TO SHORT SELL OR NOT TO SHORT SELL?

Clients frequently ask me whether they should short-sell property or not.  My answer is that one should consider a short sale within the context of a bankruptcy.  I DO NOT THINK ONE SHOULD SHORT SELL PROPERTY WITHOUT CONSULTING WITH COUNSEL. 

Case in point, recently I met a client who short sold his residence because it was substantially underwater.  He had first and second deeds of trust and had consulted with a real estate agent specializing in short sales.  The client sold the property, but did not receive a release from the second deed of trust holder.  When I met the client, he was being sued by the second trust lender.  This has happened time and time again. 

I would have advised the client differently.  If he could have short sold the property with a release from the second trust lender or for a small payment to that lender, then I would have blessed the transaction.  If not, then bankruptcy is a consideration among other factors.

Credit Consequences

I have continued to monitor on-line publications from Freddie Mac, Fannie Mae and FHA concerning the consequences of a short sale or bankruptcy.  While a short sale may be equivalent to a material adverse credit event or a chapter 13 bankruptcy filing, it has a less dramatic impact on credit scores than judgment liens, a foreclosure or a chapter 7 filing.  Using a dart board, the biggest impact on credit score would be a foreclosure, then the entry of judgment liens against the debtor, then a chapter 7 filing, then a deed in lieu of foreclosure, then a short sale and in the center of the bull's eye would be a chapter 13 filing or voluntary debt resolution (if the latter works).  The center of the bull's eye represents the smallest impact on credit, around 150 points on the FICO score.  Hence, the best way to preserve your credit score would be to file a chapter 13 and to short sell a property during the bankruptcy.

Bankruptcy

If the above client had qualified for bankruptcy, I would have advised the client to remain in the house and file.  The client could have stated his intention on his bankruptcy filings that he wanted to retain the property and continue to pay.  In such an event, he would have been relieved of his obligation to pay on the second deed of trust.  After the bankruptcy, the client could have short sold the property without the threat of a lawsuit by the second trust lender.  In a Chapter 7, the underwater property could have been abandoned.  In addition, the administration of a chapter 7 case is relatively brief.  In a chapter 13, the court may have granted permission to short sell the property.  The court will not approve a short sell over the objections of a lender, but if the chapter 13 trustee will otherwise endorse the order, then the court will let the sale go through. 

Tax Considerations
We expressly do not give tax advice.  However, one should be aware that a short sale, foreclosure or surrender of a primary residence (upon the expiration of a patch Congress passed in 2008) or of an investment property can result in the realization of taxable income.  Sometimes, a taxpayers' basis in property will be so low that even in the event of a foreclosure, the disposition of the property results in capital gains.  Moreover, if the lender foregives some of the debt, the taxpayer may have phantom income known as "discharge of indebtedness income."  The short sale, surrender or foreclosure of investment properties in highly inflated markets, such as Florida, Arizona or California, may result in the realization of substantial discharge of indebtedness income.  According to the Internal Revenue Code, a bankruptcy filing offers an exception to the discharge of indebtedness rule. 

This blog is not intended to render legal services to the reader, including advice about bankruptcy or taxes. Consult with a lawyer concerning the specific application of the law to your unique circumstance.