Foreclosures and Short-Sales – Part I – Overview

Originally published in the Pacific Grove Hometown Bulletin

June 15, 2011

 

Over the past three years I have been involved with approximately 80 foreclosures and short-sales.  Ultimately, it is a combination of strong tax and legal advice that will help you safely navigate these troubled waters.  The stakes are high, the rules are complex, and we have no roadmap for future audits on these transactions.   The common thread I have seen is that each foreclosure or short-sale is surprisingly unique and there is no one-size-fits-all approach to handling them successfully.  Let’s start with an overview…

In a foreclosure, you stop paying the loan and the bank eventually repossesses the home and sells it.  In a short-sale, you find a buyer, but the buyer will not offer enough for you to pay off the loan you owe.  So you go to the bank and say, “Hey, I found someone willing to pay this much.  I know it is short of the amount I owe you, but will you let the sale proceed, and let me off the hook for the rest?”  These processes can take anywhere from three to 15 months from my experience, and in the end, most short-sales fail to materialize.  Another animal, deed -in-lieu of foreclosure, is where you voluntarily give the home back to the bank in exchange for cancelling your debt obligation.  A deed-in-lieu of foreclosure is rarely seen in California (zero out of my 80) because it does not absolve the bank of the junior lien holders on the property.  Liens can be tricky to find and the bank does not want to get stuck with your other debts.

I am often asked which is better for credit scores and future ability to buy a home.  I cannot tell you for sure – it depends on a lot of factors, but generally I think a short-sale is better for a lot of people (not all).  Whether it is a short-sale or foreclosure, credit scores will be impacted significantly – maybe 200-300 points.  With credit counseling you can typically rebuild it substantially in two to three years.   Your future ability to buy a home will often depend on the loan program (FHA, VA, conforming loan, jumbo, etc.) and how much money you can put down.  At this point, the best advice is to plan on three to seven years for foreclosures and two to seven years for short-sales (although I have heard less).  Given the vast number of people losing their homes, I tend to think banks will become more lenient than in the past.  I also think they will reward people who worked to accomplish a short-sale.

From a tax perspective, the big problem with these transactions is that they can create potentially taxable income…and a lot of it!  The reason for this is quite simple – by cancelling your debt, the bank effectively gave you money to pay off your loan.  Just as lottery winnings are taxable, so is debt that is cancelled.  Fortunately, the IRC also contains sections which allow you to exclude the income.  Next issue I will start discussing your tax options.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, Pacific Grove, CA, 93950.  He can be reached at 831-333-1041.

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