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Foreclosure not the only option if you're 'underwater': look at long-term implications and watch for scammers.

As North Central Washington residents begin to feel the economic crunch, many property owners are finding themselves faced with the dilemma of deciding to walk away from their property and allow a foreclosure to run its course or to attempt to negotiate a "short sale" transaction.

A "short sale," also sometimes referred to as a "we-foreclosure sale," is a sale of property where the lender receives less than the full amount of the loan on the property. Short sales have become more prevalent due to the state of the economy, as both property owners and lenders often have incentives to avoid the foreclosure process.

Credit score

Many property owners may prefer a short sale over a foreclosure based upon the effect on their credit report. A short sale may drop a property owner's credit score by the same amount as a foreclosure; however, the time period to reestablish credit and regain loan eligibility may be significantly less with a short sale. Due to the increased incidence of short sales, Fannie Mae recently adopted a new policy, establishing a two-year elapsed time period for reestablishing credit following completion of a short sale (see Fannie Mae Announcement 08-16). Thus, where it may take five to seven years to reestablish credit and purchase another home after a foreclosure, a property owner could be eligible to buy another home in as little as two years after the completion of a short sale.

Tax implications

While property owners may prefer to avoid the stigma of the foreclosure process and its effect on their credit report by negotiating a short sale, they should seek professional legal and tax advice about the consequences of a short sale of their particular property because a short sale can have dramatically different tax consequences than a foreclosure.

Generally, if a debt for which a taxpayer is personally liable is cancelled or forgiven (other than as a gift or bequest), the amount of cancelled debt is included as ordinary taxable income. If a lender agrees to write off a loan deficiency in conjunction with a short sale, the amount of cancelled debt may constitute taxable income to the property owner, potentially resulting in a hefty tax bill at year-end.

For example, if the balance of a property owner's mortgage was $300,000 and the property owner negotiated a short sale to a third party for $260,000 with the lender's agreement to waive the deficiency, the property owner could have $40,000 of ordinary taxable income resulting from the short sale. If this property owner was in the 25-percent tax bracket, $10,000 in taxes would be owed for the forgiveness of this debt. The Mortgage Forgiveness Debt Relief Act of 2007 and the Emergency Economic Stabilization Act passed in October of 2008 exclude this type of debt forgiveness from a property owner's ordinary taxable income when the property is their primary residence. This exclusion from income does not apply to investment or commercial properties. However, other tax relief may be available for property owners interested in accomplishing a Short sale on their commercial or investment properties. If a property owner is insolvent when the debt is cancelled, some or all of the cancelled debt may be excluded from taxable income. Regardless which category a property owner fits into, the tax issues are complex and every property owner should consult a tax and/or legal professional before electing to proceed with a short sale.

Lender approval

Every short sale must be approved by the lender. If the property owner is facing foreclosure, the lender may elect to approve a short sale (and write down the deficiency owed by the property owner on the loan) in lieu of exercising its rights of foreclosure. However, a lender will do so only when it makes financial sense for the lender--and not out of the goodness of its heart. Some lenders are agreeing to short sales due to the realization that the foreclosure process requires lenders to incur marketing, legal and holding costs, which may reduce the net proceeds eventually recovered by the lender post-foreclosure. However, other lenders appear content to simply move forward with foreclosure. A lender is more apt to approve a short sale and waive a loan deficiency where the value of the property has decreased, the property owner is default on the loan, and the property owner has no other assets to satisfy the loan.

Foreclosure basics

There are two types of foreclosures: judicial and non-judiciaL A non-judicial foreclosure requires the lender to give 90 days' notice before the foreclosure sale. Additionally, the sale must be at 'least 190 after the default on the loan. A lender cannot obtain a deficiency judgment through a non-judicial foreclosure. This means that once the sale is completed, the entire obligation of the owner to the lender is extinguished, even if the lender does not recover the full balance of the loan and its costs from the sale.

A judicial foreclosure requires the lender to file a lawsuit. Unlike in a non-judicial foreclosure, a lender may obtain a deficiency judgment in a judicial foreclosure and pursue the owner for the remaining loan balance and costs. After a judicial foreclosure is completed, the owner has a one-year right of redemption, in which the owner can get the property back by paying the entire amount of the default.

Getting help

Most foreclosure proceedings do not result in the loss of the property. This is due in large part to the fact that lenders are in the business of providing mortgages, not owning and selling property. However, the property owner must also be proactive. Property owners in default on their mortgage or confronted with a pending foreclosure often feel hopeless. One of the biggest mistakes property owners make is ignoring warnings from the lender about late mortgage payments or notices regarding foreclosure proceedings. Even if the situation seems hopeless, there are often ways to avoid the foreclosure. Waiting until the eleventh hour to ask for help drastically reduces the options available to the property owner.

If a property owner knows a payment will be late, they should alert the lender and discuss the situation before the lender sends the default letter. Similarly, if a property owner receives a notice of foreclosure, they should seek the advice of an attorney. The sooner a property owner seeks help, the better chance they have of avoiding foreclosure.

For those who cannot afford to hire an attorney, some free services are available. The Homeowners Preservation Foundation is a nonprofit organization that provides free services and advice to property owners faced with foreclosure (the 24-hour advice hotline is 1-888-995-HOPE). Unfortunately, there are many scammers out there seeking to take advantage of susceptible owners, so it is important to be cautious of third parties offering assistance. Some classic foreclosure scams to be wary of involve: a third party offering to buy the property and rent it back to the owner; and a third party accepting a large up-front payment thus allowing the owner to stop making the mortgage payments.

Facing a foreclosure can be overwhelming and the most important thing a property owner can do is seek professional legal and tax advice regarding their specific situation.

J. Kevin Bromiley's practice areas are business, commercial and real estate law. Michelle A Green's practice areas are real estate, land use, business law and civil litigation. They can be reached at 662-3685.
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Title Annotation:BUSINESS & TAX LAW
Author:Bromiley, J. Kevin; Green, Michelle A.
Publication:Wenatchee Business Journal
Date:Jun 1, 2009
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