When real estate is sold for more than the outstanding balance owed on the mortgage loan on the property, the lender is paid in full at the closing from the buyer’s funds, and the seller pockets the excess.  Everyone is happy. Such was the world before 2008.  

But, if the property is being sold for less than the outstanding loan, the lender comes up short at closing and there are no proceeds for the seller to retain. Indeed, the seller must then dig into his pocket for funds with which to pay the shortfall to the lender. Or, the seller can try to do what is referred to as a “short sale.”

Simply stated, a “short sale” is the sale of any real estate – residential or commercial – for less than the balance owed to the lender holding the lien on the property, with that lender’s approval of the sale. A seller is not required to obtain the lender’s permission to sell the property as long as the full balance of the loan is repaid at closing, and when the lender is paid in full, it is legally obligated to release its lien. With a short sale, however, the lender’s approval is required to sell the property because the bank will need to release its lien in order for the sale to be completed, and only the lender has the authority to agree to release its lien in exchange for a payment of less than the full mortgage balance owed. A lender has no obligation to release its lien when paid anything less than the full balance owed.

Mere decline in a property’s value below the amount of the outstanding loan balance does not qualify the seller for a short sale. Most lenders will not consider an application for a short sale without a demonstrated financial hardship. Typically, this means that a homeowner will have to miss one or more mortgage payments in order to have sufficiently demonstrated to the lender that financial assistance is warranted. While lenders have come to realize that short sale transactions are often better options than foreclosing on the mortgage, they usually assert that if a borrower is current with his payments, the borrower doesn’t need the lender’s assistance, and the short sale application is denied.

Demonstrating financial hardship is not limited to missing mortgage payments. It will also likely entail providing financial statements, check stubs, unemployment stubs, bank statements and tax returns to prove the hardship. It is not uncommon that a short sale will be denied by the lender because the lender finds that the homeowner “strategically defaulted” in order to be considered for short sale approval (i.e. the homeowner purposefully failed to make its mortgage payments in order to be considered for a short sale). Unless the seller can prove that his monthly expenses exceed his monthly income, the short sale may be denied.

Most lenders will require the seller to list the short sale property with a real estate agent for the current fair market value of the property. Short sale applications for significantly less than the fair market value of a property will almost certainly be denied, and “for sale by owner” transactions are almost never approved for short sale.

After a short sale is completed, the lender has a choice to either write off the deficiency balance, or pursue the borrower for the deficiency. More often than not, lenders write off the deficiency balance.  That can create another problem for the seller: the amount of a forgiven debt is treated as income to the seller for federal income tax purposes. At year’s end, the lender will send an IRS form 1099C to the seller. If the seller is solvent (i.e. if he is able to pay his debts as they become due) at the time of the short sale, the tax consequences for the bank’s forgiveness of debt could be substantial. However, if the seller’s total debts exceed the fair market value of his total assets at the time of the short sale, some or all of the cancelled debt may not be taxable. This should be explored carefully.

The seller may also find his credit score impaired as a result of the missed mortgage payments and the reporting of the debt after a short sale as “paid for less than full balance.” The drop in credit score may make it nearly impossible for the seller to purchase another property with conventional financing during the seven years that the foreclosure remains on his credit report. On the other hand, completing a short sale can help build the credit score more quickly by eliminating the debt and allowing the person to focus on making timely payments toward his other debts.

Sellers of property worth less than the outstanding mortgage balance on the property should carefully weigh their decision to sell the property before making an election to complete a short sale, but if a financial hardship arises, a short sale may be the best option.


Crystal L. Siver
Attorney at Law
(708) 724-6959 - Direct