In the wake of the real estate market meltdown and freefall of foreclosures in 2008-09, many homeowners, lenders and mortgage servicers quickly became very familiar with the ins and outs of foreclosure. For many, they found the short sale to be one of the last-ditch efforts to stave off foreclosure.

How Does A Short Sale Work? 

Short sales became fairly common after the real estate crash of the late 00s, when many borrowers found themselves owing more than their homes were worth after home values plunged. In a short sale, the net proceeds that come from selling the property fall short of what the borrower owes and what is secured by liens. Liens could refer to the note itself, or to mechanic’s liens or tax liens that have been levied against the property. If all parties involved can agree to accepting less than what’s still outstanding on the debt, then the short sale can go through.

For the short sale to be approved and to occur, the lien holders must be agreeable to taking a loss on the sale and a buyer has to be on board for a purchase that’s at or less than the property’s appraised value. An “agreeable selling price” will be then inherently be defined at a number that’s at or lower than the property’s appraised value. No bank will write a note for greater than the appraised value, and of course no borrower should offer more than appraised value in a depressed market.

The short sale will have a negative effect on the seller’s credit, although not as severe as a foreclosure would. It also doesn’t release the borrower from a “deficiency judgment” after the short sale, where the lender and lien holders can go after the borrower for the shortfall on the note or for any other outstanding balances still owed. Some states, including Arizona, California, Nevada, and Oregon, prohibit deficiency judgments after a short sale.

For the seller, while a short sale is negative in terms of credit score, it still demonstrates a sense of responsibility in that the seller tried to settle the note rather than letting the home be lost to foreclosure. On the other hand, the seller will then walk away from the deal without any money, making it tough to find another place to live. A short sale will also just about never be approved unless the note is already in default. In addition, a lender will seldom green-light a short sale if the seller has filed for bankruptcy, since a short sale is technically a collection effort and collections are prohibited if a bankruptcy has been filed.

The seller will receive a 1099-C (for Cancellation of Debt) from the IRS, and may also be eligible for exemption from tax liabilities if the short-sale property was a principal residence. It can also be itemized as a total loss on a Schedule D at tax time.

Buying a Short Sale Home 

While a short sale obviously puts the seller at a disadvantage, it can also be seen as a potential boon for an investor or anyone else interested in buying short sale homes. The buyer can get a piece of property at a price that’s substantially lower than market rate, and the lender might be willing to offer some pretty favorable financing since they will be eager to recover the money that’s still outstanding. In addition, the seller is usually pretty much at the end of their rope and will most likely already be out of the house (not always the case with a foreclosure).

On the other hand, it can get complicated:

  • There’s a good chance the property is going to be in rough condition and will need remodeling or repairs.
  • There may be liens and second mortgages that aren’t apparent at first glance.
  • The lender has to be open to the purchase, and has to be amenable to financing in a way that’s favorable to you.
  • There may be proposals, counter-proposals and negotiations.
  • State laws can vary greatly in the details of this process.

In other words, there’s likely to be a considerable amount of red tape involved before the deal is closed. In addition, the housing market has recovered and is back to boom status again in many parts of the country, which is a dramatic turnaround from the days of 2008-09. That means that short sales are going to be harder to come by, and lenders may be less inclined to sign off on them. Still, if you’re a savvy investor or a home buyer who’s looking for a great first-time starter home, real estate short sales can be worth hunting down. Just make sure that you know the pros and cons before getting in too deep.