What is a Short Sale?

If you are facing a mortgage loan default or foreclosure, a short sale can help wipe out your home loan. To understand if this is a good option for you, the following information will help you understand what a short sale is, how it works, the advantages and the pitfalls.

What Is a Short Sale?

A variety of factors can lead to a homeowner being behind on mortgage payments and unable to refinance. A declining housing market, usually accompanied by a rise in foreclosures also typically precedes economic slowdown and job loss. In a slow economy, many people find themselves unable to keep up with payments and facing default or foreclosure.

A short sale is an alternative that lets you avoid foreclosure. In a short sale a homeowner, with the mortgage lender's permission, sells the home before foreclosure. The lender agrees to apply the proceeds of the sale against the mortgage debt.

How a Short Sale Works

If you're convinced your current personal financial situation will end up with you defaulting on your mortgage loan and you think your home can sell for near its current market value, here's how a short sale works. You approach your lender for permission to short sale. It is important to note that even if this is the best alternative for you and the lender, the lender cannot approach you about this.

If the lender allows a short sale, the home will be appraised and listed with a real estate agent. Typically, the lender will allow you to accept an offer that is 90 percent of the home's current market value.

If the home sells, the lender takes the proceeds and cancels your debt. If there is equity remaining in the home, it is yours. But it is highly unlikely a lender will allow a short sale if the home's value and market conditions mean you end up with money in your pocket.

Advantages of a Short Sale

There are advantages for you and the lender in a short sale.

    * For the homeowner. You get out of debt and there is no foreclosure on your credit history.
    * For the lender. The lender avoids the lengthy and costly process of foreclosing on your home and selling it at auction.

Pitfalls of a Short Sale

If proceeds from the short sale of your home do not cover the full balance of the mortgage, a lender can request the difference from you. Typically in a short sale, the lender forgives the balance, but you should iron this out before starting the short sale process.

Assuming the lender does forgive the balance of your mortgage after a short sale, depending on your tax basis in the home, the IRS might treat the forgiven debt as income to you on which you would owe taxes.

Watch Out for the Appraisal Trap

A lender might accept a low appraisal on a home in hopes of selling it faster. That might seem like a good thing, it increases your odds of selling. But it also lowers the proceeds of the sale which increases the amount of the mortgage loan not covered. As listed above, that could mean more money you still owe or more money on which you owe taxes.