The Credit Score Truths and Tax Myths of A Short Sale Vs. Foreclosure
By Aaron Gordon

Recently a group of loan officers at my bank were gleefully boasting about developing a marketing strategy.   They were going to be the "preferred lender" on foreclosure tour buses.

The company had to remind them that, as a lender, to specialize in financing the purchases of foreclosures and short sales is nothing to be joyous of.   There are real lives at stake here.   Real families and the nation´s top, most respected, financial institutions are being destroyed as a result of this mess.  

These homes are the end-result of what will likely be more than a TRILLION DOLLARS lost by banks and firms on Wall Street.   To the point where, some say, our nation´s standing as the world´s greatest economy could even be in jeopardy.

If you are a top REO salesperson or lender, yes, you should be proud of the success you have earned in this challenging situation.  However, it´s also important to remember to keep in mind the tragedy that creates this opportunity.

When life gives you lemons you make lemonade.   Much of our business today is related to the listing, selling and financing of homes that are being sold "short" or homes that are bank-owned as a result of foreclosure.

Foreclosures and short sales are the biggest part of many of our businesses today.      And this is what I am hearing:

"Your credit score won´t drop as much on a short sale."

"You won´t have to pay taxes on the debt forgiveness of a short sale."

"A short sale is nowhere near as bad as a foreclosure."

How many of you have said any of these to you clients?   Are you certain any of the statements are true?  

At this point I am sure I don´t need to tell you the difference.   A short sale usually occurs when you sell your home before it goes into foreclosure but for less than you owe on the mortgage.   A foreclosure usually occurs when the bank takes your home for lack of payment. 

Either way this is very difficult on the homeowner.  A dream has been lost.  They are losing the home they live in, one they vacation in, or one they had dreams of making money on as an investor.

This is why I am a bit troubled by the information that mortgage professionals and real estate agents are giving their clients when discussing the decision to let the homeowner´s property go. 

First let me say this.   To lose any property you have signed a personal note for, like a mortgage, without meeting your obligation is bad3;.really bad.   

The difference between short sale and foreclosure, like one expert put it, is like the difference between getting hit by a bus or a train.    You don´t win by doing either.   There are minimal differences on the homeowner.

#1) WILL MY CREDIT SCORE DROP LESS IF DO A SHORT SALE INSTEAD OF A FORECLOSURE?

The short answer is "don´t count on it."  No one can answer this question for you correctly and that is because every case is different.  

The scoring model for all three of the credit bureaus is unique and the courts have ruled time and again that they don´t have to share their methodology with the public.

How your credit will be affected all depends on how it is reported by the homeowner´s lender.  If they report it correctly, and most will, your credit is going to be hurt badly because of it.

Let´s say I have a credit card with a major electronics store and I owe them $5,000.   Times get real tough for me and I can´t keep paying the $300 per month interest payment, so I call them to negotiate to pay them a lump sum of $3,000 one time to cancel my account.  

If they report this correctly, it will show up as a "SETTLED" for less than owed, which is horrible for my credit and will cause my score to plummet.   

Now I call them and try to negotiate with them to report this to the credit bureaus as "paid" and not as "settled" so it won´t hurt my credit at all.   Do any of us honestly believe the electronics store or the lender of a home will go for this?  

It´s certainly worth a try.   You may be saving the bank $100,000´s in a short sale vs. a foreclosure so it´s worth asking.   I know many agents are making the request of banks on behalf of their short sale clients.   However, I haven´t heard of any being successful in this.

Keep in mind your credit score is a snapshot at the moment of your credit worthiness and how risky you are to loan money to today.   Credit score experts say a settlement, of any kind, for less than the amount originally owned, is the same as a collection, repossession, foreclosure, charge off, etc. 

Now, this kind of settlement may be better from a lending perspective when you go to buy your next home years from now but not from a credit score perspective.  However, that remains to be seen as well.

If you are thinking about calling your bank today to try and arrange a short sale, you have to understand that, typically, they won't even consider this if your payments are current.   Lenders will be more agreeable to negotiation if your payments are late or in arrears because the risk of you failing to stay afloat is more obvious.

As soon as you are late on your first mortgage payment, your credit score is going to nose-dive.     And as each month passes, it will get worse and worse.

