Is a Short Sale Really an Alternative to Foreclosure?
By Lynn Arends
I am both an attorney and managing broker. Most of my law practice involves negotiating debt and advising borrowers on foreclosure, deed-in-lieu, bankruptcy, short sales, and loan modifications. As a Managing Broker, I am predominantly a listing agent and most of my listings are short sales. I start with a thorough, two-hour consultation. No one gets to see me as a real estate agent until they first see me as a lawyer. This is very important because more often than not, a short sale is not the answer.
Short Sale Basics
A short sale occurs when a bank agrees to accept less than what is owed on a mortgage or deed of trust to release its lien. Negotiated correctly, a short sale can be an excellent alternative to foreclosure to both sellers and buyers. And banks will consider a short sale because it allows them to recoup some of their investment without the work and expense of selling the home themselves.
New Obama administration initiatives, such as the Home Affordable Foreclosure Alternatives Program (HAFA) and recent changes to HUD’s Pre-Foreclosure Sales Program (PFS) for FHA loans, have made short sales an ever more viable option in today’s current economic state. But before signing up for a short sale, here are some issues to consider:
Assuming the property is underwater (more is owed than what it’s worth), here are the necessary criteria to be considered for a short sale.
• The mortgage is in default or default is foreseeable.
Yes, borrowers can be current on their payments and still be considered for a short sale.
• The seller has experienced a true hardship.
Basically, this is the “what has changed since you took out the loan that you could afford it then but can’t now” test. Examples of a hardship are unemployment, job relocation, divorce, bankruptcy, illness, or disability.
• The seller has no assets.
Before accepting a short sale, a lender will require the seller to submit a short sale package. This includes the seller’s tax returns, financial statements, bank and credit card statements, hardship letter, and schedule of assets. If there are assets, the lender may not approve the short sale because the seller has the ability to bring cash to the closing or the seller may still be granted a short sale but be expected to pay back the deficiency.
A deficiency is the difference between the amount received and the amount owed. Although a promissory note makes the seller personally liable for the debt, whether the bank can pursue a deficiency judgment after a foreclosure or short sale depends in part on the security instrument used and that state’s deficiency statute.
Most lenders foreclose through a trustee’s sale. In some states, that extinguishes the debt and usually does not give the lender the right to pursue a deficiency judgment. However, when a senior lienholder nonjudicially forecloses and the second lienholder is wiped out during a foreclosure under a trustee’s sale, the junior security interest is extinguished but the obligation on the note is not—possibly giving the junior lienholder the right to pursue a judgment on the debt.
And yes, a lender can issue a 1099 to a borrower and still attempt to collect the remaining debt. The mere issuance of the Form 1099 does not alter the creditor’s legal right to attempt to collect the debt and it does not act as an admission that the debt is no longer due (although the creditor will need to amend the 1099 issued to the borrower upon collection).
The property may be encumbered by more than one lien. If so, all junior lienholders (and any mortgage insurer) must agree to accept a short sale. This is where good negotiation skills and playing well with others kicks in. In today’s typical short sale, it is often the only the first lienholder who is receiving any money. Generally, it is up to that first lender to give some of its proceeds to the junior lienholders. This encourages the junior lienholder to agree to the short sale and release its lien. That amount, whether it is $3,000 or $5,000, is negotiated between the senior and junior lienholders.
But lately some junior lienholders have been demanding outrageous sums of money to approve the short sale and requiring contributions from the buyer, seller, and/or real estate agents. Often, all of this occurs without any disclosure to the first lender. Monies not disclosed or paid outside of closing? That’s called mortgage fraud.
To me this is a case of the junior lender cutting off its nose to spite its face. In the event that the short sale fails, the first lender will most likely get the property back in the foreclosure, thus eliminating the second lien entirely.
It’s All About the Debt!
Even if a client is a perfect short sale candidate, I spend a lot of time walking people through what nonjudicial foreclosure looks like. To me, this is the “what if I wake up tomorrow and do nothing” option. That’s the baseline. Everything else—short sale, deed-in-lieu, loan modification, or bankruptcy—requires some action and needs to yield a better result. What that means is that I need to negotiate a better settlement in a short sale than any of the other options, especially with respect to the remaining debt.
