The Real Estate Short Sale Explained!

The real estate short sale is a phenomenon that has taken the real estate industry by storm in recent years. Not to be confused with selling a publicly traded stock “short,” a real estate short sale involves a mortgage company accepting less than their full payoff in order to get rid of their defaulted loan prior to having to foreclose on the property.

For a mortgage company, a real estate short sale is a better financial alternative than taking ownership of the property through foreclosure. It allows them to “cut their losses” early and avoid the sometimes long and drawn out nightmare of carrying vacant property on their books for months or even years. But lenders are not the only ones who benefit from a real estate short sale.

Who can benefit from a short sale?

A short sale creates one of the few win-win transactions in real estate, by helping the borrower, the buyer, and the professionals involved in the transaction. The borrower who is falling behind on mortgage payments benefits by getting rid of the property prior to a foreclosure. This helps prevent the word “foreclosure” from appearing on the borrower’s credit report.

The buyer benefits by getting a great property at a bargain price. Since the lender is going to lose a chunk of money if they foreclose anyway, many lenders are happy to pass on some savings to the buyer while still making out better than foreclosing.

And finally, all the professionals involved in the transaction benefit by getting some much needed business–from the title company, to the home inspector, the appraiser, the mortgage broker (if any), and the real estate agents involved.

What about the tax liability for the borrower?

Despite this seemingly perfect scenario, for many years the real estate short sale was unable to circumvent the negative tax consequence created when a lender forgives a person’s debt (which is what a lender does when they agree to accept less than their full payoff–they are forgiving the borrower of the shortfall).

Just like a foreclosure or a bankruptcy, the IRS has a rule that states that any debt that is forgiven in excess of $600 must be reported as a 1099. Therefore, debt forgiveness created by a short sale, a foreclosure, or a bankruptcy became a tax liability to a borrower. Ouch!

Imagine having to pay tax on $100,000 you never put in your bank account! It’s an uglier side of our beloved tax code and over the years it has further crippled those who are already financially down, either through foreclosure, bankruptcy, or even a short sale.

A ray of hope for the borrower…

Luckily, borrowers faced with a short sale have a ray of hope. The Mortgage Debt Forgiveness Relief Act of 2007 was put in place to aid borrowers who were doing a short sale on their primary residence avoid that tax liability created by the short sale.

And for borrowers doing a short sale on an investment property, the IRS now allows certain borrowers to be classified as “insolvent” at the time of the short sale, which can reduce or, in some cases, completely eradicate the tax liability. (Remember to always consult with a licensed tax professional on all tax matters, especially those dealing with a real estate short sale.)

The real estate short sale is one true win-win solutions in real estate, and in this current economy, it is vital to the health of the real estate industry.

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