Filing Bankruptcy? Then Forget About a Short Sale. Here’s why:

A short sale is when you sell real estate and the lender holding the mortgage agrees to accept less than the full amount due on their loan.  Short sales are common in a depressed real estate market.

For example:  Let’s say you bought a home in 2005 for $700,000, with a first mortgage of $600,000 and a second mortgage of $100,000.  The market value of the property is now only $500,000 and you have a buyer who is willing to pay $500,000.  If the lender holding the first mortgage agrees to the sale, it will receive $100,000 less than the full amount and the lender holding the second mortgage will receive nothing.  In most cases, the second mortgagee agrees after a nominal payment, such as $5,000.

The problem is:  The short sale usually triggers a mountain of problems that you don’t discover until later.  However, if you file bankruptcy, you usually have no reason for the short sale. 

In many cases, the short sale does more harm than good, for several reasons:

Reason #1:  The short sale is a taxable transaction.  It allows the lender to issue a 1099-A or 1099-C, a copy of which goes to the IRS.  It states that you received income on which you now must pay taxes.  In the previous example, you would need to pay taxes on income of $100,000.  You can get around paying this tax if you qualify.

Reason #2:  The short sale damages your credit.  Since you are not fulfilling your obligations under the contract, the lender can tell the credit reporting agency that you did not pay the full balance.  The short sale has the same effect on your credit as a foreclosure and appears much worse than filing bankruptcy.  It can cause your credit score to plummet by as much as 200 points.

Reason #3:  The short sale probably isn’t necessary.  Since the lender likely has no other recourse against you, the short sale will not change any issues of liability.

Reason #4:  The short sale is a waste of your time and money.  The only persons benefiting in the short sale are the realtor and the buyer.  You do not benefit at all, since you get nothing for your work, worry and money.  The realtor gets a sizable commission and the buyer gets property at or below market value.  But what do you get?  Nothing. 

Reason #5:  The short sale puts you out of your home many months before a foreclosure.  Most foreclosures take over a year.  So a short sale now puts you out at today’s market value, where a foreclosure a year from now allows you to benefit from the rising value of your property.

In most cases, your best option is to surrender your home after you file for bankruptcy.  Under bankruptcy laws, a foreclosure after bankruptcy is not a taxable event, with the possible exception of a capital gains tax.  The lender cannot report a foreclosure to the credit bureau; instead, it reports only the balance of your bankruptcy discharge.  This gets reported in all bankruptcy cases, even if you keep the home, and is usually easier on your credit score than a foreclosure or short sale.

So before you decide on a short sale, if you’re considering filing for bankruptcy, talk with your bankruptcy lawyer about whether a short sale benefits you in any way.  The fact is, it may not.