With distressed properties, including foreclosures (or REOs)
and short sales, making up about half of all single-family home
sales in California in January, according to the CALIFORNIA
ASSOCIATION OF REALTORS®, many underwater sellers will
face the tough decision between a foreclosure or a short sale.
Some of the most important factors to consider before making
the decision include deficiency judgments, tax implications,
credit consequences and timing.
Deficiency Judgements and Tax Implications
The good news is that California offers some protections for
consumers against deficiency judgments after short sales and
foreclosures. A homeowner is generally protected against a
deficiency judgment after short sale for a one-to-four residential
unit property. The instances in which a homeowner is generally
protected against a deficiency judgment following foreclosure
include, among other things, a non-judicial foreclosure or a loan
that is all of the following: 1) owner-occupied, 2) secured by a
one-to-four unit dwelling and 3) purchase money. Homeowners
are also protected against deficiency judgments after
foreclosure of seller financing.
Sellers may be responsible for taxes on, among other things,
cancellation of debt (COD) income, which is approximately the
difference between the outstanding loan balance and the fair
market value. The exceptions to being taxed on COD income
include bankruptcy, insolvency and forgiveness of a
nonrecourse debt after foreclosure.
Nonrecourse debt in California is when a loan is made to
purchase a one-to-four unit, owner-occupied property or
when the seller carries back financing. In the case of a short
sale or foreclosure, the Mortgage Forgiveness Debt Relief
Act of 2007 also provides an exception from federal taxation
when the following conditions are met: 1) property must be a
qualified principal residence as defined, 2) loan is secured
by the residence, 3) income relief is capped at $1,000,000
for married couples filing separately and $2,000,000 for all
others, and 4) loan is discharged after January 1, 2007 and
before January 1, 2013. Additional rules apply under
California law.
Credit Consequences and Timing
Credit may be adversely affected regardless of the type of
sale—foreclosure or short sale. Credit score declines can
vary and the negative mark may remain on the credit report
for seven years. Both foreclosures and short sales might
affect the ability to quality for a loan to purchase another
home. In some short sale cases where the seller may have
even been current with mortgage payments but sold the
home for less than the outstanding loan amount, the credit
report could indicate that the debt was settled for less than
what was owed and the impact may be less severe.
In the event of a foreclosure, a borrower may not be able to
qualify for another home loan for seven years without any
extenuating circumstances, or five years with extenuating
circumstances, under current Fannie Mae guidelines. The
wait may be less with short sales. If payments are in arrears
in a short sale, buyers may qualify to purchase another
home within about two years for a Fannie Mae backed
mortgage, or approximately three years for a FHA loan. If
payments were current, consumers may qualify for another
loan immediately, but it can be difficult to find a lender.
Exceptions and additional considerations apply to the
conditions discussed, depending on individual
circumstances. For consumers facing these difficult choices,
it is advisable to seek professional assistance from an
attorney and/or an accountant who can evaluate your
specific situation.
