Should I try a short sale, file bankruptcy, or both? That is the question. Do short sales and bankruptcy make sense together? The answer is, not usually.
Often when people are in the eye of a financial storm they address problems piecemeal. They may try credit counseling for credit card debt, an offer in compromise for tax debt, and to get out from under a burdensome mortgage they might try the obvious: selling their house. The problem with this last idea is obvious, if the house is “under water” or, in other words, saddled with a mortgage worth more than the house, one can’t sell it without the lender’s permission. That’s called a short sale.
A short sale happens when a lender agrees to allow a person to sell his house for an amount that does not result in the mortgage being paid off. Along with mortgage modifications, short sales are a useful tactic to try when a mortgage is the main source of trouble. There are also significant credit reporting advantages to a short sale over the alternative, a foreclosure.
But in bankruptcy it’s a different story. The main purpose of a short sale is, after all, to get out from under a mortgage debt. This can be achieved by “surrendering” a house in bankruptcy. This is possible in either a Chapter 7 or Chapter 13 bankruptcy. The surrender to the mortgage lender, however, still will occur via a foreclosure. That’s how a mortgage lender gets the house back after it’s surrendered. This results in some credit reporting damage, but the homeowner walks away from the mortgage debt with no deficiency debt. Consequently, a short sale is often unnecessary when someone has multiple debt problems and bankruptcy is inevitable.
However, with all that being said, a short sale can be possible and even advisable if the homeowner has the energy and the desire to avoid a foreclosure on his credit record (in addition to the bankruptcy) after the bankruptcy case is over. The timing on these post-bankruptcy short sales can be tricky. Ask your bankruptcy lawyer if this is an avenue you are interested in exploring. He or she may be able to refer you to a real estate broker experienced in short sales.
Interesting perspective on doing a short sale After Bankruptcy. This guy hits it on the head and considerations for the IRS should always be a at the top of your mind when making any decisions.
Okay, I admit it. As bankruptcy counsel, I - like many of my colleagues- used to scowl at potential clients that came to me looking for a relatively quick "fresh start" in bankruptcy, while at the same time telling me that they were in the process of (or at least trying to) "short-sell" their real property.
A short sale is when the lender agrees to accept less than the amount that you actually owe, in order to pave the way for you to pass clear title to a bona fide purchaser.
In theory this sounds great. Many properties in today's market are significantly "upside-down" (i.e. worth less than the amount of the mortgage(s) on the property).
Savvy purchasers know that they are living in a buyer's market right now. Don't expect them to "overbid" the fair market value simply as a favor to you, to permit you to break even, or heaven forbid, actually make a profit. That's just not going to happen. And that's where the lure of the short-sale steps in. The "deal of choice"of a good many real estate agents and brokers today - well, if not by choice - perhaps necessity.
Why do agents and brokers like short-sales? (Note that there are plenty of reasons why they also despise them - but that's a topic for another day). In theory, these folks like short-sales because it allows them to price the properties at present day fair market value, not merely the "wishful" value of sellers still living in denial.
Short sales - at least in theory - put brokers and agents back to work doing what they do best: selling, or at least trying to move the real estate markets again.
And... after a lot of hard work - for the successful short sale - the broker and agent reap a well-earned reward - the commission - payable just like in the good old days of the real estate bubble.
And of course the real estate brokers and agents aren't the only ones that get put back to work. You've got mortgage brokers working for the buyers, title closers and title companies, appraisers and real estate attorneys, etc. Everyone goes back to work and (when things go well) they make money on the short sale, and of course the buyer gets a great deal compared to yesteryear's prices.
So why the scowling? Well, most consumer bankruptcy practitioners believe that if it's your intention to file for chapter 7 bankruptcy (fresh start), you're simply wasting your time and valuable resources in pursuing the short sale.
Here's the arguments that even I used to make:
1. "You are making money for everyone- except you!"
2. "What are you actually getting out of the short-sale? Not the one thing that you need the most - a general release of liability"
3. "Your short sale might trigger a taxable event - cancellation of debt income owed to the IRS"
All of these arguments are still valid ones -valid to this day. You do make money for everyone else. And in most cases, alas, your friendly lender will not let you off the hook for the difference between what you owe and what you actually pay the lender. They generally will reserve the right to sue you for the "deficiency" if you signed what's known as a "recourse" loan.
Even if they don't sue you, unless you were short-selling your primary residence, they can still whack you with a 1099-c (cancellation of debt income) that becomes a priority tax obligation (generally not dischargeable) in bankruptcy.
These are all indeed very good reasons to scowl - and to scowl still.
So why the sudden change of heart? If not an outright change, at least to give pause - to "revisit" the issue of the short-sale, even with an impending bankruptcy on the horizon?
