Out of the Depths: Is a Short Sale the Best Option for your Client?
Helen Berenyi, president and founder of Red Triangle, a planning firm in Charleston, S.C., has a client who moved to the area and bought a condominium as a primary residence. He ultimately didn't like the area, so he moved and found a renter for his condo.
But the rent couldn't cover the mortgage, taxes, insurance and upkeep, and the property's value dropped. "He bought it for around $400,000 and could maybe get in the $200,000s for it now," Berenyi says. The client is planning a short sale.
He's just one of millions of homeowners who have fallen victim to the housing collapse and whose properties are underwater.
Short sales and their alternatives don't require a financial planner, though a lawyer is often helpful. It is a valuable service, however, when an advisor can give clients a sense of their options in managing an overleveraged real estate situation.
Though a short sale can feel like an endless march through bureaucratic purgatory, in theory it's a very simple idea.
"You sell the home at market value and the bank forgives whatever part of the loan isn't covered by the sale," says Christopher Van Slyke, founding partner of Trovena, a wealth management firm with offices in Austin, Texas, and Southern California.
"The alternative is to let it go into foreclosure," Van Slyke says. "That's bad for you and bad for the bank" because foreclosures are expensive, banks aren't set up to manage real estate sales or rentals, and property can be damaged if it's left vacant after a foreclosure.
Some people avoid trying to get out of a mortgage because they feel it's irresponsible or embarrassing. But Van Slyke says he finds that, as short sales have become more common, "people have redrawn the moral line. The bank made money on the interest and took on the risk knowingly. It's a business deal."
Opinions differ on how to begin the short-sale process. "The bank will not begin talking to you until you stop making payments," Van Slyke says. "That seems to be the way the game is played."
But another expert, Chaun Pflug, a lawyer at the Pflug Law Firm in Mount Pleasant, S.C., says there's no need to be in arrears to try to arrange a short sale.
"You could put a home on the market and get an offer and then negotiate with the bank," Pflug says. "Some banks will approve the short sale; some won't." A short sale that's approved without halting monthly mortgage payments is likely to be less stressful for a client and can leave a credit score in far better shape.
A real estate agent who specializes in short sales can be helpful, particularly if the agent has strong connections with the banking community. Van Slyke says he has clients who hired a short-sale specialist and were able to buy a three-bedroom home at a 2010 price and interest rate before they finalized the short sale (with its associated credit score dip) of their previous home. "They've suffered very little damage," Van Slyke says.
Any short-sale approach leads to reams of paperwork, then a yes or no from the lender. "You submit paperwork as though you were going to purchase the home again, and they do a full financial workup, and then they decide if a short sale is in the bank's best interest," Van Slyke says.
It's difficult to predict whether a bank will accept a given short-sale application. Applicants with other significant assets, however, are unlikely to win bank approval. "If you have assets, the bank probably won't negotiate," Pflug says. "If someone is just getting by, they have a much better chance of getting help."
Van Slyke saw that play out with clients who had jointly purchased a Texas investment property and were unable to resell it. "The clients had millions in a checking account and were jointly liable with the husband's parents, so a short sale was not an option," he says.
Before a property owner decides to pursue a short sale, it's important to know whether the geographical entity where the property is located is a recourse or nonrecourse state.
In a recourse state, a bank may sue a borrower for the difference between a home's selling price and the amount the seller still owes on a mortgage, even if the bank forecloses or agrees to a short sale. A bank can offer a short seller a deficiency waiver, however, voluntarily agreeing to absorb the loss.
"It comes down to this: Is there going to be a deficiency judgment hanging over your head that will force you to file for bankruptcy?" Van Slyke asks. If so, you might be better off keeping the property and paying off the mortgage.
Even in states with recourse statutes, the details can vary. In New York, for instance, a lender is permitted a single lawsuit in its attempt to recoup the loan's value and must choose between foreclosing and suing to collect the debt.
In a nonrecourse state, by contrast, a bank that forecloses or agrees to a short sale cannot recoup its full loss by suing the property owner. But some states permit lawsuits designed to recoup a limited amount of a mortgage's value. A client who can't pay that limited amount needs a bank deficiency waiver if a short sale is to be a viable option.
No homeowner should pursue a short sale without understanding the tax consequences. Normally, debt forgiven by a lender counts as taxable income. For the tax years 2007 through 2012, however, the Mortgage Forgiveness Debt Relief Act exempts homeowners from up to $2 million in forgiven debt on their primary residences. (The IRS website has details on rules and conditions.)
