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Arizona Short Sale - If bankruptcy is in your future, be careful

Selling your home “short”… What does this mean and why would you want to consider it?

When homeowners sell a home “short”, they are asking the lender to agree to the sale even though they will not be paid the total amount of the mortgage.

The common Scenario:

Home purchased in 2006 for $480,000.00. The first mortgage amount is $370,000 and a second for $85,000.00. The house is now worth $320,000.00. A buyer exists who wants to purchase the home for about $320,000.00. If the lenders that hold the first and second mortgages agree to the sale, they will be paid less than they are owed.

In theory, this sounds great for the homeowner. He or she can avoid the foreclosure stigma and all its hassles and move on with life more quickly.

The question is then, why would the seller who is considering a bankruptcy, want to be careful about doing it?

1. From a debt liability standpoint, it may be unnecessary.

In the scenario above, both the first and second mortgage holders will lose money. Normally, they could sue the homeowner for the deficiency balance either after a foreclosure sale or after a short sale anyway.

However, Arizona state law prohibits the collection of the deficiency balance on a residence in most instances, especially where the loans are “purchase money” and a foreclosure would be “non judicial”. Further, the lenders may agree in writing, not to sue on the deficiency.
If they don’t waive that right, or if it is otherwise collectible, then bankruptcy may be the best way to deal with it. Especially, if bankruptcy was going to be used anyway, to deal with all issues at once.

So, if the sole purpose of the short sale is to avoid a deficiency based collection action, be careful.

2. It may damage credit.

If you don’t pay or breach the contract, the lender will report it to the credit bureaus. Some say that the effect on the report is as bad as or worse than foreclosure or bankruptcy.

3. Taxable event
A short sale causes a “taxable event”. In essence, the unpaid difference is treated as income to the seller. There are ways to avoid the “income” from being treated this way. Primarily, the Federal Mortgage Forgiveness Debt Relief Act must apply to the seller; the seller must meet an “insolvency” test or file for bankruptcy (preferably prior to a foreclosure sale).

Before the short sale is finalized, the seller must make sure #s 1 or 2 apply or timely file for bankruptcy.

4. There are lots of players who make money from the short sale, and the seller isn’t one of them
The list of players in the system who stand to make money from the short sale is lengthy. Other lenders, brokers, real estate agents, title agencies, escrow agencies, the IRS, and the buyer all stand to come out farther ahead then the seller. If bankruptcy is going to be used anyway, all of the effort made to complete the short sale may be a waste of time.

5. Other debt
If the seller has a substantial amount of other debt, and his or her circumstances make it clear that bankruptcy may be necessary anyway, then why bother? The seller may simply choose to file the bk, give up the home in the bankruptcy and discharge all the debt. (A foreclosure may still appear on the credit report and the question becomes which is worse again)

6. Chapter 13 bankruptcy may help save the home
A chapter 13 bankruptcy will allow the qualifying filer to catch up home mortgage arrears over time. It may also allow the homeowner to treat the completely unsecured second mortgage as an unsecured debt and wipe it away leaving just the first mortgage payment to contend with.

If the home is worth less then is owed on the first, (like in our scenario) and the seller has steady income, a chapter 13 bankruptcy is at least worth talking about with your attorney before the short sale is complete.