By Mike Heayn Real Estate 101
The foreclosure rate in California went up last quarter. News of increasing foreclosures will likely continue into the near future simply because people can not afford the homes and mortgages they purchased during the recent bubble. Some can blame unscrupulous mortgage brokers, overly aggressive lending institutions or even naïve homebuy-ers. But regardless the excuse, ultimately a solution must come about to solve the foreclosure problem. One potential solution is a short sale.
Pretend for a moment that you were almost at the point at which you could no longer make your mortgage payments, yet you could not sell your home for more than its current mortgage balance. Would you believe me if I told you the bank might allow you to pay back the mortgage with the money you sold your home for, even if that amount is not the total mortgage amount? Such an option does exist, and it is known as a short sale.
Banks are not in the business of owning real estate. For every home — or non-performing asset, as the bank calls them — that is held on a balance sheet, the institution must set aside a percentage of value in the form of cash reserves. The problem for a bank is that money set aside for a non-performing asset cannot be lent out. If a bank cannot lend money, it cannot make a profit on the interest it would charge. Banks could theoretically accumulate several thousand homes and have to put aside money for each one. Eventually, this would cripple the bank’s ability to generate revenue.
The other issue is the foreclosure process. Quite simply, foreclosures cost a lot of money and take up a lot of time. Banks do not want to waste resources on foreclosures that are going to cost them a lot of time and money for little or no return.
Now, back to the homeowner who cannot make the mortgage payments. If the bank agrees, the owner can sell the property and repay the bank the total proceeds from the sale. For example, if at the time of purchase, the value of the home was $500,000, but now the home is only worth $450,000, the owner can sell the property for $450,000 and give it to the bank. The bank will allow this lower amount because the loss is less than the cost of foreclosure. Remember: Non-performing assets hurt the bank’s profit margin.
However, the homeowner is not completely off the hook. The IRS will look at the $50,000 loss as income. Since the homeowner did not actually get $50,000, this type of income is known as phantom income. The problem with phantom income is now the homeowner will have to add $50,000 to their taxable income, probably placing them into a higher tax bracket, thus forcing them to pay more in taxes. Most homeowners who need to complete a short sale usually cannot afford to pay higher taxes at the end of the year.
Sure, a short sale has its down sides but, if structured correctly, a short sale can allow homeowners to get out of properties they cannot afford. This may save their credit along with the time, not to mention the headache of having to go through the foreclosure process and possibly having to file for bankruptcy.
Not all banks will allow a short sale. If you are on the brink of financial ruin because you cannot afford your mortgage payment, consider contacting your lender and explaining your situation. Most lenders do not want to go through the foreclosure process and may offer you some type of payment relief in the form of lower mortgage payments or a way to get out of the property with a short sale. Always discuss your individual situation with an accountant, debt advisor or other professional before proceeding with any payment relief strategy.
MIKE HEAYN is a Washington Mutual multi-family loan consultant. He (310) 428-1342 or
Originally published in the Santa Monica Daily Press print edition on February 7, 2007. Read the original PDF.