Q: I am in over my head on a condominium and cannot make the mortgage payments any longer. Friends of mine have told me I should try a short sale. Other friends tell me I should just deed it back to the bank. Can you explain these options?
A: Many people bought property that they can no longer afford. Some of those involve the adjustable rate mortgages with extremely low starter rates. Others involved loans that the lenders simple should not have approved in the first place. In any event, our country is faced with a large number of real estate loans that the borrowers cannot afford.
The easiest option would be to give the property back the bank. The bank must accept the property for that to be a viable option. You can not merely sign a deed, record it and be done with it.
Deeding to the bank is known as a deed in lieu of foreclosure. The bank accepts a conveyance of the property and releases the borrower from further liability under the mortgage. In some cases, the bank accepts the property but does not completely release the borrower.
When the bank accepts a deed in lieu of foreclosure, the bank investigates the property to be sure it does not have any other liens, such as a second mortgage, home equity line or mechanics lien for improvement. If such liens are present, the bank usually wants them released or it will refuse the deed in lieu. If the bank forecloses, the foreclosure process will wipe out the inferior liens so the bank will usually prefer foreclosure over a deed in lieu where there are other liens against the property.
The bank also will appraise the property to determine value and review the borrower's financial position to see if the bank agrees the borrower is not financially strong enough to continue the mortgage. If those criteria are met, the bank may accept the property and discharge the debt. Banks are more reluctant to accept a deed then they are to foreclose. If the bank forecloses and the property is worth less than the mortgage debt, the bank can also obtain a judgment for the difference against the borrower. In the typical deed in lieu scenario, the debt is discharged and the bank is left holding property that may be difficult to sell.
A short sale is a sale in which the lender agrees to accept less than full payment of its mortgage and to release the mortgage lien from the property at closing. As with a deed in lieu, a short sale requires convincing the lender that it is in the lenders best interest to accept the deal. That usually requires proof that the borrower is in weak financial position and that the proposed sale is at or near market value for the property.
The short sale is to a third party buyer, not to the lender. The lender will review the borrower's financial position and may even require tax returns. The lender reviews the contract, has the property appraised, and has to approve the closing statement. The lender sometimes will limit the commission to be paid, will usually refuse any unusual expenses and will always mandate that the borrower receive nothing from the sale. If the lender is receiving less than full payment, the lender is certainly not going to allow the borrower to get anything.
In a short sale, the lender usually accepts whatever money it is going to get from the sale as payment in full of the mortgage. Where the borrower has other real estate or financial resources, the lender may require the borrower to sign a new note for part or all of the shortage or a new mortgage to transfer the shortage to other property.
What can be a surprise to the borrower after closing is that the borrower may have to pay income taxes on the amount of debt that is forgiven. This is true even in a foreclosure. If the borrower does not have to repay the entire debt, the portion not paid is forgiveness of debt income.
There are some exceptions to taxation of forgiveness of debt income. It is not generally taxed if the forgiveness is in connection with a debt secured by the taxpayer's principal residence. There is also no tax if the cancellation is due to bankruptcy, the taxpayer is insolvent or certain business related debt.
As you can see, there are many factors to consider when trying to get out of a mortgage you can no longer afford. Before proceeding further, I suggest you consult with an experienced attorney and discuss the potential tax ramifications with your CPA.