Overview:

A short sale of real estate is when the sale proceeds are less than the balance owed on the property's loan. A short sale typically occurs when a borrower is unable to pay off the mortgage loan on the property, but rather than foreclosing on the property, the property is sold to a third party buyer for less than what is owed on the loan with the origianl borrower/buyer (current owner). The proceeds are then distributed to the lender. The lender and borrower both consent to the short sale process because it allows them to avoid foreclosure, which is beneficial to both parties in that the lender avoid hefty fees and costs and the borrower incurs a less detrimental negative credit impact.

One of the main concerns facing borrowers considering a short sale is the lender's right to recover a deficiency (difference between the balance due on the loan and the sale price). The agreement between the borrower and the lender does not always release the borrower from the obligation to pay the remaining balance on the loan (i.e. deficiency). The deficiency will remain unless teh condidions of the short sale clearly indciate that the lender is waiving their right to pursue the borrower for a deficiency because the cost of recovering a deficiency from a defaulting short sale borrower is great relative to the probability of beneficial recovery; therefore, the probability that the lender will pursue the borrower for a deficiency is small.

Even though the potential that a lender will pursue a borrower for a deficiency is small, the reality is that the lender has the right to pursue a deficiency from a borrower for four years. For many borrowers, the looming prospect of a potential future lawsuit that will be in existence for four years drives them to negotiate settlement with the lender. Once again, the lenders use a benefit-cost analysis approach to determine whether they will be willing to negotiate settlement with the borrower regarding a potential deficiency.

Example - Lender's Right to Deficiency

Betty Borrower, a 70 year old retiree, owns a home with a fair market value of $500,000. Betty bought the home 3 years ago for $750,000. Due to the real estate market crash and Betty's lack of steady monthly income (retiree), it is economically unfeasible for Betty to continue making her monthly mortgage payments of $3,500. Betty decides to short sale the property.

Bank of America (Betty's lender) and Betty agree to a short sale to Penny Purchaser for $500,000. Betty had paid down the principal by $50,000 on the initiial loan of $750,000 - Betty still owes $700,000. B of A has the right to a deficiency against Betty for $200,000, which is the difference between the amount due on the loan ($700,000) and what the house sold for to Penny Purchaser ($500,000).

What does this mean for Betty?

B of A can go after Betty for the $200,000 deficiency and has the right to do so for four years.

Will B of A go after Beety for the $200,000 deficiency? B of A's financial department has to weigh the benefits and costs of pursuing Betty for the deficiency.

Betty is retired and gets $500 in social security every month as total income. Betty has no other income or assets. To pursue Betty, B of A will have to pay an Attorney and incur the costs of pursuing the deficiency lawsuit against Betty, which will be extremely costly. Even if B of A pursues Betty and gains a deficiency judgment, collectin the money will be difficult to impossibel as Betty has nothing to collect. Therefore, the judgment will essentially be worthless.

If Betty does come into come money and/or Betty has other debts she needs to get rid of, Betty can always file for Bankruptcy and completely discharge the short sale deficiency debt, leaving B of A no right now, or four years from now, as the deficiency will be treated as an unsecured debt and wiped out in Chapter 7 Bankrupty.

Thus, pursuing Betty is very costly and the potential benefits are minimal, so B of A liekly will not pursue Betty. However, this does not mean that the B of A will not pursue Betty - it is the bank's right, and thus, the possibility always exists.

Let's say Betty is the grandchild of a wealthy Sheik in the middle-east and there is apotential that Betty may inherit a great deal of money in the future. Betty is fearful that the B of A will discover her potential inheritance. Betty wants to eliminate the possibilty that the B of A will have the right to come back in four years (after Betty potentially gains her inheritance from her grandfather) and get a deficiency against her. Betty negotiates with B of A and as part of the short slae (terms included in the contract), B of A agrees to waive their right to a $200,000 deficiency, so long as Betty pays B of A $5,000 cash. Betty pays $5,000 cash to B of A. 3 years later, Betty receives $5 million from her Grandfather. B of A cannot go after Betty for anything as teh right to the defiency was wiaved by the B of A upn Betty payin gthe Bank $5,000 as a settlement and release of all claims.

