Short sale - what is it and how does it work?

"Short sale" has become the new buzz word in real estate because of the huge increase in the number of foreclosures. This term refers to the process whereby a lender is asked to accept less than the unpaid balance of a loan which is in default in order to facilitate a sale of the property and avoid foreclosure. In many cases the bank would rather accept less rather than having to take the property back as a bank-owned property at the trustee's sale.

In the present Washoe County real estate market about one-third of monthly sales are bank-owned properties and one-third of monthly sales are short sales.

What's in it for the homeowner/borrower?

Homeowners are sometimes willing to go through this process in order to avoid having a foreclosure on their credit record. This might also avoid being sued for a deficiency after a trustee's sale. The credit record is still going to suffer, but it won't be quite as bad as a foreclosure.

Not all homeowners will qualify for a short sale. The bank typically will ask for a hardship letter and financial records from the borrower. If the bank thinks it has a good chance to recover the whole unpaid balance, it may not agree to accept less.

What's in it for the bank?

From the bank's perspective, it's all a matter of economics. The bank does not want to take the property back if it can avoid it. Holding a foreclosure property in inventory ("real estate owned" or "REO")has a negative impact on the bank's financial records because the REO is a non-producing asset. Owning an REO hurts the bank's ability to make additional loans, which is how the bank makes money.

When a bank takes back a foreclosure property, it knows that it will incur expenses to sell the property. These expenses include real estate commissions, potential deterioration and damage to a vacant property, further loss of value as the market declines, insurance, taxes, administrative expenses, and lost opportunities. When the bank weighs the anticipated expenses and days-on-market against the benefits of a short sale for a known amount within a known period of time, the bank may decide that it's in its best interest to accept the discounted payoff. It's all in the numbers!

How do you go about it?

First, the homeowner should anticipate receiving a flood of postcards and letters from real estate investors as soon as the notice of default (NOD) is recorded and becomes public record. For a discussion of the foreclosure process, click here. There are some very knowledgeable and honest investors who well understand the short sale process, and there are others who don't meet that standard. It's important to ask for references.

From a homeowner's perspective it usually makes sense to list the property for sale with a licensed real estate agent who is familiar with the process. In almost all situations the bank is going to demand proof that the property has been listed and on the market for a minimum amount of time before the bank will approve a short sale.

Most lenders won't consider this process until the borrower is in foreclosure, that is, until after the NOD is recorded. It's amazing how the banks' attitudes change once the NOD is filed. Partly this is because the loan is then transferred from collections to the loss mitigation department.

A first step is contact the lender's loss mitigation department. This can be a frustrating and time consuming experience. The first frustration might be getting the right phone number for the bank. Sometimes it can be obtained from previous collection letters, and sometimes it can be obtained from the office conducting the foreclosure sale. There is usually a contact number and a loan number on the NOD.

The next frustration involves an unending menu of automated telephone announcements from which the caller asked to make a selection. As soon as contact is made with a live person, it's important to attempt to get a name, a direct extension, and a fax number in order to avoid the phone tree process every time you call.

Under federal privacy laws the bank won't discuss any credit matter without a written authorization from the borrower. If the person working on the short sale isn't the actual borrower, it is critical to fax a written authorization from the borrower to the bank to start the process. The authorization should include the borrower's name, signature, social security number, and date. It should also include the name of the person(s) to whom the borrower is giving the authorization. It's also important to have the loan number(s) and the property address.

Once the bank has the written authorization and is willing to talk, the next step is to ask the loss mitigation department for a short sale package. This package will include the paperwork which the lender requires to process the request. It almost always includes:

A hardship letter from the borrower detailing why they are asking for help - the sadder, the better. This letter doesn't have to be fancy or formal. In fact, it may help for it to be handwritten.

A financial statement - often on the lender's own form and usually including information about assets, liabilities, income and expenses.

Bank statements and copies of tax returns.

A preliminary net sheet. This form is often referred to as a HUD-1.

This is an estimated closing statement showing the proposed sales price, the estimated closing costs and real estate commissions, and how the proceeds will be distributed. One rule of thumb is that the bank isn't going to approve any sales proceeds going to the seller - the lender won't want the borrower to get a dime! If the foreclosing bank is the holder of the 1st deed of trust, it may approve a small payoff to the 2nd deed of trust, but not much - often $5,000 or less. The HUD-1 is usually prepared by the real estate agent, an attorney, or the title company.

The purchase agreement.

A comparative market analysis (CMA) giving information about comparable property sales and values.

It's also a good idea to include a detailed description and photographs about the physical condition of the property and required repairs. Repair estimates from licensed contractors help to fortify this information.

The bank is also going to want proof of a listing agreement and proof of the buyer's ability to complete the sale.

The short sale package as detailed by the bank should be submitted in its entirety - not piecemeal! Because of the huge volume of foreclosures, a deficient package may not get a second look.

After the lender has received all of the requested documentation, it will order an appraisal. In order to save expense, banks prefer to order a "Broker's Price Opinion" (BPO). In Nevada, however, state law requires a licensed appraiser to give opinions of value about real estate, and the Nevada Real Estate Division has issued warnings telling licensed brokers and agents that they cannot give BPOs except in connection with a listing or sale of the property for their client.

The appraisal is a critical part of the process. The bank will make its decision about how much it will discount on the appraisal. It doesn't matter how much is owed. What matters is the amount of the BPO. It therefore stands to reason that the lower the BPO, the better the chances of getting an approval of a short sale from the bank.

If the bank approves a discounted sale, it will require a quick closing, and it will want all cash! Usually the bank will not be interested in financing the new buyer.

Other issues . . .

The IRS has long taken the position that the forgiveness of debt is a taxable event. Thus if the lender discounts the amount owed by $20,000 and it forgives that debt, the IRS may take the position that the debtor has received $20,000 in taxable income. That rule has been softened somewhat as to personal residences by the Mortgage Forgiveness Debt Relief Act of 2007. The borrower should seek competent tax advice about this issue.

Likewise, some lenders are requiring the borrower to sign an unsecured promissory note for the amount of the difference between what the bank receives and the unpaid balance. Whether that happens depends on the bank and the relative negotiating strength of the parties. If the homeowner won't sign the unsecured note, the bank may not approve the sale. Again, it's all about the numbers.

Finally, there is a potential that a bank could seek a deficiency judgment for the difference between what the bank receives and the unpaid balance of the loan. There is some disagreement about whether the bank can do this. Dave Guinan is of the opinion that a short sale precludes a deficiency judgment, but the issue has not been decided by a court.

In closing . . .

Short sales form a large part of the present real estate market. Anyone who is buying or selling property today must have an understanding of how this long and tedious process works. This is definitely an area where it would help to have an experienced attorney on your dream team.

Our firm is knowledgeable about these issues, and we would be pleased to assist you in this area. Please contact us by clicking here.