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Options for Underwater Homes: Short Sale, Bankruptcy and Foreclosure Considerations
By Gregory A. Braun, Partner and Beth Prendergast, Associate

Homeowners face complicated options when they can no longer afford their mortgage payments, especially when their homes have a market value lower than their mortgage balance. Homeowners often must choose between waiting for a foreclosure and filing for bankruptcy, or selling the home through a short sale. A “short sale” (or “preforeclosure sale”, as termed by Fannie Mae) is where the lender agrees to accept less than the balance owed on the mortgage upon sale of the property by the borrower/homeowner to a third party. Assuming the homeowner does not want to keep the home, a short sale may be the better option, even if bankruptcy is inevitable. This article compares these options while highlighting the benefits of a short sale.

• Clean break from other property-related liabilities – One of the greatest advantages to the short sale is that the homeowner disposes of all ancillary liabilities associated with the property. If the homeowner files for bankruptcy, he will still own the home after the bankruptcy discharge. This means that although the homeowner is not liable for the mortgage debt, he is still liable for post-bankruptcy homeowner’s assessment, utilities, premises liability and repairs required by the municipality. The homeowner will incur these expenses while he awaits a likely inevitable foreclosure. While a bankruptcy discharges the personal obligation to pay the debt, a discharge in bankruptcy does not affect the mortgage lien on the property or transfer title to the property back to the bank. Thus, a lender still must foreclose on the property (unless the lender agrees to a deed in lieu of foreclosure or a short sale). If the homeowner short-sells the property, the new purchaser assumes these liabilities on the date of the transfer of title, giving the selling homeowner a clean break and a fresh start.

• Shorter restriction period before subsequent homeownership – Another benefit from completing a short sale is that, generally speaking, a short sale will prevent the homeowner from acquiring another home for a period of only two years, compared to a period of five to seven years after a foreclosure. These restrictions follow from Fannie Mae’s requirements regarding the time period that must elapse before borrowers can demonstrate they have reestablished their credit history. See FNMA Announcement 08-16.

• Less severe impact on neighborhood valuation – A short sale may also have a less damaging impact on the neighborhood than will foreclosure. Foreclosures destroy home values in neighborhoods, hurting everyone, to a greater extent than short sales. Short sales generally result in higher sales prices than in foreclosure auctions and bank sales by as much as 25% according to industry insiders.

• Reduced stress – A homeowner can usually avoid the stress, expense and complications of foreclosure legal proceedings by short-selling the home. A successful short sale will also allow a homeowner’s exit from the property on his own terms, as negotiated with the buyer persuant an agreed contract, not by the force of the Sheriff.

A Few Caveats – When Short Sales May Not Be the Better Option:

• Credit concerns – The homeowner’s credit rating will take a hit after a short sale. Make that two hits if the homeowner files for bankruptcy as well.

• Where the Mortgage Debt Relief Act will not apply to exclude tax liability for the forgiveness of debt - There is no tax liability for forgiveness of debt in bankruptcy. The Mortgage Debt Relief Act extends this benefit to other debt forgiveness, including mortgage debt forgiven in connection with a foreclosure between the calendar years of 2007 and 2012. However, the Mortgage Debt Relief Act may not always apply in the case of a short sale. For example, any portion of cancelled or forgiven debt from a loan used for purposes other than acquiring or improving the property may be considered income on which the borrower must pay taxes. Filing for bankruptcy instead of undergoing a short sale will completely eliminate that tax liability in such situations. For more information about tax considerations of short sales, see Taxing Consequences of Short Sales.

• Where the homeowner is considering filing for bankruptcy - Eliminating the mortgage debt in ashort sale may cause the homeowner’s debt level to be too low and his income level to be too high to qualify for a Chapter 7 bankruptcy, thereby making a Chapter 13 bankruptcy the only available route. A Chapter 7 bankruptcy is generally preferable to a Chapter 13 bankruptcy for a number of reasons. For example, a Chapter 7 bankruptcy wipes debts clear whereas a Chapter 13 bankruptcy instead establishes a three to five repayment plan, the success rate of which is often less than 50%. Also, the homeowner is prohibited from purchasing a new home for four years after a Chapter 7 bankruptcy discharge, compared to effectively five to seven years after a successful Chapter 13 bankruptcy discharge (the prohibition is for two years after the Chapter 13 discharge, which occurs three to five years from the date of approval) or, if the Chapter 13 repayment plan fails, then four years from the date the plan is dismissed. However, a Chapter 13 bankruptcy does carry at least one benefit to the homeowner - if the homeowner has income, albeit lower than in past years, a Chapter 13 bankruptcy can strip away second or third mortgage loans if the value of the home is lower than the outstanding debt of the first mortgage, possibly making the home affordable.

The complicated options that face homeowners who find themselves “upside down” with their mortgage payments can be daunting. Talking to an attorney who is familiar with the options discussed in this article can offer clarity and guidance related to your particular circumstances. The attorneys at McCormick Braun Friman, LLC have experience defending foreclosure actions, representing debtors in bankruptcy and facilitating short sales. We can walk you through your options and help you choose the course of action that best fits your needs, helping you get back on your feet.

For more information or to discuss your options with an attorney, please call McCormick Braun Friman, LLC at (312) 466-0800. Gregory A. Braun can be reached at (312)327-3354 / gbraun@mbflegal.com and Beth Prendergast bprendergast@mbflegal.com can be reached at (312)327-3369.