Now, keep this in mind as well.  You have seen inquiries in the past from your credit card companies and your insurance company for cars, house, etc.   These companies randomly check your credit from time-to-time to analyze how risky you are now vs. how risky you were when you first became their customer.  

So as soon as you start to miss those mortgage payments, your credit score will plummet.   One of your other accounts will likely run a procedural inquiry during this period to check you out and they will now see you are a greater risk than you were when they first gave you money.    These companies have a right, based on this change in your risk, to raise your interest rates, charge you more for your insurance premiums, and limit your credit based on your current risk.    Be prepared to have your credit lines reduced substantially without notice.

That may make this time even more challenging for you financially.  

It´s going to take a lot of positive credit activity, over a long period of time, to bring your score back to average levels.

Even if the bank lets you enter into a short sale today although you aren´t late, which is rare, the short sale will likely and eventually look as bad if reported correctly, even if it reports slower.

Many short sale experts believe that it´s easier to rebuild your bad credit after a short sale than a foreclosure, but all agree your credit will be very bad once the sale is complete.  Don´t listen to those who say your score will drop "between 80-100 points."   Plan on your score being in the 400´s to low 500´s as that´s where I see most of them today.   670 or so is an average credit score today.

The bottom line here is the only real chance you have to save your credit is to try and negotiate a short sale, without missing a house payment, and then trying to negotiate with the lender to not report it as settled for less than owed.  

It´s an extreme long shot, some say even impossible, but if you can pull this off, you may have saved your credit from destruction.

#2) WILL I BE ABLE TO BUY ANOTHER HOME QUICKER IF I DO A SHORT SALE INSTEAD OF A FORECLOSURE?

Once again, chances are no.   Keep in mind; lenders make mortgage loans based on your ability and willingness to repay the loan.   We determine this based, primarily, on your past credit history.  Especially your past mortgage history.  

It´s going to take some self-determination and time for your credit to be repaired to satisfactory condition. 

If you couldn´t successfully live up to the terms of your last home loan, why would a lender believe this new one will be different?

The next time you buy a house, your loan is going to have to be sold to another investor.  That investor will have guidelines for the loans they will buy.   Most of these guidelines today don´t allow home purchases unless you are at least two to three years out of foreclosure.   They look at short sales the same way.

When your next loan goes through underwriting as it always does, underwriters will analyze your credit report.   When they look at your previous mortgage trade line and see "settled," they are going to immediately recognize this as a short sale.

Plan on renting for two to four years before buying another home, based on today´s guidelines, if you are thinking about a foreclosure or short sale and only if there are very few other blemishes on your credit report over these years.

#3) IS IT TRUE I AM NOT RESPONSIBLE FOR DEBT FORGIVENESS IN A SHORT SALE BECAUSE OF THE NEW MORTGAGE FOREGIVNESS DEBT RELIEF ACT OF 2007?

First let say, IN BOLD, I am not a tax professional.  It´s of the utmost important that you seek the advice of a tax professional before proceeding with a short sale or foreclosure.

The Mortgage Forgiveness Debt Relief Act of 2007 was primarily started so that people, who were upside down in their homes, could refinance their home using an FHA loan and then the second mortgage holder would write off some of their loan to enable this.  This kind of loan hasn´t caught on because most lenders didn´t go for it.

Now, today, some tax experts have interpreted this Act to help you get tax relief in a short sale.  So your ability to write off this debt depends on the interpretation of the IRS and your accountant.   Here is how it can work.

Let´s say you bought your home, as a primary residence, in 2005 for $300,000.  You secured 100% financing so you borrowed $300,000 and today you short-sold your home for $240,000.   

It used to be that, in a short sale, the amount of the lender´s loss could be reported to the borrower as income, creating an income tax liability for the borrower.   You would be 1099´ed for the difference of $60,000 in this case.

This means you had to declare that $60,000 short-fall, as taxable income, to the IRS and pay taxes on it at year´s end.   

Then came this 2007 bill and now, many argue, and interpret, you don´t.    This may or may not be accurate.  