Everyone learns from his/her own experiences. I've experienced the frustrations of several clients that thought that by simply "surrendering" their property in bankruptcy, they could wash their hands of it, once and for all. In text-book fashion, that's the way it's supposed to happen.
You would tell the Bankruptcy Court you intend to surrender the property. You might even move out and take up residence elsewhere. You would notify your lender that it's okay for them to go ahead and foreclose against the property only (otherwise known as obtaining an "in rem" judgment - not a personal judgment against you - i.e., it does not go on your credit report as a foreclosure).
And in pure textbook fashion, your lender quickly "swoops in" to cause an immediate changing of the guard - relieving you of the pangs and perils of your former home ownership by causing the instantaneous sale of the property to a new purchaser.
The reality for most homeowners in this situation, however, is staunchly different. For most, there is no immediate "swooping in" by the lender. No quick "changing of the guard." In most instances, your beloved former home will continue to sit empty. The hallowed halls wallowing in self-pity. Festering. And dreaming about the possibility of taking you - its abandoned homeowner - down with it.
You think I'm kidding? Well, until there is a changing of the guard, title to that bird's nest is still in your good name, bankruptcy notwithstanding. And that bird's nest has a real possibility of becoming a bee's nest if misfortune should cross its path.
Picture someone tripping and falling at your former residence. Guess who the first party is going to be, named in that lawsuit while you're still on title? I'll give you a hint: it's not Bank of America.
If mold starts to grow from the inside-out of that former residence because you cut off the electricity when you "surrendered" it in bankruptcy, guess who's going to face a possible stiff fine from the Department of Health or Environmental Protection Agency?
Claims of these types can accrue post-discharge (after your bankruptcy case is concluded). Meaning, those debts are new debts and your former bankruptcy case will not speak to them. And your former bankruptcy case will not protect you from them.
Folks, the list can go on and on. It's the gift that can keep on giving, and not in a very good way. These are the things you've got to think about, given the current economic climate, the glut of properties on the market and the vast number of foreclosures clogging our courthouses. Lenders are not really in all that much of a rush to make anything happen these days.
So instead of scowling, I'm suggesting that your best bet might actually be to hedge: file for bankruptcy and do the short-sale. For the simple reason that if there's one good thing that a short-sale will do for you, it will be to provide you with a measure of certainty and closure: that on a date-certain you are no longer the record-owner of that property and no longer legally responsible for it, if something should go dreadfully wrong.
Now it's a delicate dance that you've got to do. If that bird's nest wasn't your primary residence, and was simply investment property, timing here is of critical importance. If you execute the short sale before your bankruptcy, then it could trigger the dreaded 1099-c (cancellation of debt income) and lead to a possible non-dischargeable priority tax obligation owed to the IRS, in your bankruptcy case.
There is an exception to that cancellation of debt rule: if you can prove that you were "insolvent" at the time the transaction took place, you can avoid the tax liability.
I'm suggesting that the better practice may actually be to file the bankruptcy case first, and then look to short-sale the property. In most situations if you were contemplating a short-sale, the likelihood is that the trustee appointed to your bankruptcy case would have abandoned the bankruptcy estate's interest in that property - usually even before your bankruptcy discharge. If not, you'll want to request the abandonment from the trustee, before entering into any short-sale arrangement. (Legally, until the bankruptcy estate abandons the interest, it belongs to the trustee - not you).
The bankruptcy discharge (assuming you get one) will wipe out your personal liability on the promissory note to your lender. Once that puppy is gone, it ain't comin' back. Trust me.
I don't care if your lender has you sign something post-bankruptcy at your short-sale closing, saying that you acknowledge that they reserve all rights to proceed against you for any deficiency. It's not going to happen. On this point, the feds are pretty clear.
11 U.S.C. §524(c) states that a dischargeable debt in bankruptcy (i.e., your promissory note) can only survive your bankruptcy case, if the new agreement entered into with your creditor was "made before the granting of your discharge" and you received certain required "disclosures" and the new agreement "has been filed with the court", among other technical requirements.
Many short-sale lenders (in a tacit nod to the feds) will follow up their boilerplate acknowledgment by you, with a statement "unless otherwise prohibited by law." You obviously don't need their statement, since such an agreement made outside the watchful eye of the bankruptcy court is in fact prohibited by law.
So now you can go ahead and tabulate your game plan. You can get your discharge (if you're entitled to it) and finally rid yourself of that bee's nest - all at the same time (well, almost the same time).
Tell your broker or agent you heard it from a bankruptcy attorney first. They may actually thank you for it. More importantly, they won't have a reason to scowl at me and my colleagues any more.
Michael E. Zapin is a consumer bankruptcy practitioner and proud member of NACBA (National Association of Consumer Bankruptcy Attorneys) with offices throughout South Florida. Tel. 800-447-1329. Local 561-367-1444. Visit http://www.thebankrupter.com for more information.