Tuesday, July 12, 2011

Sellers in a Short Sale

For a brief explanation of a short sale, see the post on Purchasers in a Short Sale here.  As mentioned in that post, a short sale involves a sale of the seller's home which the proceeds of the sale will be insufficient to pay off the entire outstanding balance of the seller's home loan.  The seller's mortgage holder accepts this short payoff to enable the sale of the house and removes its mortgage lien on the house.  A short sale is an attractive option to both the seller and the seller's lender because it avoids foreclosure.

The seller should know, however, that even though the mortgage holder may agree to a short sale of the seller's home, the the mortgage holder has the right to pursue the seller for the deficiency amount unpaid on the outstanding mortgage loan after short sale proceeds have been applied.  For example, the short sale of the seller's home brought about the sum of $300,000.00 to be applied to the seller's mortgage debt.  Seller's mortgage debt is an outstanding balance of $400,000.00.  That means the seller's bank has the right to sue or collect, from the seller, the remaining balance of $100,000.00.  This is because even though the bank may agree to release its lien on the house, the seller is still personally liable to the bank for the loan.  When obtaining a mortgage loan, the seller signs two important documents among hundreds.  The first is the note, which makes the seller personally liable to the bank for the loan.  The second is the mortgage instrument, which gives the bank security, for the loan given to the seller, by holding the seller's property as collateral.  As part of a seller's short sale transaction and as one of the most crucial elements to the seller in this kind of a deal, the seller's attorney should be ensuring that the seller's bank agrees to forgive the remaining balance of the debt of the seller, or that the seller is released from any further obligation on the mortgage loan, or that seller's bank waives and forgoes its rights against the seller for the remaining balance of the loan.

However, even when the seller's bank agrees to forgive the seller for the deficiency, the seller should be aware that he or she may be liable to the IRS in a transaction of this kind.  This is because the IRS treats debt forgiveness as taxable income.  Therefore, if the seller's bank forgives the deficiency amount of $100,000.00, the seller is potentially liable to the IRS for additional income tax on income of $100,000.00 for that tax year.  The good news is that this tax rule has been temporarily suspended in certain scenarios.  Because of the mortgage crisis, Congress has passed the The Mortgage Forgiveness Debt Relief Act of 2007.  Reduced mortgage debt through mortgage restructuring and forgiven mortgage debt are not considered taxable income for taxpayers whose debt forgiveness is in connection with their qualified principal residence.  This legislation was extended in 2008 and is set to expire at the end of year 2012.  If a seller can not avoid the payment of income tax on forgiven debt, or is unable to pay such income tax, then the seller should consider other or additional options, such as bankruptcy, as part of his or her debt relief plan.

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