This article comes from First Tuesday Journal Online
Part I of this article series details the process of qualifying a negative-equity homeowner for a short payoff, setting the sales price at the broker price opinion (BPO) and submitting a purchase agreement to the lender for appraisal and closing conditions, with a brief discussion of tax aspects of a shortsale and alternatives.
The discounted payoff from start to finish
Consider an unemployed homeowner who misses a monthly mortgage payment. The homeowner’s lender contacts him as mandated regarding the delinquency and discusses the homeowner’s financial situation. Unable to make payments and desperate to avoid the personal onus of a foreclosure, he solicits the help of a real estate agent.
Before meeting with the homeowner, the agent downloads a “property profile” (title condition) for the home and a printout of recent sales in the surrounding area from a title company website, the first step in any seller counseling and listing effort. The agent, on review of the reports, comes to a preliminary opinion of the property’s fair market value (FMV) ― a broker price opinion (BPO) ― he will use to set the listing price.
However, he quickly notes the mortgage on the property is an amount that greatly exceeds the property’s value, a negative equity situation. His prospective seller is thus “underwater.”
The meeting between the homeowner and the agent focuses primarily on the homeowner’s inability to clear title of the lender’s trust deed and close escrow on a sale of the property at current prices. The agent advises the homeowner that to avoid a foreclosure by selling the property himself he must consider negotiating for the lender to accept the net proceeds from a sale of his home in full satisfaction of his mortgage debt ― a discount called a short payoff.
The homeowner decides he would rather sell the home than allow it to go to a foreclosure sale. Either way, the homeowner understands he will net nothing from the sale but will pay nothing to live in the property until the property is sold. While a loan modification is discussed, the unavailability of a principal reduction rules out that option. [For more information about the scarcity of principal reductions, see the January 2010 first tuesday article, Cramdowns, cramdowns, cramdowns.]
The agent advises the homeowner he will not have to vacate until:
- a shortsale closes, which will take roughly three to six months after a buyer’s purchase offer is submitted to the lender; or
- a foreclosure sale is held, around ten months after missing his first payment.
The owner and the agent enter into a listing agreement, pricing the property at the BPO set by the agent. The agent adds a provision to the listing agreement stating:
“The owner will first qualify with the mortgage lender for a discounted payoff of the loan and reconveyance of the trust deed on a sale of the home at which time the agent will begin marketing the property in search of a buyer.”
The agent instructs the owner to contact his lender and discuss how to proceed with an agent on a shortsale. [For more information regarding lender pre-foreclosure procedures, see the April 2009 first tuesday Legislative Watch, Residential mortgage loan foreclosure procedures.]
On contacting the lender, the owner is referred to the lender’s loss mitigation specialist, sometimes called a negotiator. In response, the owner is sent a shortsale information packet, requesting he deliver the following to the lender:
- Authorization to release information to an agent. This document signed by the homeowner gives his lender permission to deal with and furnish information about the mortgage to the homeowner’s real estate agent. Without this authority, lenders will not communicate with anyone acting on behalf of his homeowner, making the document one of first priority. [See first tuesday Form 124]
- A hardship letter. In order for the lender to determine whether or not the homeowner is financially qualified to make payments on the mortgage, the homeowner prepares a letter detailing his current personal and financial situation. The homeowner explains he was laid off and has not been able to find a new job. He also discloses he is the only wage earner in his household. [See first tuesday Form 217-1]
- His most recent pay stubs, bank statements and tax returns. The lender wants to confirm the homeowner is purchasing only necessities in lieu of making mortgage payments (i.e. groceries, car repairs and school supplies). Tax returns are used to verify annual income. Often the lender will also require the owner to fill out a financial statement (equivalent to an application for a loan) to determine whether the owner has other assets available as a source of funds to pay off the mortgage without a discount (i.e. cash on hand, equity in other property, stocks/bonds, etc.).
- Proof of occupancy. The homeowner provides the lender with a utility bill in his name at the property address to prove he occupies the residence and doesn’t rent it to others.
Unless the homeowner is financially unqualified to pay the mortgage and foreclosure on the property is inevitable, a lender will not agree to a discounted payoff of the loan.