HOWEVER, let´s say you bought the same home in 2005 for $300,000 and your house went up in value to $500,000, so you took out a home equity line of $150,000 that you didn´t use to improve your home, so now you owe a total of $450,000.  

Now today you short sold your home for $320,000.  You will NOT likely get debt forgiveness tax relief for the home equity line.  This lender loss is now reported as income to you, so get ready for a huge tax liability at year´s end.  

For the debt to be forgiven, according to the Act, the house must have been used as a primary.  The debt must have been used to buy, build, or make substantial improvements to the home.

Home-equity loans where the proceeds were not used to buy, build, or improve the residence are not forgiven.  Second mortgages and home equity lines used to purchase the home can be forgiven.  Also, mortgages for second homes and rental properties do not qualify.

The bottom line here is before you do this, meet with your accountant to discuss the ramifications.   There are too many possibilities to go over here.

If you get a 1099-C form in the mail, after a short sale that looks like this, http://www.irs.gov/pub/irs-pdf/f1099c.pdf" target=_blank>http://www.irs.gov/pub/irs-pdf/f1099c.pdf href="http://www.irs.gov/pub/irs-pdf/f1099c.pdf" target=_blank>http://www.irs.gov/pub/irs-pdf/f1099c.pdf">http://www.irs.gov/pub/irs-pdf/f1099c.pdf" target=_blank>http://www.irs.gov/pub/irs-pdf/f1099c.pdf, you need to head to your accountant immediately.

Once again, I am not a tax professional.  It´s of the utmost important that you seek the advice of a tax professional before proceeding with a short sale.

#4)  BASED ON ALL OF THIS, WHY WOULDN´T I JUST LET MY HOME GO INTO FORECLOSURE?

For one, because you are giving the lender a chance to recoup some of their money.  It is far cheaper for a lender to negotiate a short sale with you and your buyer than it is to rack up attorney fees and other costs in a foreclosure.  

Foreclosure can take eight months to a year and in a declining market, your decision could cost them $100,000´s more than a short sale.

The next reason is because some believe, as we discussed earlier, it may be easier to rebuild your credit after the process.   Your credit likely be destroyed either way, but the road back to a respectable credit score may be shorter in a short sale, according to many experts.

Finally, and probably the top reason for a short sale, is depending on what kind of loan you have, and in what state, the lender may be able to go after you personally for a deficiency judgment at a later date.   In Nevada, lenders have three months after the sale to try and obtain a deficiency judgment.

This means if you owed $300,000 and he was only able to sell your home for $150,000, he may be able to come after you for the $150,000 difference plus legal fees and more, which could force you into bankruptcy.   

There are only two ways out of a deficiency judgment; pay it or bankruptcy.   Many lenders and real estate agents are wrongfully advising their clients by saying that "banks rarely come after you." 

It´s mostly true that banks don´t come after you but they can sell the obligation to aggressive, debt collectors for pennies on the dollar.  

For example, let´s say you were foreclosed on and the deficiency after sale was $100,000 and the bank gets a deficiency judgment against you.   You owe them $100,000.   They don´t have the manpower to collect on everyone today so they sell this debt to the Law Firm of John Q. Collector for $5,000-$10,000.      Whatever the firm collects, they keep.   I can assure you there are firms out there today trying to get lenders to secure deficiency judgments so they can buy these notes.

Aggressive Law Firms that specialize in collections can go after you with everything they have to collect this debt or force you into BK.  Because this is a judgment, enforceable in a court of law, they can possibly seize your assets and garnish your wages.

In addition, second lien holders, like the ones who gave you the 20% on your 80/20, who usually don´t get anything at all in a foreclosure, like a house to liquidate, can still likely come after you for the Note you signed with them for years.

The bottom line is you should try and do anything possible to try and avoid a short sale or foreclosure like a loan-workout program.  I wrote about loan workouts here in a newsletter I called "Help Your Past Clients Save Their Home From Foreclosure."   If you would like a copy of that, please let me know.  

The banks are very negotiable today and mostly want to try and help you stay in the home.    In fact, I am hearing through the grapevine that many large banks, in the very near future, are contemplating rejecting all short-sale offers on homes that are not owner-occupied.

Loan workout programs should be your first option. 

Have a great and prosperous month!!!