A divorce can oftentimes exert considerable stress on a couple’s financial situation, resulting in the need to make important decisions about the distribution of assets and satisfaction of liabilities. Where a couple is faced with a property valued under what is owed on a mortgage or the prospect of foreclosure due to nonpayment, a short sale may be preferential. A short sale is the sale of real estate in which the sale proceeds equal less than the amount owed towards the mortgage or mortgages on the property. A short sale requires that the lender, or holder of the lien on the marital property, agrees to a discounted or reduced repayment of the loan.
In these circumstances, when a short sale is considered, there are frequently many benefits associated with retaining a qualified and knowledgeable real estate attorney. A competent attorney will be able to provide answers to all of your questions regarding the short sale process, as well as review your agreement with the lender and realtor in order to ensure that all potential ramifications of the short sale are accounted for. Important considerations may include tax consequences, credit score and reporting activities on behalf of the lender, and the potential for a deficiency judgment (an amount that may be owed to the lender representing the difference between the loan balance and the proceeds of a short sale).
The first important consideration, in deciding whether to utilize a short sale to solve a financial problem, is the potential effect of a short sale on the couple’s credit report and score. While a short sale will almost inevitably cause a decline in an individual’s credit score, a short sale’s impact on a borrower’s credit score will often depend on the timing of the short sale and will almost always be less than the decline resulting from a foreclosure. In most cases, the longer a borrower is in arrears and is unable to pay amounts owed to a lender, the worse the impact is on the credit score. If a borrower is able to remain current on mortgage payments during the short sale process, the decline in the credit score will be less significant. Understanding the resulting implications of a short sale and the way in which these implications will impact a couple in the future is an important step in making an informed decision regarding the disposition of the marital home.
The next issue to consider is whether the lender will have recourse against the borrower for the difference between the sale price of the property and the amount owed on the mortgage loan. A deficiency judgment is a judgment awarded by the court which allows a creditor to recover the unsatisfied portion owed on a loan after the sale of the mortgaged property fails to repay the debt owed in full. In order to assure that the lender will not pursue payment of the amount owed after a short sale, it is imperative that an attorney negotiate and draft a forbearance agreement on the borrower’s behalf. Such agreement will outline the terms of repayment and specify that the lender agrees to withhold their right to pursue payment for any amounts owed after the sale. Without the help of an educated attorney, practiced in contract negotiation, drafting, and real estate law, divorcing couples seeking to utilize a short sale may find themselves owing the lender money for years after the conclusion of the short sale transaction.
Lastly, it is important to determine the possible tax consequences of a short sale transaction for a couple investigating the use of a short sale in the distribution of assets during a divorce. The U.S. tax code taxes individuals based on income or gain. Income is defined as all income from whatever source derived whatsoever. According to American tax law, this definition of income includes cancellation of debt, because it is considered a freeing of assets under the case of U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931). The tax code outlines specific cancellation of debt income which does not need to be included in an individual’s gross income in 26 U.S.C. § 108(f). These exclusions include:
- If the discharge of indebtedness occurs in a title 11 bankruptcy case;
- If the discharge of indebtedness occurs when the taxpayer is insolvent;
- If the indebtedness discharged is qualified farm indebtedness; and
- If the indebtedness discharged is qualified real property business indebtedness
The tax consequences are some of the most important and significant ramifications of a short sale transaction. The Mortgage Forgiveness Debt Relief Act of 2007 added another exemption to the above referenced list, known as the qualified principal residence exemption, in an attempt to provide relief for qualified taxpayers who were not covered by the traditional exemptions. The Act provides relief from taxation on cancellation of debt income, such as that experienced in a short sale situation, so long as the forgiven or cancelled debt was used to buy, build, or substantially improve a borrower’s principal residence, or to refinance debt incurred for those purposes and the debt was secured by the home. This new exemption may offer assistance to many individuals facing the possibility of a short sale; however, it is important to note that the exemption does not apply to second homes or investment properties. Due to the complicated nature and intricacies of the tax code, as well as the manner in which the tax code can be applied to different individuals in a variety of situations, an attorney can be an invaluable asset in determining whether a short sale is a desirable solution to a divorcing couple’s financial woes.