Short Sale vs. Foreclosure: Which is Best?

This post is neither legal nor tax advice. Moreover, this post is focused on Washington State, and the laws of each state differ.  For actual legal or tax advice, you need to consult an attorney or tax professional about your specific situation. Rely on a blog for legal or tax advice at your peril.

Short Sale vs. Foreclosure: What’s the difference and is one better than the other? Many, many people now own property that is worth less than the amount owed on it.  Moreover, many people purchased the proverbial “starter home” within the last five years, and they’re ready to move on to their next home (commonly kids are on the way).  Under these circumstances, an owner can either sell the home and then write a check at closing for the balance owed — OUCH! — or get rid of the home with, hopefully, cancellation of the balance of the debt.

If you’re hoping to avoid the debt without repaying it in full — like most people — then you have essentially two options: You can either seek a “short sale,” or you can let the home go to foreclosure.  There are advantages and disadvantages to each. (For more about short sales, see “What is a Short Sale? The Short Sale Process In Washington Explained”.)

SHORT SALES AND FORECLOSURES SHARE A SIGNIFICANT DOWNSIDE

First, though, there is one disadvantage common to both: Your credit will be ruined.  Your credit score tells potential creditors whether you are a “good debtor,” i.e. whether you repay your debts on time and in full.  Unless you write that check at closing, you will not have repaid this very substantial debt on time or in full.  Your credit score will reflect that outcome.  Generally speaking, it takes credit scores seven years to fully recover from this sort of negative report.

ADVANTAGES OF A SHORT SALE OVER A FORECLOSURE

So what are the advantages of a short sale? First, a short sale will probably have less of a negative impact on your credit score over the long term.  Moreover, Fannie Mae guidelines now prohibit it from buying any mortgage issued to a debtor who had a short sale in the last two years, compared to seven years for a foreclosure.  Accordingly, if you think you’ll want to buy again anywhere from two to seven years down the road, a short sale is better.

DISADVANTAGES OF A SHORT SALE

What about the disadvantages?  There are several.

  1. It is hard to sell your home.  It requires a lot of patience and effort, and with a short sale you won’t see a nickel of the proceeds, which all go to the lender.  At the same time, banks are notoriously difficult to deal with in seeking short sale approval.  Plus, most short sales fail, so you will likely invest that effort without getting a good result.
  2. To sell the home you only need the lender to release its lien on the property.  In some instances, the lender will do so but will not release you from the debt obligation.  In that instance, you may need to keep paying for a house you no longer own — double OUCH!
  3. There’s even a downside if the lender does release you from the debt.  While you won’t have to repay the debt in full, you might be liable for income tax on the forgiven amount.  You will likely avoid that tax bill (the amount of the forgiven debt times your top tax rate) only if you are living in the home at the time of the sale. This is a temporary exclusion from income (until 2013) established by the Mortgage Forgiveness Debt Relief Act of 2007.

ADVANTAGES OF A FORECLOSURE

A foreclosure, on the other hand, may avoid many of the disadvantages that come with a short sale.

  1. A foreclosure requires virtually no work.  All you do is stop paying the mortgage, and you can continue to live in the home “rent free” until foreclosure.  You don’t need to even talk to the bank, let alone “negotiate” some voluntary resolution.
  2. A foreclosure extinguishes the debt being foreclosed, so you don’t have to worry about continuing to owe money on a house you don’t own. Note that the debt of any second mortgages or other junior lien will survive foreclosure of the first mortgage, so be very careful if you have more than one mortgage.
  3. Finally, you are less likely to have any tax liability in the event of a foreclosure.  The law on this issue is still being sorted out by attorneys and courts, so there is no universally accepted analysis of this issue.  That said, a foreclosure will probably not lead to any income tax liability even if the auction price is less than the amount owed.

DISADVANTAGES OF A FORECLOSURE

The downside of a foreclosure?  As noted above, it’s worse for your credit.  Moreover, many people think it is simply wrong to not repay your debts, and a short sale is at least a good faith effort to mitigate the problem for everyone.  Simply allowing the property to go to foreclosure just punts the problem entirely into the bank’s lap.  But I’m a lawyer, not an ethicist :-) so I’ll leave it to you as to whether stiffing your creditor entirely is a disadvantage.

This post simply touches on some of the relevant considerations.  If you’re thinking of either a short sale or a foreclosure, you should consult an attorney or other tax professional about what is best in your specific situation.

Posted by Marc

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