A short sale is the process of selling a piece of real property for less than what is owed on the loan(s). Short sales require the approval of the lender who will be affected by the sale, because the funds received will be"short" of what is owed to the lender. For example, consider a person who has real property worth $500k, with a first mortgage of $400k and a second mortgage of $200k. In this case, the second mortgage holder would have to approve the short sale and agree to accept less than the full balance owed on the loan. Even if the lender agrees to accept this arrangement, the borrower is not entirely off the hook just yet. A short sale by definition is an agreement to sell property for less than what is owed. If the lender agrees to accept a short sale, they are most often agreeing to forgive the remaining debt that is owed so there is no deficiency balance the borrower can be sued for (Read the agreement very carefully. Some lenders may try to hold you responsible.)
However, the forgiveness of debt is a taxable event that can trigger a 1099-C by the lender requiring the borrower to pay income taxes on the amount of debt forgiven. With the drastic decrease in home values over the last several years, the tax liability on forgiven debt can be thousands of dollars in this scenario! There may be exceptions to this general rule under State and Federal law and consumers are strongly encouraged to discuss their potential applicability with an accountant before moving forward with this option.
Foreclosure is the process of taking back property, generally pursuant to a deed of trust or other security interest. California is a non-judicial foreclosure state, meaning the lender does not need to get the court system involved in the process in order to recover the property. Judicial foreclosure is an available remedy in California, however it is the rare instance that it is pursued. Borrowers who are contemplating letting their home foreclose need to be aware of exactly what that decision means to them.
Purchase Money Rule
Purchase Money Rule- This statute prevents a judgment from being entered against you for any deficiency balance resulting from a foreclosure assuming the following is true:
1) The lender(s) loaned you 100% of the money to purchase the property. (Includes 80/20 loans on 100% financed property).
2) Upon the original purchase, you occupied the home as your primary residence.
3) The loan(s) have not been refinanced, or purchase money HELOC's have not been paid down and borrowed against.
One Action Rule- Lenders in California are allowed to take but one action against you, either a non-judicial foreclosure (ie. take back the property) or a judicial foreclosure (ie. sue you on the contract/loan.) Because of the uncertainty and costs associated with judicial foreclosures, they rarely take place. The One Action Rule may not apply to a sold out junior lienholder who has not had the option to take their "One Action." Subject to the Purchase Money Rule above, junior lienholders may have recourse against borrowers in this instance.
Forgiveness of Debt and The Insolvency Exception
Forgiveness of Debt Rule- California and the IRS tax you for the amount of forgiven debt in any given year. Debt is forgiven when the lender gives up all rights to collect the debt or are otherwise legally barred from collection.
Insolvency Exception- California and the IRS both exclude forgiven debt as taxable income, but only to the extent you are insolvent. The insolvency test is met when your debts exceed your assets, and assets include all real and personal property including retirement accounts.
Bankruptcy: For those individuals who have refinanced their original loans, taken out equity lines, or in addition have other significant debts they want to eliminate, bankruptcy may be the choice for them. In this instance, bankruptcy would discharge any money owed to the lender for a deficiency balance and also prevents the lender from suing to collect it. Moreover, bankruptcy would wipe out any tax implications that would normally result from a short sale or foreclosure.
The bottom line here is to do your homework and get competent advice before choosing the course of action that best suits you.