For Distressed Homeowners, Short Sales Stave Off Credit Ruin

Wednesday, April 4, 2007 | As a growing number of homeowners stare down the barrel of foreclosure, some are electing to negotiate with lenders to sell their homes at a loss, hoping to avoid the credit-marring implications of surrendering the home to the bank.

Lenders might take losses of tens of thousands of dollars instead of repossessing the home and putting it up for auction. The auction process would incur additional costs for the bank and may result in a meager selling price. Homeowners, in turn, avoid getting slapped with a seven-year black mark on their credit.

A larger number of homeowners find themselves upside-down in their homes — owing more than their home could sell for — than in previous years. And the number of them hoping to execute a short sale is also increasing. Some analysts say the phenomenon could mitigate the potential hazards ahead for the uncertain housing market. Fewer homes going to auction could help keep prices steady.

“They tend to insulate the market from the worst effects of the foreclosure problems,” said Rick Sharga of RealtyTrac, a national real estate data firm. “They do that by allowing properties to be sold at the earliest stages of foreclosure, the notice-of-default stage, at less of a discount that they might at, say, a foreclosure auction.”

But the process isn’t simple. A price agreed on by buyer and seller may not be accepted by the lender, launching a new round of negotiation. And the seller may have to pay taxes on the forgiven debt.

There were 1,065 new foreclosure filings in February, which includes notices of default, notices of auction sale and bank repossession, according to RealtyTrac. That’s up from 881 such filings in February 2006, and 299 in February 2005.

Jim Supples is a Realtor focusing mostly in the neighborhoods from Scripps Ranch to Escondido. He said short sales are growing in prevalence — not because they’re the ideal situation for buyer or seller, but because they’re becoming a necessity. Buyers who banked on the housing market continuing to increase are now unable to refinance loans while their payments balloon out of reach.

“People got into these situations, and then the market dips down,” he said. “People are just getting squeezed out.”

“Last year, it was negligible,” Supples said of the short-sale phenomenon. “Two years ago? Nothing.”

But Tuesday, when Supples reviewed the database used by Realtors to list and search for homes for sale, he found more than 700 combinations of the phrase “short sale” among the 16,000 active listings in the Sandicor database. Agents use variations of the “short sales” phrase to identify the distressed properties, but the occurrences of the phrase don’t necessarily include all of the short sales on the market.

In a typical short sale, the seller has missed at least one mortgage payment. That distressed seller hires an agent to list the home as if it was a regular sale, and the agent alerts the lender that the seller will pursue a short sale. When an interested buyer makes an offer, the seller’s agent submits that offer to the mortgage lender for approval. It may be a couple of months before the parties hear from the lender, who weighs the offer. If it is accepted, the lender forgives the debt of the homeowner, and the buyer completes the purchase at that price.

The Internal Revenue Service may count that forgiven debt as taxable income, depending on the terms of the homeowner’s original loan. Often, if the homeowners have never refinanced, they don’t have to worry about that tax bill. But for those who do, the black mark on a credit report is preferable to potential tax payments on the forgiven tens of thousands of dollars.

In some cases, the lender decides to forgo the short sale idea entirely in favor of sending the property to auction. In that case, the willing buyer falls out of escrow on that property, the homeowners receive the seven-year black mark of foreclosure on their credit, and the buyer’s and seller’s agents make no commission. Lenders usually choose that option only if it appears that the home could sell for more in auction. But sending a home to auction leaves the lender with thousands of dollars in extra fees and costs, such as months of missed interest payments, maintenance costs and insurance fees. The offer would have to be substantially lower than the loan amount for the lender to consider that option.

Buyers are often attracted to short sales for their promise of discounted prices. However, they take more time and involve that faraway third party. Some buyers’ agents actually steer their clients away from such sales because of the potential for headaches.

Short sales are only the best option for would-be buyers if they have the time to be flexible with the process, Supples said. It can take a few months and potentially end with a denial of the buyer’s offer. Still, buyers who were priced out of the market a couple of years ago may return to those same neighborhoods they once sought homes in, now finding a 10 percent price reduction.

“Short sales are not easy transactions,” Supples said. “If you’re getting a deal, there’s going to be some work.”

John Woodall’s Vista-based company, Home Auction Advantage, focuses on approaching homeowners in foreclosure and offering to attempt a short sale on their behalf. He’s closed four such sales so far this year. He garners clients by examining public-record foreclosure lists and knocking on doors.

“I screen the ones that look like prospects for short sales,” Woodall said. “What I mainly look for is 100 percent financing. Whenever I see that, and the loan was created in the last three years, I tell them we can approach the bank about lowering the loan.”

He looks for homeowners who eschewed a down payment and instead took out loans for their entire purchase price.

Without the cushion of a personal investment in the property, the road to becoming upside-down in the house moves quickly when a market starts to decline. In the heated market of a few years ago, so-called distressed homeowners could sell their homes — often for at least what they’d paid — and excuse themselves from the terms of the mortgage. But as values decline, homeowners in trouble don’t always have that option anymore.

The increased foreclosure rates nationwide, though much worse in several states in the Midwest than in California, spark fears that housing values will plummet. If three homes in the neighborhood sell, or are auctioned, at discounts of 20 or 30 percent, the other homes in the neighborhood ostensibly lose that value, too.

Short sales usually mean a smaller loss of value in that neighborhood than a foreclosure auction would. And as the banks become deluged with consumers in trouble and loans in default, they’ll become more likely to accept the offers from willing buyers in a short sale scenario.

“If you have a huge increase in the volume of properties, you’re going to be a little more inclined to take a reasonable offer on a property and cut your losses there,” said Sharga of RealtyTrac. “Short sales become a good way of the market correcting itself.”

(Correction: The original version of this story incorrectly used the RealtyTrac foreclosure data as aggregate information for the entire market. It should have simply reflected the foreclosure activity for the individual month. We regret the error.)

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