sale by the lender is required. A short sale can be a superior option compared to a foreclosure for both the lender and borrower. The lender can avoid fees and expenses associated with a foreclosure, and may also be able to sell the house more quickly. Although the borrower’s credit report will reflect a short sale, it will not have as negative of an impact as a foreclosure. Borrowers who short sell their property might even be able to purchase another home more quickly than if they had gone through a foreclosure, typically about 2-3 years after the short sale.

Deed-in-Lieu

A deed-in-lieu is another alternative that a borrower can take in order to avoid foreclosure. This alternative deeds the property back to the lender, in exchange for a release of all commitments as stated in the mortgage contract. This option can save time and money compared to a foreclosure. There could also be the possibility of the borrower leasing the property back from the lender and remaining in the home.

Foreclosure

If a borrower is unable to short sell a property, or deed the property back to the lender, a foreclosure is typically the final option. Depending on the terms of the mortgage and/or deed of trust on the property, the lender can take control of the property and sell the property. The deficiency of the mortgage payments by the borrower will be reflected in the borrower’s credit report. A borrower desiring to purchase another home after going through a foreclosure must typically wait anywhere from 5-7 years after the foreclosure.

Effects on Borrowers

Although a short sale will be reflected on a borrower’s credit report, a foreclosure will be the most detrimental to the borrower’s credit rating. A short sale or deed-in-lieu with no delinquent mortgage payments will have the least negative impact on a borrower’s credit score. Short sales or deeds-in-lieu following a series of delinquent payments will be more harmful, and a foreclosure will have the most negative impact on a borrower’s credit report. A single late payment of 30-days could drop a credit score by 40-110 points, a 90-day delinquency may reduce a credit score by 70-135 points, and a foreclosure, short sale, or deed-in-lieu might decrease a credit score by 85–160 points. It is important for borrowers who are delinquent on their mortgage to keep current on all other obligations that are reflected in their credit report.

Credit reports can affect a borrower’s life in a few different situations. Employers often run credit checks on prospective employees, and could see a foreclosure and other negative events on a credit report. Landlords can also use the report to compare prospective renters.

Steps for Borrowers

The first step borrowers should take if they think they are going to be delinquent or are already delinquent on their mortgage is to contact their lender to see if a modification can be achieved. If a modification cannot be achieved, the next best option is to consult the lender about a short sale. For a short sale, borrowers will probably be required to provide the lender with a letter of hardship. This letter will demonstrate to the lender why the borrower should proceed with a short sale. Relevant material to include in the letter can consist of a detailed account of the borrower’s financial difficulties, which can be illustrated by bank statements and pay stubs from employers.

Often lenders will consider borrowers for a short sale if the borrower has a decreased income from when the mortgage contract was established, a lack of resources in a savings account, evidence that the borrower will have difficulty making future payments, the fair market value of the real estate property has declined, and the mortgage payment is at least one month delinquent.

It is not recommended that borrower’s purposely delay or avoid mortgae payments in order to convince the lender that a hardship exists, or that a modification is necessary.

Anti-Deficiency Laws

Aside from concerns about damage to credit ratings, the most common concern facing borrowers with an underwater property is “Will the lender sue me to collect the shortfall on the loan amount?” The answer to that question can be complex and nuanced, and takes into account certain factors about the property and the type of loan.

Deed of Trust

If the debt is structured as a deed of trust, the statute that allows for a deficiency judgment is A.R.S. §33-814. According to A.R.S. §33-814, a deficiency can be received if the property is more than 2.5 acres of land and is not used for a single one-family or two-family home. However, the lender/beneficiary must file for the deficiency judgment within 90-days after the sale of the real estate property. If there is more than one trustee’s sale, the date of the last sale will be the date that begins the 90-day time period. The 90-day time period is crucial and must be complied with or the proceeds from the sale will be considered as full satisfaction of the borrower’s obligation to the lender/beneficiary. No exception will be considered if the 90-days has lapsed. As authorized in A.R.S. §33-814, the amount of a deficiency judgment shall be for the total amount owed to the beneficiary as of the date of the sale, less the fair market value of the property on the date of the sale or the sale price at the trustee’s sale, whichever is greater.

Mortgage

If the debt is structured as a mortgage, the statute that allows for a deficiency judgment is A.R.S. §33-727. Analogous to a deed of trust, a deficiency judgment can be received if the property is more than 2.5 acres of land and is not used for a single one-family or two-family home. However, A.R.S. §33-727 does not mandate a 90-day filing period against the mortgagor. But if the debt is structured as a mortgage, a deficiency judgment is not allowed if the mortgage was purchase money. Purchase money is when a mortgage is given to secure part or all of the price of the property.

It is important to take into account all of the different kinds of debt secured by the property. Borrowers often times have first and second mortgages on their property, and may also have home equity lines of credit. While a lender who has given a borrower a first-lien purchase money loan may not be able to pursue the borrower for a deficiency, the same may not be true of a second-lien lender or a home equity credit line lender.

Tax Considerations

Another important consideration for borrowers contemplating a short sale, deed-in-lie or foreclosure is whether the borrower will have income from the cancellation of debt. Cancellation of debt income is the amount by which the canceled debt exceeds the fair market value of the property securing the debt. Cancelation of debt can occur when a lender forgives part (or all) of a debt for which the borrower was personally liable. The Mortgage Debt Forgiveness Act of 2007 was enacted to provide relief to borrowers facing cancellation of debt income as a result of a short sale, deed-in-lieu or foreclosure of certain types of property. A person seriously considering a short sale, foreclosure, or deed-in-lieu should discuss the potential tax consequences of a specific transaction with a tax attorney and/or accountant.