Tell lender to forget short-sale shortfall

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Dear Real Estate Adviser,
What happens to the difference between what’s owed on a mortgage and what the short sale brings? Is the owner responsible for paying the difference and paying taxes on it? Are there any special clauses to find a way around this?
— S. Lerner

Dear S.,
That difference between what you owe and what the lender received in a short sale, simply known as the deficiency, can be sought by lenders in more than half the states through something called a deficiency judgment.

However, lenders in those states may agree to give you a full or partial waiver of your deficiency in order to clear the mortgage off their books. You can try to negotiate this personally or have your agent or attorney attempt it. If accepted, you’ll have to make sure that appropriate “no-recourse” language is inserted into the final agreement, stipulating the lender must accept the sale price and has no recourse to collect the difference against you.

First, research your own state’s foreclosure laws to see where you stand. and other sites feature basic summaries of each state’s laws and deficiency practices. Lenders can seek deficiencies in more than 30 states, including New York, Florida and Texas. California, on the other hand, is a “nonrecourse” state and typically doesn’t allow deficiency judgments for purchase loans. There are exceptions: In California, for example, refinanced mortgages may be subject to deficiency judgments.

Lenders won’t always pursue the difference in those states that allow deficiency judgments because of the legal costs and the difficulty of asset recovery. However, some will wait years to pursue you, depending on state laws, presumably to allow you time to amass assets again.

Even if they can’t get the lender to forgive the deficiency, most people elect to still move forward with a short sale for a variety of reasons. They may want to stop the payoff clock, avoid foreclosure, push the deficiency obligation to a later date or avoid legal fees. Or they may believe the lender will eventually write off the loss and not attempt to collect it. If the lender does try to collect, some will then file bankruptcy.

There’s a little good news for you. Prior to the passage of the Mortgage Forgiveness Debt Relief Act in 2007, any such debt forgiveness was considered taxable federal income. But now, as long as your mortgage debt is for your primary residence, the discharged debt is not considered federal income under the act, which applies through 2012. By the way, the forgiven debt cannot exceed $2 million (or $1 million if married filing separately). These rules also apply to mortgage debt forgiven from foreclosure and refinancing, as long as the refinancing was done for the purpose of substantially improving your residence.

Warning: Some states still consider any forgiven mortgage debt as income, which must be accounted for on state tax returns.

Here’s hoping the pain is short-lived in your short sale. Good luck.

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