How Lenders Handle Deficiency After A Short Sale

Preforeclosure | What To Do When You Are Late On Mortgage Payments - Short Sales vs Foreclosures

Are you facing foreclosure and want to settle your debt?  If so, I’ve got the best option for you to salvage your credit and get you off the hook with the banks.  I’m going to show you how doing a short sale can satisfy your lender and enable you to move forward.  By understanding why your lender prefers a short sale to a foreclosure, you’ll see how you have more options than you realize.

What most people don’t realize is that a short sale is in the best interest of the banks, as it mitigates their losses.  The loss suffered by the lender—in this case, the entire financed amount of your home loan—is called a deficiency.  The lender will handle this with a few main processes.

Expect A 1099 From Your Lender

Choosing a short sale enables a homeowner to salvage their credit and settle their debts.  While this is the best alternative to foreclosure, expect that your lender will be sending you a 1099 tax form.  This is not as disastrous as you might think, for a few main reasons.

The reason your bank files the 1099 on the deficiency amount is to report the extra debt—and their lost income—to the IRS.  This doesn’t mean it’s a bad thing for you, as it’s technically a cancellation of debt.  In essence, the lender is writing off the loss as income to you.  Their loss is your gain, and the 1099 reflects taxable income to you.

When the lender sends you this 1099, they relinquish the right to pursue any more deficiency.  You might be worried at the taxes that you’ll now have to pay on this taxable income—but this is not necessarily the case.  A borrower that receives a 1099 resulting from a foreclosure or short sale can be forgiven from any IRS liability if they are insolvent.  This means that your debt and liabilities are greater than your assets or net worth.  Most people that have faced foreclosure or done a short sale fall into this category.

If you were running a business and you faced a loss, you’d want to write it off to avoid paying unnecessary taxes.  The bank is essentially doing the same thing.  Once they do, they won’t be able to purse the balance.

For Example: Let’s say your mortgage was $400,000.  After your short sale, the bank nets $250,000.  The loss of $150,000 is the deficiency amount that you’ll receive the 1099 for.

Promissory Notes and Cash Contributions

Depending on how collectible you are, the bank may have other means of collecting the deficiency judgment.  If you aren’t facing financial hardship after your short sale, the bank might make it a bit more difficult to settle your debt.  A lender may issue you a promissory note, sometimes called a “hope note.”  It’s a way for the bank to get more money out of the seller and requires you to pay a specified amount monthly over a number of years.

There are four reasons a bank might ask you to sign a promissory note:

  • You’re financially strong
  • The loss to the lender is large or over 50%
  • You’re current on your payments
  • A PMI company is involved

Your last option to get out of signing a promissory note is to offer a one-time cash contribution, paid at closing.  Depending on how your negotiations go, the lender may ask for this contribution in the amount of $200-$5,000.

By being aware of how the bank handles loss, you’ll be in the best position when negotiating your short sale.  The short sale is really your best option if you find yourself falling behind on payments.  If you’d like more information on how a short sale works and can benefit you, contact us and we’ll get back to you right away!

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