A short sale is the sale of real estate to a purchaser for less than the full amount owed. This option is widely advised by real estate brokers and may appear to be an attractive option to a homeowner whose house is underwater or who has fallen behind on the mortgage and is concerned about foreclosure. We have had clients come to us frequently and inform us that a real estate agent advised them that they need to do a short sale. They may be told that doing a short sale relieves them of liability for the mortgage and will stop foreclosure action and is much better for their future credit.

It would be wonderful if this were always true. Unfortunately, it is not broadly the case. This doesn’t mean that a short may not be a good idea; however, the homeowner-seller needs to be aware of all the pros and cons of doing a short sale.

1) Will the holder of the first mortgage agree to forgive any deficiency on the loan? You might think that the answer to this question would always be yes (since a foreclosure would be more costly in time and money for the bank and they would not be able to get a deficiency on a debt for the primary residence of the debtor). The answer is strangely yes, most of the time, but not always. We have reviewed short sale documents for clients where they are asked to stipulate (agree) that they are personally responsible for any deficiency. In a case like this there may be no advantage at all to doing a short sale, unless the bank can be persuaded to drop this requirement.

2) Is there a second mortgage or a home equity line of credit attached to the house? If so, even if the first mortgage holder signs off on any deficiency, the second mortgage holder usually will not. This potentially leaves the ex-home owner owing a substantial amount after the house is gone.

3) Any monies that are forgiven by the bank as part of a short sale may be counted as taxable income by the IRS. Banks are required to send a Form 1099-C to the IRS for any tax year in which debt has been forgiven. There are exceptions to this taxability, but there are not as broad as people often believe them to be.

So, is a short sale a good idea? Lets take a scenario where Homeowner A owes $250,000 on a first mortgage for a house that is now worth $150,000. He has a buyer who is willing to pay $150,000. The bank has agreed to accept this offer and forgive the remaining $100,000. The homeowner does not own any other real estate or other significant assets, has very little other debt, little in the way of any savings or retirement accounts, and has been unemployed for several months.

The bank will send a 1099-C to the IRS who will then consider that this individual has forgiveness of debt income of $100,000. Ordinarily this would be taxable income and the ex-homeowner would be liable for taxes on $100,000. But in this particular case, the ex-homeowner has no assets and no income; thus he would be considered insolvent. (The taxpayer would need to file a Form 982 with his income tax return, when filed, to show this.) Therefore the IRS will not assess taxes on the $100,000 that was forgiven. Homeowner A comes out ahead by doing a short sale.

However, if Homeowner A had a first mortgage of $200,000 and a second mortgage of $50,000, he would still owe that second mortgage of $50,000 after the short sale, unless the second mortgage holder agreed to forgive this debt. While it is true that he no longer owes $200,000 on the first, and he has no forgiveness of debt income from the sale, he is stuck owing $50,000 on a second mortgage for a house he no longer owns. And he can be sued for this amount.

Now lets change a few facts. Homeowner B owes $150,000 on his first mortgage and $100,000 on his second. He also has $125,000 in an Individual Retirement Account (IRA). He is employed and earns $88,000 a year. The first mortgage holder agrees to a short sale of $100,000. The second mortgage holder agrees to the sale, but does not agree to forgive the $100,000 balance owing. Homeowner B has $50,000 that was forgiven, and $100,000 still owing on his second mortgage.

Unlike Homeowner A, he is not insolvent because his assets (IRA of $125,000) are greater than his debts. He is off the hook for $150,000 owed on his first mortgage, but he will owe taxes on the $50,000 of forgiven debt income. And he still owes $100,000 on the second mortgage. Is a short sale a good alternative for this individual? Probably not.

Homeowner C has a similar scenario but has an additional $75,000 in credit card debt. He also has an IRA with about $125,000 in it, is employed, and earns a good living. Homeowner C decides to file a bankruptcy and surrender his home in the bankruptcy. In this case Homeowner C completely discharges the full amounts owed on both the first and second mortgages, as well as all of his credit card debt. Debt that is cancelled in a bankruptcy is not taxable income, so no IRS tax obligation on income from forgiven debt. His IRA of $125,000 is completely protected in his bankruptcy. For Homeowner C, a short sale would be a very poor choice compared to bankruptcy.

So, when is a short sale beneficial? Well, it is generally beneficial to the real estate broker who earns a commission. But often, it is not in the best interest of the homeowner to short sell. Short sales should be evaluated in the context of your personal situation. A real estate broker who tells you that your best option is a short sale may be advising you to take an action that is not in your best interest. Get a second opinion from an attorney who understands the advantages and pitfalls of both the tax ramifications and bankruptcy and other options, before going ahead with an action that may have very unpleasant surprises.