When experiencing financial hardship, some homeowners may fall behind on their monthly mortgage payments. This, in turn, can often lead to a foreclosure action against the property if the financial hardship is not resolved and the homeowner’s mortgage arrears are not cured through reinstatement, obtaining a loan modification, or possibly chapter 13 bankruptcy. An inability to make timely monthly mortgage payments can be caused by numerous reasons including: a reduction in income or loss of overtime, loss of employment by one or more family members, or unanticipated household expenses such as an emergency home repair or unexpected medical bills, etc. The reason a debtor falls behind on their mortgage may be no fault of their own, however the homeowner will want to review their potential options to resolve their past due mortgage issues. Although usually it’s not the first option, a short sale is one such option.
What Is a Short Sale?
If a homeowner owes more on their mortgage than the value of their home, they must seek approval of their mortgage lender before selling their property. This is what is known as a short sale, where the lender agrees to take less than the full balance of the mortgage loan plus the costs of the sale, and the seller can walk away from a property with negative equity.
The mortgage lender has an interest in approving a short sale since it can be more efficient than waiting for a foreclosure proceeding to complete. For context, a foreclosure in New York may often take years to complete. In addition, the lender may obtain a better sale price from a short sale than through a sale by foreclosure auction. However, in recent years, lenders have been more aggressive when negotiating short sale approvals.
Applying for a short sale requires the submission of financial documents, typically called a loss mitigation package, to the mortgage lender, similar to those required for a loan modification. Once the submission is deemed complete, it will be sent to underwriting for review. The process of applying for a short sale can now take several months before a determination is reached.
If a short sale is approved, the sale of the home can proceed, and the title will be transferred out of the seller’s name. It is important to note that the short sale price offer still must be reasonable to the lender if they are going to realistically proceed with a short sale. In addition, the lender will typically agree to forgive any mortgage deficiency, which is the difference between the total mortgage debt owed and the final sale price. To complete a short sale, any potential additional liens (e.g., second mortgage, judgments, water bill, etc.) on the property need to be resolved. Resolving such liens may delay the completion of the sale or result in a cancellation of the short sale.
What Are the Tax Consequences of a Short Sale?
If the lender agrees to forgive a mortgage deficiency as part of a short sale, there can be significant tax ramifications for the seller. At the conclusion of the short sale, the lender may issue a Form 1099C (Cancellation of Debt) to the seller and the IRS. This can potentially result in a large tax obligation to a seller who is already in financial distress. The IRS views cancellation of debt, in this case mortgage debt, as income, therefore the seller would have to pay taxes as if they received the cancelled debt as income.
However, there are three ways to be relieved of the tax consequences of a short sale. First, the debtor may qualify for the Qualified Principal Residence Indebtedness (QPRI) exclusion which has been extended to cover debt forgiven before January 1, 2026. The exclusion also applies to debts forgiven that were incurred to purchase, build, or renovate your principal residence, or a refinance of such debts. (See I.R.C. § 108(a)(1)(E)). This exclusion only applies to a debtor’s primary residence and not to investment properties or vacation homes. Refinanced debt will only qualify for the exclusion if those proceeds were used to make significant renovations or improvements to a principal residence. Second, is if the seller is legally insolvent. For the purposes of calculating federal tax liability, a homeowner is considered insolvent if their total liabilities had a higher value than the fair market value of all their assets immediately before the short sale. Finally, is if the mortgage debt is discharged in bankruptcy prior to the short sale. Debt that is canceled in a bankruptcy case is not included in your income for calculation of federal taxes.
How Can Bankruptcy Help You Complete a Short Sale?
Whether a debtor files for Chapter 7 or Chapter 13 bankruptcy, they typically receive an automatic stay that stops all collection activity, including providing a stay against foreclosure lawsuits and stopping foreclosure sale dates. A successful bankruptcy filing, and discharge will eliminate any potential mortgage deficiency and as mentioned above, will remove the potential tax consequences from a short sale. If the Bankruptcy Court in their district offers it, a debtor can pursue a short sale in the Court’s loss mitigation program – alternatively they can complete a short sale after the bankruptcy case is complete. Either way, it can be beneficial to pursue a short sale after a bankruptcy filing, to transfer the deed out of the debtor’s name. Once a debtor receives a discharge in bankruptcy, they are relieved of their liability under the mortgage note and therefore the mortgage lender will no longer be able to pursue a money judgement against them. The lender will only be able to seek the return of their collateral for the mortgage, i.e., the property. Furthermore, bankruptcy will provide the opportunity for the debtor to receive a fresh financial start by eliminating their dischargeable debt.
Why Are Short Sales Harder to Complete Now?
As previously mentioned, mortgage lenders have become more aggressive in negotiating short sales. They approach short sales more skeptically. In contrast to the post-mortgage crisis of 2008, they are not willing to take any offer, and they want to make sure the buyer is getting an arm’s length offer and is not a straw buyer. They often send their own appraiser to the property, will check the comps in the area, and use online auctions to insure they are getting the best possible price. This does not mean that a short sale is impossible to complete, just that it is more challenging than in the past.
Contact the Law Offices of David I Pankin, PC
For over 25 years, the Law Offices of David I Pankin, P.C. have helped homeowners facing foreclosure with Chapter 7 and Chapter 13 bankruptcy, fighting foreclosure lawsuits in state court, loan modifications, as well as short sales If you have any questions regarding the dischargeability of SBA EIDL loans, please feel free to contact the Law Offices of David I. Pankin, P.C or contact us using our easy online form.