After the lender receives and reviews the completed documents from the homeowner, the homeowner will be advised whether the lender will consider a short payoff if he sells the property. If advised he qualifies for a shortsale, the homeowner will be able to obtain a reconveyance of the lender’s trust deed lien and close escrow on a sale. Of course, the agent will need to generate an offer at a price with net sales proceeds the lender will actually accept in full satisfaction of the loan.
Editor’s note —When a buyer’s agent finds a property listed as a short sale, the first question he must ask the seller’s agent is “Have you qualified your homeowner for a shortpay with his lender? If not, why not?” Buyer’s agents have a limited role in the short sale process, but they must — on behalf of their buyer — confirm with the seller’s agent on a short sale listing that the homeowner has been qualified for a shortpay with his lender. As a comparison, a seller’s agent does not take a buyer seriously who has not been pre-approved for purchase-assist financing by a lender. In the same way, a buyer’s agent must protect his buyer, along with everyone’s time and energy, by being assured the seller has been qualified for a shortpay with his lender before spending any additional time putting together an offer from his buyer.
Once a purchase offer is received and accepted by the seller, it is submitted to the lender for consideration. An appraisal is then ordered by the lender to determine the FMV of the property ― the acceptable sales price in the eyes of the lender.
If the appraisal is at or below the sales price, the lender will likely indicate the buyer’s offer is sufficient and orally agree to accept the net sales proceeds and reconvey its trust deed on the close of escrow. If the appraised value is greater, the lender will likely indicate the sales price must be set at the appraisal amount before they will consent to a discounted payoff ― the short payoff.
The solvent but underwater homeowner’s story
Now consider a homeowner who has the financial ability to make his monthly mortgage payments. He has multiple investments and a steady job, but his home has a loan-to-value ratio (LTV) ratio higher than 125%. Thus, he owes more to his lender than his home is worth, making it an underwater asset, commonly called a negative-equity property.
Wishing to dispose of the home and rid himself of his excessive mortgage obligation, the homeowner approaches a real estate agent for advice on the best way to get out from under his financial mess. The agent explains lenders will not discuss a short payoff with anyone who still makes his monthly mortgage payments. A homeowner must first default and take damage to their credit score before a lender will even consider negotiations.
The homeowner further inquires about the lender’s likely reaction if the homeowner intentionally stops making mortgage payments in order to open discussions about a short payoff.
Although a default in payments is the homeowner’s first step in getting the lender’s attention to begin the shortsale process, a defaulting homeowner must also meet financial incapacity standards and have endured a significant hardship (in the opinion of the lender). Lenders (and Congress) do not consider owing more on a mortgage than the home is worth to be a hardship. If a homeowner is financially able to make payments or owns other valuable assets, it is highly unlikely a lender will qualify him for a short payoff and agree to take a loss on that mortgage – other than through a foreclosure sale/real estate owned property (REO) situation.
Rather than have the homeowner trudge through this tedious process only to be rejected, it may make more sense for a homeowner who wants to rid himself of a negative-equity property to exercise his put option contained in the lender’s trust deed. To do so, he strategically defaults, thus forcing the lender to sell the home at a foreclosure sale which automatically eliminates the mortgage debt. [For more information regarding strategic defaults, see the November 2009 first tuesday article, California homeowners: exercising your right to default.]
According to a study by the Fair Isaac Corporation (FICO), a foreclosure has the same effect on an underwater homeowner’s credit score as a shortsale. Also, FICO scores damaged by either a shortsale or a foreclosure sale have the same estimated recovery time. [For more information regarding FICO’s credit report study, see the May 2011 first tuesday article, Short sale or foreclosure? The naked truth for underwater homeowners.]
In this destabilized real estate market, brokers and their agents don’t have the time, money or talent to waste marketing a negative-equity property whose owner fully qualifies to borrow the principal amount remaining on the mortgage. A seller’s agent can make a quick assessment of whether or not a shortsale will ever be approved by:
- investigating the property’s title conditions;
- working up a Comparative Market Analysis (CMA);
- initially setting a BPO; and
- analyzing the seller’s financials (balance sheet and income analysis).
Although agents do not generally receive a fee for giving advice to strategically default, (but properly may as an unlicensed financial consultant) they will save themselves months of wasted effort by moving on to more promising listings.