For example, when my office receives the standard short sale letter of consent from a certain lender on a first mortgage, it always says that the lender is not waiving its right to a deficiency. I practice in Washington, where we have non-judicial foreclosures. If the client is delinquent in its payments, and facing a nonjudicial foreclosure on the first, given that the Washington Non-Judicial Foreclosure Statute prohibits the lender from obtaining a deficiency (except against a guarantor in certain settings, which does not apply in virtually all residential sales), the client is better off simply allowing the property to go to foreclosure rather than allowing it to go to short sale. So the question is: Why does the lender not recognize this reality and waive its deficiency in transactions involving a pending nonjudicial foreclosure? Or if the mortgage insurer is calling the shots, why is it not able to convince the mortgage insurer to pay the claim without proceeding to foreclosure? Of course, foreclosure procedures and deficiency treatment varies from state to state and the prudent practitioner will consult the most current version of its state’s foreclosure statutes before advising the client.
So who is the perfect short sale candidate? Three scenarios immediately come to mind.
- There is only one loan and there is a program for dealing with the deficiency. HAFA, HUD’s PFS, and the VA’s Compromise Sale Program are all attempts to waive deficiencies in short sales and deeds-in-lieu.
• Two loans and the first is being fully paid off in the short sale. Foreclosure does not benefit the borrower in any way. It’s all about the second lien and I can negotiate that debt as part of the short sale.
• Borrowers who are able and desire to remain current on their payments. Obviously, being current never triggers the foreclosure. And if credit is important, clearly the biggest hit to credit is every month a borrower doesn’t make a payment. Again, this is debt I can negotiate.
In the end, it’s all about the debt.
Beware of Condominiums and Any Super-Priority Liens
Unless the former owner of the unit files bankruptcy, he or she remains liable for the preforeclosure assessments on the foreclosed unit. States have differing HOA acts, but most afford the association some preference for association dues owed prior to a foreclosure sale (in Washington it is 6 months). What that means is that HOAs are a force to be reckoned with in any short sale transaction because if an HOA can collect the “preferential” (i.e. in Washington the six months) dues from the lender or new buyer in a foreclosure, they will need to be offered more than that amount to accept a short sale and release its lien. So it’s important to do the math when dealing with an HOA. But the good news is that when an HOA approves a short sale, it is usually for satisfaction of debt and the seller is not liable for any additional preforeclosure or short sale assessments.
Buying Again After a Foreclosure or a Short Sale
At the time of this writing, the dust has not yet settled on the requisite waiting period after a short sale or foreclosure. Not long ago, Fannie Mae came out with new guidelines. Unless the foreclosure was the result of documented extenuating circumstances, which only requires a three-year waiting period (with additional requirements), all borrowers will now be required to meet a seven-year waiting period after a prior foreclosure to be eligible for a new mortgage loan eligible for sale to Fannie Mae. Contrast that to the waiting period after a short sale which can be as little as two years depending on the loan-to-value ratio and other factors.
Final Short Sale Thoughts: Seller Beware!
A short sale is nothing more than a voluntary agreement on the part of a lender to release its security interest. Unless an express written term of the short sale approval is the waiver of any right to a deficiency, that lender, or the lender's assignee, will have the right to seek recovery of the deficiency, and may pursue an action up to the expiration of the statute of limitations for collection of a note. In my opinion, any attorney advising a borrower otherwise is committing malpractice. Finally, always seek legal counsel before attempting to pursue a short sale. A real estate agent cannot give legal advice.
Lynn Arends, concentrates her Seattle practice at Lynn Arends Law Group PLLC and Lynn Arends Realty Group, on short sale and foreclosure issues. She is a frequent speaker for the Washington State Bar and the King County Bar and an instructor for Washington Association of Realtors. Contact her at email@example.com or visit her blog and website at www.lynnarends.com.
Originally published in the March 2011 issue of the King County Bar Association Bar Bulletin. Copyright 2011© by the King County Bar Association. Reprinted with permission of the King County Bar Association.
© Copyright 2011, American Bar Association.