Defining terms and context

In real estate vernacular we refer to a “short sale” as a transaction where the proceeds of the sale are not enough to satisfy the liens on the property in-full. Practically speaking, somebody is owed money and will not be paid the full amount they’re owed.

Let me step back a moment and sketch the framework we’re working within:

• Loans on the property are secured by the property itself, and appear as liens on title.
• In a California residential real estate transaction, there is a buyer, seller, buyer’s agent and seller’s agent. The seller has transactions costs related to this change of ownership: escrow and title fees, city/county transfer tax, commissions, etc.
• In an appreciating market, the equity (growth of value) in the home can be sufficient for the seller to easily pay off loans and closing costs (aka costs related to closing escrow)
• For ownership transfer to occur, the title must be cleared by releasing all liens on title. This happens by paying off loans attached to said liens.
• For our purposes, let’s assume the overhead for selling a property is 7% (6% commissions + 1% closing costs).

As the reader is aware, the US real estate market is currently in an overall downward cycle with many homeowners owning properties that have dropped in value. Compounding the problem is the access to easy money that was offered to buyers over this past decade which resulted in people purchasing homes with little money down – and, sometimes zero down – the homeowner is left with no equity cushion with which they can weather market fluctuations.

This begs the question: How does a homeowner sell a property that is worth less than what they paid for it, particularly if they do not have the money to make up the difference between the money they owe on the property and the current market value of the property?

Welcome to the land of short sales

Essentially, a short sale is like a regular residential property sale except that, with a short sale, in addition to the seller accepting a buyer’s offer, there’s a negotiation and approval process to go through with the lien holders to the seller’s property. In this case, one or more lien holders (usually banks) will be the beneficiaries of the sale and must release their liens to allow the title transfer to happen. But that doesn’t necessarily mean that they release the homeowner from the liability of the debt.

The homeowner will have hardship conditions that brought about the short sale to begin with:  loss of job/income, divorce, job relocation, etc.

The property will go onto the market for sale in an effort to get interested buyers to bring purchase offers to the seller. The seller selects an offer and enters into a purchase agreement with one of the buyers by accepting their offer, and then the offer becomes part of the short sale package that is submitted to the seller’s lender(s)

A short sale package will include items such as the seller’s financial information (pay stubs, financial worksheet, etc), hardship letter, property listing agreement, etc.

The most important document in a short sale package is the estimated HUD-1 statement, which is the net-sheet reflecting all the numbers for the transaction. This document lets the bank know what amount of money it will receive, and allows them to get a handle on their loss severity.

Why would the bank even consider a short sale if they are losing money? The answer lies in the fact that they usually lose even more if the homeowner is foreclosed upon. Banks are in the business of lending money and not owning real estate (REO = real estate owned) so they want to liquidate properties in their portfolio and turn them into cash that can be lent out again.  Banks also realize it costs them money to sell properties from the REO portfolios, and know REO’s aren’t attractive to the bank’s stockholders.

The whole approval process (from seller’s offer acceptance to lender’s short sale approval) can take a while because banks are simply overwhelmed, incompetent and the system is set up in such a way as to squeeze more money out of all parties involved. The result of lender’s strategy results in a very time-consuming negotiation. A lender will keep pushing their collections strategy tactics till the very end of the transaction.

Realistically nowadays, sellers and buyers are looking at 90 to 120 for short-sale lender approval, and then another period (typically 30-45 days) for close of escrow to occur.

Short sale seller’s don’t pay realtor’s commissions

The closing costs related to the sale of the property will be picked up by the seller’s lenders, so commissions and closing costs are rolled into the short sale negotiation. That doesn’t mean however that the short sale buyer won’t need to contribute money, or sign a promissory note in order to ultimately satisfy the seller’s lender/make the deal happen.

If a short sale seller has assets the lender is aware of, then the lender will expect the seller to cough up money. Sorry, but there is no free lunch.

Short sale versus Foreclosure

There are a variety of reasons sellers opt for short sales over foreclosure. The two primary reasons are: 1. the short sale is less damaging than foreclosure to the seller’s credit rating, and 2. there are less severe tax implications for the short sale seller than that of a foreclosed seller.

Since a short sale is a negotiation, it offers some leverage as to what will be reported by the lender on the seller’s credit reports. A foreclosure is a significantly negative mark, but a short sale – especially when there were no late payments – can have a small impact, and sometimes no impact whatsoever.

Tax-wise, a short sale is also a better deal than foreclosure because the cancelled debt amount will be smaller than that in a foreclosure situation (where the bank will lump in various costs related to taking back, as well as costs associated with selling the property).

Folks, this is important because the IRS considers cancelled debt as income.

There is an emotional benefit also when doing a short sale: you pick the buyer for your home instead of being evicted by a sheriff.

Consult an attorney and a CPA

It is advised that homeowners seek the advice of an attorney and/or CPA to regarding their specific situation. Every seller’s situation is unique, and a multitude of variables come into play, e.g. purchase money mortgages vs. refinance loans, etc., and real estate agents are not qualified to give legal or accounting advice.