Consequences Between A Short Sale And Foreclosure

Many homeowner are frustrated on figuring out how to resolve their mortgage being underwater and many are just walking away but this is a mistake. A homeowner can ask for a short sale even if they are not late on their mortgage, but the reality is that a lender has no incentive to allow a short sale if payments are still being made on time. But still homeowners should spend the time to explore their options before walking away.

For homeowners looking at their options, the two most important reasons to find a way to resolve their situation is the impact to their credit rating and having to deal with lenders chasing them for any unpaid mortgage balances.

Foreclosure Impact
Credit Score: Drops score approximately 200-250 points
Length of Time on Credit Report: 7-10 years
Buying Another Home: Disqualified for a mortgage for at least 3 years and may take as long as 7 years.
Interest Rates: Revolving credit accounts, auto loans, short term loans will all have higher interest rates and most likely a reduction in credit offered.

Short Sale Impact
Credit Score:Drops score approximately 60-100 points
Length of Time on Credit Report:7 years
Buying Another Home: Qualify for a mortgage with a decent interest rate after 18 months
Interest Rates: Revolving credit accounts, auto loans, short term loans will all have higher interest rates and most likely a reduction in credit offered, but the time for credit recover is much less than for a foreclosure


The main point that homeowners should realize is that if they are successful on doing a short sale to get out of their situation, the road to credit recovery is shorter than if they went to foreclosure. Protecting ones credit score will help to minimize the amount of interest a borrower pays on credit cards an loans.

Deficiency Judgements
Regardless of a foreclosure or a short sale, there will always be a concern on whether or not a lender will come after the homeowner to collect any unpaid mortgage balances.

If a lender cancels debt that you owed, a 1099-C may be received. The amount reported on this form is considered taxable income by the IRS, unless insolvency can be proved at the time the debt was cancelled. In recent months, it has been reported that more homeowners have been receiving a 1099-C.

The main reason to give your best efforts to try a short sale, is that it can reduce the amount of deficiency you would be liable for on your tax filing.

There are some states that do not allow lenders of 1st mortgages to pursue a seller for the unpaid balance. But in all states, second liens and equity credit lines can pursue the seller unless an agreement has stated otherwise. Borrowers will have to pay tax of any unpaid mortgage balance unless they meet IRS's home exclusion or insolvency rules.

Primary Residences:
If there is an unpaid mortgage balance that is considered purchase money, which is money from a loan used to purchase a home, they can qualify for the homeowner exclusion rule, which is 250K if you are single and 500K if you are married. The unpaid mortgage balance is reported as income and this exclusion can cure any amounts the lender can pursue. For example if you had a 100K of unpaid mortgage through a short sale or foreclosure, you would not have to pay any taxes on the amount. For second liens, most likely the lender will continue to try an collect from the homeowner. The good news is that the debt is unsecured and would mostly go to collections, which makes it easier to negotiate an amount to satisfy the debt.


Second Homes and Investment Properties.
Owners of second or investment properties do not qualify for the home exclusion rules. The only way to avoid taxes on any unpaid mortgage balance is if you can prove and file for insolvency with your tax return. To better understand how to file for insolvency, review Form 982 from the IRS http://www.irs.gov/pub/irs-pdf/f982.pdf. The same can be said that the debt will be unsecured and would mostly go to collections, which makes it easier to negotiate an amount to satisfy the debt.

It is highly recommended for any homeowner considering a foreclosure or short sale to consult a professional to ensure they are making the best financial decisions.