Tax aspects of the short payoff
Taxwise, the two most significant consequences of a shortsale of an owner-occupied one-to-four unit residential property encumbered by a purchase-assist loan, improvement loan or refinance on a purchase-assist loan — called a nonrecourse loan under California anti-deficiency law — are:
- the short sale does not trigger tax reporting of ordinary income for the discounted and discharged portion of the loan if the home is sold on or before December 31, 2012; and
- the discount on a short payoff produces a capital loss that cannot be used to reduce taxable income. [See first Tuesday Tax Benefits of Ownership Chapter 15: Short payoffs on loans in foreclosure.]
The discount on a short payoff is not to be reported by the seller as discharge-of-indebtedness income, and instead produces a “personal loss” (capital loss) on the sale that cannot be written off. However, the lender will file a 1099C indicating the discount occurred, reporting it as debt relief that is otherwise taxable except for the negative equity home sales rule. [Internal Revenue Code §108(e)]
California anti-deficiency laws prevent a lender from collecting any amount from a homeowner beyond the net proceeds on a short payoff, or the amount received at the foreclosure sale of the property. [For more information regarding antideficiency protection, see the August 2011 first tuesday Legislative Watch, Antideficiency protection extended to second trust deed discounts.]
Editor’s note ― When processing a short payoff, some homeowners are asked by the lender to contribute cash in addition to the net sales proceeds of their home before they will reconvey their trust deed lien. Homeowners confronted with this lender demand after entering into a shortsale purchase agreement with a buyer must understand they cannot legally be required to throw their reserves into a transaction that has already damaged their credit ― by design of the lender ― and will further damage it on closing as though a foreclosure sale had taken place, whether or not they add cash to close a negative equity sale.
If the lender fails to accept the net sales proceeds in full settlement of the debt and the buyer will not pay the amount demanded by the lender, a homeowner with a purchase-assist mortgage needs to then consider his right to cancel the sales transaction and let the lender foreclose on the property. This strategic default requires no out-of-pocket cash from the homeowner nor can the lender collect any deficiency in the property value from the homeowner. A second trust deed complicates the liability analysis as seconds are recourse paper, unless the second trust deed lender gives written consent to a shortsale. [For more information regarding antideficiency protection, see the August 2011 first tuesday Legislative Watch, Antideficiency protection extended to second trust deed discounts.]
If a homeowner wants or needs to get out of his home, a short payoff is just one of many options he can investigate.
Unsurprisingly, lenders are leaving negative-equity homeowners with very few routes to take. Nationally, banks modified only 558,000 mortgage loans in the first half of 2011 when delinquencies were rising – a 42% decrease from the 968,000 modifications made in the first half of 2010. [For more information regarding loan modifications, see the August 2011 first tuesday article, Loan modifications walk the plank, California homeowners don’t have to follow.]
A modification is rarely an escape from the burdens of an excessive mortgage since on modification the principal is rarely reduced. In fact, the principal is almost always increased during a loan modification, leaving the owner with a worse LTV than before. The government’s attempt to persuade lenders to modify more loans through the Home Affordable Modification Program (HAMP) has proven vastly ineffective. For negative equity homeowners in California with their excessive LTVs, a meaningful loan modification is nothing more than a short-lived dream. [For more information regarding HAMP, see the June 2011 first tuesday article, More bad news for HAMP.]
Likewise, any rumors of modifications granting principal reductions to correct jacked-up LTVs have proven false. Lenders know agreeing to a cramdown for one homeowner means all homeowners will expect the same treatment. If they refuse short payoffs for most negative equity homeowners who want out of their properties, there is no way they will shed the debt of that 90% of homeowners who faithfully make payments and still want to keep their homes. [For more information regarding cramdowns, see the July 2011 first tuesday article, Lenders are reducing principal?]
We’ve said it for years and its worth repeating once more: at the behest of the banks, employed underwater homeowners are left with no other choice than a strategic default. A strategic default allows a homeowner to both move on to another residence and increase his family’s standard of living – things very American to do.
Until lenders muscle up or are forced to report their mortgage losses, the real estate market will continue to heave under the disproportionate weight of delinquencies, foreclosures and REO inventory. Until then, lenders will be too suppressed with foreclosure-related activities and solvency issues to lend.