It’s no secret that the real estate market is in the bathroom. Borrowers are facing foreclosure. They are being bombarded with ads from real estate agents and brokers urging them to sell their homes (or investment properties) “short”—that is, for less than what is owed on the property. Some wonder whether they should file for Chapter 7 or Chapter 13 bankruptcy. Homeowners are understandably confused by the conflicting information out there.
Yesterday I received an email from a real estate agent with wrong information. There was a long and detailed description of the distinction between the effects one versus the other has on a borrower’s ability to get a new mortgage. I won’t go into the details of the comparison, but you’ve probably already guessed which resolution the broker proclaims victorious: short sale! I am never again surprised when this happens. No disrespect to the real estate industry. Some of my best friends are agents.
There is the possibility of quite complicated and expensive tax ramifications for almost all forms of disposing of debt, except through bankruptcy. There is a special provision in the Internal Revenue Code (which we all appreciate so much) for debt discharge in bankruptcy. That debt that is “forgiven” cannot be taxed. Well, what would it be like anyway, you ask? Because most debts that are “forgiven” will generate a 1099 form from the lender. It’s what I call “phantom income.” You didn’t actually pocket any cash. But in the eyes of the IRS, YOU DID IT. Is that how it works. Let’s say you sell a short house. You owe $500,000 and it sells for $400,000. The bank signs the sale, lets the deal close, and in this case, is not going to sue you for the $100,000 they didn’t pay you. But the bank will issue a 1099 for the $100,000 as “forgiven debt.” Oh! Did the bank or agent talk about THAT when you were first signing the listing contract and then the escrow instructions? I’m often thinking, no. Now, you may be in big trouble with the IRS.
Many people don’t realize that not all short sales are created equal. Sometimes you can negotiate some of these terms with the lender. Still, many borrowers don’t bother asking because they aren’t aware of the risks of getting a 1099.
Anyone seriously considering a short sale should also, and first, consider bankruptcy. One of the beautiful things about bankruptcy is that it eliminates the debt on the home (and other debt as well), so the debt isn’t even reported on the borrower’s credit report. And because of that special exception in the federal tax code, no tax will be owed on that debt that is eliminated. The ideal short sale occurs AFTER a bankruptcy, not before. Ironically, however, many borrowers sell short to AVOID bankruptcy. Because? Because they’ve been told, wrongly, that a short sale will be better on your credit report than bankruptcy, usually. Realtors beware: advising a delinquent borrower NOT to file for bankruptcy may very well be characterized as you providing legal advice, and that without a license to do so.
My next article will address the distinction between how credit reporting agencies treat foreclosures, short sales, and bankruptcies. Until then, bye.
