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New Seasoning Requirements To Obtain Traditional Mortgage Financing Following a Short Sale or Deed-in-Lieu

The Arizona Association of Realtors form of Short Sale Addendum to the Residential Resale Real Estate Purchase Contract contains the following disclaimer: “Seller acknowledges that Broker is not qualified to provide financial, legal, or tax advice regarding a short sale transaction. Therefore, the Seller is advised to obtain professional tax advice and consult with independent legal counsel immediately regarding the tax implications and the advisability of entering into a short sale agreement.”

Sellers should not dismiss this cautionary statement. Short sales involve potential consequences that sellers might not expect. Here are a few key reasons why sellers should seek tax and legal advice so they can enter a short sale armed with good information.

Your lender may be able to sue you after the short sale A short sale occurs when a lender permits a homeowner to voluntarily sell their home even though the lender receives less from the proceeds of the sale than the outstanding balance on the loan. Unless the lender gives the homeowner a written release of liability, the lender could sue the homeowner for the unpaid balance of the loan (also called the deficiency). Some lenders even include in their short sale approval agreement an express provision reserving the right to sue the homeowner or require the homeowner to sign a promissory note for the deficiency.

In contrast, the anti-deficiency provisions contained in Arizona’s foreclosure statutes protects many (but not all) homeowners from liability to the lender after a foreclosure or trustee’s sale. A desperate homeowner might be grateful to learn the bank approved a short sale and rush to sign the bank’s approval agreement only to later face a lawsuit from the lender for a substantial liability. If anyone wonders whether banks would really pursue borrowers for deficiencies, they should consider lenders’ recent and ongoing efforts at the Arizona legislature to severely reduce the scope of the anti-deficiency statutes.

You could owe taxes as a result of the short sale Even though the seller receives no cash at closing in a short sale, the seller might owe taxes on the short sale. There are two possible types of taxes from a short sale – taxable cancellation of debt income (or COD income) and a taxable gain from the sale of the house.
Generally, if a lender cancels a debt, the cancelled debt will be COD income unless the borrower qualifies for an exclusion. Exclusions include qualified principal residence indebtedness and insolvency. Cancellation of a non-recourse debt (meaning a loan for which the lender’s only remedy the borrower’s default is to foreclose) does not result in COD income, but there can still be a taxable gain.

As strange as it may sound, a seller can have a taxable gain on a short sale. The gain or loss on sale of a property equals the difference between the seller’s adjusted basis in the property and the amount realized. In the case of a non-recourse loan, the entire unpaid debt immediately before the sale constitutes the amount realized for tax purposes.

Attempting a short sale does not stop a foreclosure Short sales are an alternative to foreclosure, but pursuing a short sale does not prevent a foreclosure. The short sale is a voluntary agreement between the homeowner and the lender. The lender doesn’t have to cancel a foreclosure until it approves the short sale (which can take months). If the seller can continue to make payments, this won’t be an issue. Otherwise, the clock will be ticking.