August 13, 2007

BETWEEN A ROCK & A HARD PLACE -- Using A Short Sale to Avoid Foreclosure


In my December 28, 2006 post, I discussed some of the anticipated problems from the "boom" in subprime mortgages and other creative lending practices during recent years. I entitled the post, "'Creative' Financing -- The Slippery Slope in 2007."

It didn't take a crystal ball last December to predict the fall-out from adjustable rate home loans that facilitated the purchase of homes for unprecedented prices with lax underwriting and no money down. It was also apparent this would problem would create weighty issues in California real estate law during 2007 and beyond.

With the prices of homes declining in many areas, some borrowers are between a rock and a hard place. How does the owner of a home with no equity get out from under the loan without suffering a foreclosure and the resulting damage to his or her credit rating?

One strategy is a "short sale." A short sale requires the seller to first negotiate with the lender to reduce the balance of the loan subject to the sale of the property to a third party. For example, let's say the seller bought the house for $550,000 with a non-recourse loan of $500,000; the house is now worth $450,000; the seller persuades the lender to reduce the balance of the loan to $450,000 and sells the house for $454,000, with $450,000 going to the lender and the $4,000 used to pay a portion of the closing costs. The lender doesn't have to deal with the house as an "REO" (real estate owned by the lender); and the seller avoids the negative impact of a foreclosure and is no longer obligated to the lender after the sale is completed.

But there may be negative tax consequences to a short sale. Under the current tax law, the seller may have to recognize "phantom income" from the "cancellation of debt" in the amount of the loan reduction ($50,000). Any reader who wants to employ this strategy should consult with an accountant about the tax consequences of a short sale and to determine if an exemption from the payment of income tax on the cancellation of debt is available.

P.S. On August 31, 2007, President Bush proposed legislation to temporarily eliminate the recognition of income when the lender forgives a portion of the debt. Stay tuned! The Congress may move the boulder that is one of the impediments to short sale.