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Short sale best in the long run?

It's often the better option for an owner than foreclosure -- but there are pitfalls, including tax liability.

August 05, 2007|Sam Byker | Times Staff Writer

Selling "short" is an alternative to foreclosure that has been gaining popularity as more homeowners default on their mortgages. Susan M. Wachter, a professor of real estate, finance and city and regional planning at the Wharton School of the University of Pennsylvania and assistant secretary of Housing and Urban Development under President Clinton, talked with us about this option. Here is an edited transcript of her comments:

Question: What is a short sale, and why would a homeowner attempt one?

Answer: A short sale is a home sale that doesn't cover the amount owed on a mortgage. Generally, the homeowner can't keep up mortgage payments and must sell or default on the loan. In addition, the home's value may have fallen since the mortgage was made, so the sale price will fall short of what is owed. The homeowner must negotiate with the bank in order to convince them to accept the home's sale price in lieu of the full value of the mortgage.

Selling short is likely a better option for the homeowner than foreclosure, if it can be done. The major advantage is that it will have less of a negative impact on one's credit score. There may also be a feeling of not wanting to walk away from the mortgage -- this is a way of negotiating a way out as opposed to just being foreclosed upon.

Question: What are the potential drawbacks?

Answer: There are several pitfalls with a short sale. The main one is tax liability. The amount forgiven by the bank is essentially regarded as income, and that may cause a significant increase in dollars owed at income tax time.

Homeowners must spend a lot of time negotiating with their banks, and even if they're successful there, they still have to sell their homes. That can be especially difficult in a down real estate market.

If housing prices are strengthening or if they are likely to strengthen over time, it may be better to hold on and try to renegotiate the mortgage.

Question: Why do banks accept short sales, and what factors do they consider when weighing a request?

Answer: From a bank's perspective, short sales actually have a lot of appeal, because when forced to foreclose and sell to recover the mortgage, their losses range up to 50% of the amount owed. A short sale is a way of mitigating these losses -- of getting less than the mortgage, but more than a foreclosure would bring in.

The bank has a choice as to whether or not to negotiate a short sale. Banks are much more willing to negotiate if they feel that the decision to attempt a short sale is unavoidable -- that is, it isn't under the control of the borrower. What banks certainly want to avoid is encouraging people to simply walk away from loans for no legitimate reason. Evidence of financial hardship is very important -- if you've lost your job, if there's illness, etc., all of that matters.

Every seller needs to negotiate with his or her bank as to how much it will accept -- how short it will allow the sale to be. This raises a number of complicating questions, because it involves both how much the home will be sold for and how much the broker is going to get. Banks may not accept a full commission rate for your broker, and that complicates things.

Question: Why has the number of short sales increased recently, and what effects could that increase have?

Answer: We're hearing about short sales now because we have price declines in more markets today than we've ever had in the history of the United States. Defaults are continually happening to a percentage of American homeowners, but typically, one can sell one's home for more than it was purchased for.

Today, you often can't sell your home for what you purchased it for in 2005 or 2006. That's what makes short sales so common in many markets.

As the phenomenon of short sales becomes more pervasive, it will have effects on the overall market. Much like foreclosures, short sales are different from normal home sales.

A majority of properties are put on the market for a specific price, and if that price isn't matched, the seller can just keep the property on the market. Short sales put more of a downward pressure on prices -- not just for the short-selling homes but also for the housing market overall.


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