Foreclosure versus Short Sale?

I am frequently asked, “should I attempt to give a deed in lieu, let my property go to foreclosure or attempt a short sale?” My standard answer as a lawyer is, “It depends.”

Here are some of the pros and cons of each:

Deed in Lieu of Foreclosure:

Pro: It may be possible to negotiate a release of any claim for a deficiency.

Con:

• In most cases it’s not going to happen.
• If there are any junior liens against the property, such as a second deed of trust, judgment lien, or even homeowners association lien, the bank won’t take a deed-in-lieu because it would take subject to all junior liens. Even if there are no known junior liens, the bank still probably won’t do it because it doesn’t want to take that risk.
• Your credit rating is adversely affected.

Comments: Forget it!

Short sale:

Pro:

• It will allow you to continue living in the house - payment free - during what is usually a long, long period of negotiation.
• It may give you an opportunity to negotiate a release of liability for a deficiency. (Don’t hold your breath!)
• If a short sale negotiation is pending, the lender may be willing to continue (postpone) the Trustee's sale for 30 days . . . sometimes more.

Con:

• Short sale negotiations can be long and tedious, and it’s not uncommon never to talk to the same person twice.
• It’s necessary to furnish the lender financial statements, bank records, income tax records, and a hardship letter as a part of the short sale package. (If you have substantial other assets, you are showing the bank where to look if there’s a deficiency.)
• There is a potential income tax consequence. Under usual tax law, forgiveness of debt is a taxable event. This has been changed temporarily for principal residences, but it’s probably not going to last.
• It often seems that logic does not play a part in short sale negotiations.
• Your credit rating is adversely affected.

Comments:

• Most lenders will not consider a short sale unless the loan is in default, i.e. you have to quit making your payments in order to get them to talk to you.
• Short sales are much more difficult if there is a second deed of trust. You have to talk both lenders into accepting less than what they’re owed, and the first lender usually won’t agree to give the second very much.

Foreclosure:

Pro:

• There’s no negotiation involved.
• You can stay in the property payment free during the foreclosure process – a minimum of four months, but usually more as a practical matter.
• You don’t have to give the lender current financial information.
• You get the anti-deficiency protection of NRS 40.455. In brief, if there is a deficiency, the lender must file a lawsuit to collect the deficiency within 6 months or the claim is forever barred. (For deeds of trust in place before October 2009, I think the time period is reduced to 90 days, but this hasn’t been tested.) This is a big “pro.”

Con:

• Your credit rating is adversely affected. There may be questions on future credit applications about whether you’ve ever had a foreclosure.
• The lender is unlikely to continue the Trustee’s Sale unless it’s for their benefit.

Comments:

• You are not protected from a deficiency claimed by a second lender if that lender’s security is wiped out when the first forecloses.
• For purchase money first deeds of trust from an institutional lender on a principal residence recorded after October 2009, there can be no deficiency award. Note: My above comments may be too conservative. There is an opinion held by some attorneys that the purchase money deficiency protection extends to all purchase money deeds of trust from institutional lenders IF the foreclosure is commenced after October 2009.
• According to Craig Watts, a spokesman for Fair Isaac, the maker of FICO scores, “To the FICO score, there is very little difference between a short sale, a deed-in-lieu or a foreclosure — and we’ve been saying that to anybody who will listen, but this rumor that short sales are somehow benign has persisted.” See The Truth About Short Sales and Their Impact on Your Credit. by John Ulzheimer.

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