Newly Enacted Senate Bill 931

Starting January 1, 2011, a seller's first trust deed lender cannot obtain a deficiency judgment against the seller after a short sale. Providing written consent to a short sale shall obligate teh first trust deed lender to accept the sale proceeds as full payment and discharge of the remaining amount owed on the loan. This law applies to first trust deeds secured by one-to-four residential units, but does not limit the lender from seeking damages for fraud or waste by the borrower.

While the law is highly advantageous to borrowers in that borrowers can no longer incur a deficiency from a first trust deed lender, it does not limit a borrower's liabiltiy to other "junior" lenders secured by the real property.

Additional Party Approval for Short Sale

The lender, borrower, and third party buyr are not the only parties that are involved in a short sale. Typically, there are many levels of approvals and conditions associated wiht short sales. Juniro lien holders {second mortgages, HELOC lenders, and HOA (special assessment liens)} may need to approve the short sale. Common objections come from tax lien holders (income, estate or corporate franchise tax) as opposed to real property taxes that have priority even when unrecorded and mechanics lien holders. It is possibel (and commonplace) for junior lien holders to prevent a short sale.

If the lender required mortgage insuance on the loan, the insurer will likely also be a party to negotiatations as they may be asked to pay out a claim to offset the lender's loss in a short sale.

The wide array of parties, parameters, and processes involved in a short sale makes it relatively complex and specialized. It is not surprising that short sales have high failure rates and often do not close in time to prevent foreclosure when they are no thandled by a knowledgeable and experienced professional.

Consent

The major difference between foreclosures and short sales is that a foreclosure is usally "forced" by a lender (either because the borrower cannot pay and lender begins the foreclosure, or the borrower nmakes a strategic default), whereas both the lender and borrower consent to a short sale. One of the main reaons why short sales have high failure rates is due to the fact that consent can change at any time by any party and negotiations may be ongoing between the lender and borrower even while the short sale is on the market. The borrower may decide to remain and refiannce their house, or force foreclosure for other tactical reaons. The bank can also renege, if, for example, they disapprove of the sale price, or the borrower fails to enter into an agreement regaridng the right to a deficiency. All short sale contracts include a contingency that the bank must approve the sale.

In California, short sales can be tricky - most borrowers will need the advice of an attorney and a CPA. There could eb tax consequences (and potential deficency) if the loan(s) on the property are not purchase money (all the funds needed to purchase the property). If the loans on the property are purchase money, then the laons are considered non-recourse and teh debt is generally forgiven and satisfied upon termination of teh short sale.

Changing consent presents a difficult situation not only for the borrower seeking to short sale his/her house, but also for potential buyers. There is a large risk for prospective buyers who may waste a considerable amount of time and money anticipating a short sale. Deposits with the bank are usually refunded, but money expended for inspection and other services are typically not.

Several defenses exists to counteract the potential for parties to change tehir consent. If the seller has moved out of the property, that is generally and indicator that they have no intention on negotiating further with the bank. "Bank Approved Short Sales" are advertised by real estate advertisements, incidating that a real estate broker has verified the selling bank's position. While this guarantees that the bank has been somewhat inovled in the borrower's decision, it does not guaratnee acceptance for the short sale as it usually does not take junior lien holders into account.

Credit Implications

Short sales are a type of settlement and they adversely impact one's credit report/score. The negative impact may be less than a foreclosure, but in some cases, the effect is the same. Short sales show up on a credit report for 7-10 years. Some people are able to build credit as fast as 18 months and there's even been evidence suggesting that it will take 5 years for the average person to build their credit to qualify for a loan post-short-sale.