The law doesn't apply to business property, rental property or second homes, however, or to debt that was refinanced to pay off credit cards or other consumer loans.
Taxpayers who aren't eligible for tax-free debt forgiveness may still qualify for tax breaks under the IRS' insolvency rules, or may have other credits or losses that can offset or eliminate the tax bite.
That was the case for clients of Kevin Young, principal of Young Wealth Management, which has offices in Davis and Sacramento, Calif. They turned a primary residence into a rental and later negotiated a short sale. An insolvency claim let them cancel the forgiven amount.
In other situations, the difference between the amount owed and the value of the property may be so great that it's worth doing a short sale and paying the taxes, just to get out of the mortgage.
A short sale isn't the only way to dispense with an overvalued property. Owners could also pursue foreclosure, a reduction in principal or a deed in lieu of foreclosure.
Foreclosure is probably the most direct way to walk away from a home. In a foreclosure, the homeowner stops making the mortgage payments and the bank reclaims the house and then resells it in hopes of covering or offsetting the defaulted amount.
Foreclosure demands very little from the defaulting borrower. In a recourse state, however, a bank can sue the former homeowner for the difference between the amount owed and the resale price. The deficit could be more than that in a short sale, because the home's post-foreclosure selling price may be hurt by vandalism, theft or overall deterioration that can occur when a home stands empty.
Foreclosure also wrecks a defaulting borrower's credit, making it very difficult for that person to get another loan at a reasonable rate. "Besides bankruptcy, foreclosure is the worst thing you can have on your credit record," Van Slyke says.
That doesn't always matter to a client. Berenyi's condo owner, for example, is 77 and doesn't expect to need any more loans.
"He just quit paying," she says. "He said, 'I don't care about my credit at this point in my life.'"
But for most people, "foreclosure needs to be a last resort," Pflug says. "I wouldn't advise anyone to just walk away from a house. It wrecks your credit and can leave you liable for the difference between what you owe and what the house sells for. I'd suggest working with the bank for a reduction in principal or putting the house in the market for a short sale."
Foreclosure intervention programs may also help clients who can't make mortgage payments on their primary residences, Pflug says. Lawyers who specialize in real estate are a good source for program information; the Internet can also provide helpful starting points.
Negotiating a reduction in the interest rate or principal can help some clients hang on to a home. With rates at historically low levels, getting the interest rate reduced is a real possibility, unless a client isn't able to pay a mortgage of any amount.
Reducing principal, on the other hand, is harder. "It's a very tough road to negotiate a reduction of principal," Pflug says. Nevertheless, "some people are successful."
The latter group doesn't include Berenyi's client. "He kept going to the bank to apply for a loan modification, and the bank wouldn't talk to him until he quit making his payments," she says. "They didn't know what to do with him."
Other banks may be more organized. There is no penalty for requesting a loan modification, so it may be an appealing route to try before considering a short sale.
"Some banks are more willing to negotiate now than they were in 2009 or 2010 to trim a bit off the principal," Pflug says.
"It's a matter of calling your bank and talking to them." In his experience, "it's easier to reach decision makers at small banks than it is at large banks."
A borrower could also get lucky with new regulations that give loans held by Fannie Mae or Freddie Mac additional flexibility in negotiating a reduction in principal, a short sale or a waiver of deficiency judgment.
A deed in lieu of foreclosure, which trades the property deed for forgiveness of the full mortgage debt, is yet another option. "It's more frequent with commercial property, but either way it's a good avenue to try," Pflug says. A deed in lieu of foreclosure lets a bank repossess a property without going through the lengthy and potentially expensive foreclosure process and removes the risk that an angry homeowner will damage a foreclosed property.
Perhaps the last option? Refinance the debt and pay it off. That's what a pair of Young's clients did.
"They moved to Davis, Calif., and wanted to sell their house in Maryland," Young says. "They ended up renting the house, but they had negative cash flow, even with a good tenant. We were able to work out an arrangement where they found a buyer and the bank agreed to a 15-year zero-interest note that my clients will use to pay back the bank," he says.
"There's no impact to their credit, they no longer have this property they have to feed and they can get their lives in order in California." That's a win for everybody.
Ingrid Case, a Financial Planning contributing writer in Minneapolis,e is a former editor at Bloomberg News. She is the author of Your Own Two Feet (and How to Stand on Them): Surviving and Thriving After Graduation.