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Usually, when a borrower defaults on a mortgage, the bank will liquidate the property by foreclosure, auctioning off the property or selling it at a trustee sale.
As an alternative to foreclosure, many borrowers take matters into their own hands and sell their property through a short sale. Although it is a common misconception that a short sale protects homeowners automatically, that is not actually the case, and homeowners can be left with a large amount of debt after the short sale if it is not done correctly.
The following overview of short sales and the problems with lingering second mortgage debt does not constitute legal advice and is no substitute for consulting with an experienced Southern California foreclosure attorney. However, this will provide you with some basic information to help you understand why you might still owe money to a lender after the short sale of your property.
With a short sale, the lender allows the borrower to sell the property for an amount that is less than the balance owed on the loan. The remaining amount — the difference between the loan balance and the amount produced by the short sale — is waived by the lender in writing. Short sale refers to a sale where the value of the home is less than the amount owed on the mortgage.
Short sales are appealing to borrowers because, unlike foreclosures, there is no public record that reveals the transaction as a short sale. A short sale will not produce an automatic negative effect on a borrower’s credit like a foreclosure will. And borrowers are often eager to do whatever they can to keep their financial issue private and protect their credit. A lowered credit score has many repercussions, impacting a person’s ability to get future loans and even their ability to get hired in certain circumstances.
In 2007, Congress passed the Mortgage Forgiveness Debt Relief Act, which provided a tax exemption for forgiving mortgage loan debt when a home is sold at a short sale. In other words, without this law, if a homeowner sold their home for $150,000, but owed a mortgage of $175,000, they may be required to pay federal income tax on the $25,000 amount that the mortgage company “forgave” by allowing the proceeds of the sale to satisfy the loan. Under the Mortgage Forgiveness Debt Relief Act, this $25,000 would not be considered taxable income to the homeowner.
The law has many details and requirements — such as a requirement that the property in question is a primary residence or that second mortgage funds be used for home improvements — that are not covered in this short overview. Additionally, it should be noted that the mortgage forgiveness law has built-in expiration dates and must be renewed by Congress, or it is no longer in effect. Your foreclosure attorney can advise you on the status of the law and whether it could be relevant to your situation.
Many homeowners take advantage of the equity they have in their homes, borrowing against it to do home repairs, pay other bills, take vacations, or start businesses, to name just a few of the common reasons people borrow against the equity in their homes. They will take a second mortgage on their home or secure a home equity line of credit (HELOC).
If the housing market declines and the borrower needs a short sale to satisfy the primary mortgage, the short sale will not necessarily eliminate all their debt if they also owe money on a second mortgage or HELOC. The bank holding the primary mortgage may have agreed to a short sale however the second mortgage was the result of a different mortgage contract, which could result in lingering debt after the short sale, if not done properly.
Secondary lenders are supposed to get the residual equity from a sale after the primary lender has received the satisfaction of their loan. However, if there was not enough to pay the primary lender when the property is sold, there is no residual amount to go to the secondary lender. What often occurs is that, to get the second mortgage holder to agree to the short sale, all parties agree that the second mortgage holder reserves the right to sue the borrower even after the short sale has occurred. The borrower, especially if they have not consulted with a foreclosure attorney during the short sale transaction, often does not realize this “reservation of rights” is even happening until it is too late and they are served papers by the second mortgage or HELOC lender for the amounts not discharged in the short sale.
Since there is no longer a house to put a lien on, this second lender debt becomes an unsecured debt. It is a cloud that lingers over a borrower and can expose them to a lawsuit and continuing headaches such as wage garnishment and can affect their credit long after their home is disposed of and they have moved on.
If you are in a situation where you owe more on your property than it is worth, you should contact an experienced foreclosure attorney to represent your interests right away and help you avoid the common mistake of getting sued after the short sale has been completed. Short Sales can be an enormous blessing, but must be done correctly to be effective.
Contact a Southern California McFarlin LLP foreclosure attorney for a free consultation. Call us at 949-544-2640 or contact us online.
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