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Do the Homeowners Owe Money after the Short Sale?

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Posted on: 09/08/2008
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Short Sale Magic - Do the Homeowners Owe Money after the Short Sale?


The homeowners need full disclosure concerning all of their foreclosure questions surrounding your negotiations with the bank.  They want to know what will happen before, during and after the short sale.  Don’t let them believe that short sale magic will make their mortgage debt go away entirely.   


In a typical short sale deal, the investor performs some short sale magic and negotiates a purchase price that is lower than the amount of the homeowner’s mortgage on the property.  For example, the homeowner may still owe $100,000 on the property but you negotiate with the bank to purchase that property for $70,000.  This gives you a discount of $30,000 on that property, but the bank and the homeowners still need to deal with that remaining debt. 


After the short sale, the bank has two options for dealing with the remainder of the mortgage debt.  Both of these options do mean that the homeowner owes money on the short sale, at least on paper.  The bank can seek to sue the homeowner for that remaining debt by seeking a foreclosure deficiency judgment or the bank can send out a 1099 form calling that $30,000 income for the homeowner. 


The Foreclosure Deficiency Judgment 

It’s important to provide foreclosure information to the homeowners about these pre-foreclosure investing deals.  It helps make sure; he or she is well prepared for a possible foreclosure deficiency judgment. 


A bank can file for a deficiency judgment against the homeowners after completing the short sale deal.  Both parties must show up in court and for the homeowners, it’s very much like being sued.  If the judgment is awarded the court declares that the homeowners still officially owes the bank the remaining $30,000.   


If you work your short sale magic on the bank during negotiations you can get them to opt not to file for a foreclosure deficiency judgment.  When investing in foreclosures, you’ll spend a lot of time putting together packets that show evidence of the homeowners’ financial hardship.  Most banks don’t want to kick the homeowners while they’re down.  If you can prove financial hardship was the reason the homeowners couldn’t make their mortgage payment, the bank usually agrees not to file for a deficiency judgment.   


You can use that short sale magic to also get the bank to sign a waiver showing that they’ll send out a 1099 form instead of filing for the judgment.  This will certainly help put the homeowners’ minds at ease.  Most times, however, they will not put anything in writing but will make a verbal promise not to go after the homeowner.  


Dealing with the Deficiency Judgment 

It may be possible for the homeowner to work a little short sale magic on the bank to deal with the remainder of their debt.  If a foreclosure deficiency judgment is filed against the homeowner, the homeowner may also be able to negotiate another short sale deal with the bank on that deficiency.  So, the bank would accept a partial payment on that deficiency and call it ‘payment in full’ on the homeowner’s credit. 


The homeowner may also be able to file bankruptcy and have that deficiency judgment cleaned from their credit history.  However, the homeowner must be made aware that they’ll have a bankruptcy listed on their credit history for the next 7 years instead. 


The 1099 Form and the IRS 

Most of the time in short sale investing; you’ll be able to get the bank to send out the 1099 form, instead of filing for a foreclosure deficiency judgment.  The amount on the 1099 Form has to be reported by the homeowners to the IRS as income.  So, naturally the homeowners will need to pay taxes on that income listed by the 1099 Form.  In the case of the previous example, the homeowners would need to pay income taxes on $30,000. 


When working in real estate investing you should always recommend to the homeowner that he or she speak with an accountant.  However, you can give them a few short sale tips, so they know basically what they’ll be able to do about the 1099 form.   


Many times the homeowners have been living in enough financial hardship that they won’t have to pay taxes on their 1099 Form.  They may qualify for an exemption based on the sale of their property or their hardship.   


The homeowner probably hasn’t earned enough income in the year prior to the sale of their home for the 1099 Form to have a significant impact on their taxes.  Assuming that the IRS requires 10% of all income, the homeowner would only owe about $3,000 on that remaining debt of $30,000.  That’s fairly light payment on a defaulted mortgage of $100,000.   


Plus, the homeowners may never receive the 1099 form from the bank.  This isn’t something to tell them to count on.  Yet, often the banks are so busy and tied up with red tape that the 1099 form is never sent out.   


When you complete that short sale deal with the bank, the homeowners will end up being responsible for the remaining debt on their mortgage.  This responsibility doesn’t necessarily involve paying back that amount to the bank, but the homeowner may end up with a foreclosure deficiency judgment on their credit or they could pay taxes on that remainder.  Often, you’ll find that the homeowner wishes to continue dealing with you, even after learning this vital foreclosure information.  If they do nothing and won’t work with you then they can guarantee that they’ll have some sort of recourse from the bank.  
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