Struggling Homeowners' New Exit Strategy: Short Sales

Homeowners looking to avoid the stain that a foreclosure can put on their credit report are increasingly turning to short sales.

Under a short sale, a lender is agreeing to accept less than the balance owed on its mortgage. While a short sale will still negatively impact your credit, experts say it can be a better alternative than a foreclosure because you can minimize the hit to your credit, have a greater control over the process and the price you get for your home and maintain a good standing with your neighbors.

With foreclosures sitting near record highs and predictions they are only going to get worse this year, lenders are more willing to negotiate shot sales.

“In a short sale, the borrower is going to stay in the house until it gets sold,” says Ethan Ewing, president of Bills.com. “From the lender perspective, it doesn’t have a homeowner letting the house fall in a state of disrepair.”

Often times when a person forecloses on their house, they walk away leaving the maintenance up to the bank or firm that holds the mortgage. Since lenders are contending with an onslaught of foreclosures on their books, it’s hard and expensive for them to maintain the condition of all the homes. As a result, the value of the property and neighboring ones drops, resulting in an even steeper sale price when the foreclosed house sells. Because of this, Ewing says lenders are willing to accept short sales as an alternative to a foreclosure.

In many cases, in a short sale, the bank will forgive the difference between the sale price and what’s owed on the mortgage--known as the deficiency balance--but that decision is made on a case-by-case basis.

Short sales are not void of risk. Ewing advises homeowners considering identify whether their loan is recourse or a non recourse. In a non-recourse loan, the lender can’t come after you for the deficiency balance.

There are two short sale options. With a deficiency short sale, you still have to pay the difference between what the house sold for and what you owe. You can attempt to negotiate a settlement with your lender, file for bankruptcy to get rid of that obligation, or risk a lawsuit, says Ewing.

A more favorable option is when the bank agrees not to pursue the deficiency balance. In that scenario, the bank would accept a sale price and forgive the balance. If the bank is willing to forgive the deficiency, it is best to get the lender to do so upfront and ideally in writing.

“You have to be very careful when negotiating a short sale that they agree not to come after the deficiency,” says Daren Blomquist, RealtyTrac vice president. “Banks are willing to do this because they realize in agreeing to short sale that the homeowner truly can’t afford to keep making payments.”

If the bank does forgive the deficiency balance you have to make sure that money won’t be treated as income on your tax returns. Real estate experts say it pays to contact and attorney and tax advisor in your state to learn the tax implications before approaching your lender about a short sale.

When you're ready to short sale your home, it is a good idea to contact an experience real estate broker who can help you initiate the conversation with the bank and give you referrals for tax advisers and attorneys, says Marcus Fleming, market manager and broker at real estate brokerage Redfin.

A real estate broker should be available through the entire process. The short-sale process is similar to a traditional sale, however the bank will be deciding how much you home can/will sell for, Fleming says. Some lenders require lots of documentation including bank statements, evidence of income and losses, reasons why you are doing a short sale, where you are going to live and countless other documents.

While you can contact the lender on your own, having professionals in your corner will make the process much easier and protect you from other repercussions. “The attorney will look over all the paper work to ensure it’s a clean deal,” says Fleming.