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Resources on Foreclosure, Credit & Debt, and Bankruptcy

How to File for Chapter 7 Bankruptcy

Chapter 13 Bankruptcy

The New Bankruptcy: Will It Work for You?

Selling Your House in a Tough Market

Foreclosure: Articles and FAQs

Guide to Avoiding Foreclosure (HUD)

Avoiding Foreclosure: State Resources (HUD)

Foreclosure Survival Guide

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Foreclosure Survival Guide (1st Edition)

Disadvantages of a Short Sale

Short sales have some drawbacks when compared to letting the foreclosure happen or filing for bankruptcy.

No Chance to Stay and Save

If you sell your house, you will be expected to leave as soon as escrow closes. But if you let the foreclosure happen and stay in the house until you are formally told to leave by written notice, you can build a nest egg that you can draw on in the future to obtain good housing. (Again, see Ch. 9 for more about this strategy.)

You don’t have to sell your house a long time before the foreclosure sale to garner the main advantage of a short sale (no foreclosure on your record). But it’s very difficult to accomplish a short sale if you don’t get started as soon as you learn about the pending foreclosure, especially if you have to negotiate with several mortgage holders. And needless to say, if you don’t complete the short sale before the foreclosure sale, you’ll have nothing to sell.

Those Mysterious Credit Ratings

As mentioned earlier, the truth is that nobody really knows how a foreclosure or short sale will affect your credit in the future. Only the folks who set the credit scores can really tell you—and they won’t, because certain important factors used to derive credit scores (and the criteria used in follow-up “manual” examinations) are kept confidential as a business secret.

In past years, credit grantors would subjectively assess the raw information in your credit file when deciding whether or not to grant you credit and at what interest rate. For instance, they might have seen that you did a short sale and given you a break for at least being responsible enough to sell the house rather than just walking away or giving the house back with a deed in lieu of foreclosure.

Now, however, this type of examination is made only if your credit score is low enough to trigger it. And because you already have two strikes against you because of your low credit score, the results will seldom cheer you.

Even if current information we do have about credit scores indicates that a short sale is marginally better for your credit, things might change. If credit gets even tighter and the economy officially enters a recession or is slow getting out of one, it may make no difference which path you take.

Potential Tax Liability

A short sale may generate an unwelcome surprise: taxable income based on the amount the sale proceeds are short of what you owe. It can happen if you borrowed against your principal residence and used the money for any purpose other than acquiring or improving that property. For example, if you used the loan to buy a second house, to pay college tuition for a child, or to take a vacation, and you end up not paying it back in full, the amount your lender writes off (typically whatever amount wasn’t paid back) is considered forgiven debt. Although the concept is not at all intuitive, the IRS treats forgiven debt as taxable income, subject to regular income tax.

EXAMPLE: Joan owes $150,000 on her first mortgage and $50,000 on the second, which she borrowed to pay for her daughter’s first year of tuition at an exclusive Eastern college. Joan loses her job and is facing foreclosure. She arranges to sell the house for $140,000 and gets permission from her first lender to pay off the first mortgage for $135,000 and permission from her second mortgage lender to pay off the second mortgage for $5,000.

 

The $15,000 the first mortgage holder will write off (forgive) is not considered taxable income because Joan used it to acquire the house. But the amount the second mortgage holder will write off, $45,000, is forgiven debt and considered taxable income to Joan because it wasn’t used to buy or improve her principal residence.

If you face this situation and can prove you were legally insolvent at the time of the short sale, you won’t have to pay the tax. Insolvency is when your total debts are more than the value of your total equity in your real estate and personal property. You can also get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn’t much point in doing the short sale, because any benefit to your credit rating caused by the short sale will be negated by the bankruptcy.