Do not trust a Realtor's® advice on short sales.

Paul Owers, the shill real estate reporter for the Sun-Sentinel, published an article advocating short sales today:

“Short sales are becoming more prevalent as South Florida's housing slump deepens. It's an attractive option for debt-ridden homeowners who bought at the height of the housing boom or who siphoned the equity out of their homes and now are left in the lurch as prices plummet.”

“Short sellers walk away without the stigma of losing their homes to foreclosure tainting their credit reports. But they do have to count any amount forgiven by a lender as taxable income.”

“Lenders also benefit because they're saving thousands of dollars in carrying costs and other expenses by wiping the properties off their books.”

“‘It's a great tool,’ said Ron Rosen, Stark's Lighthouse Point-based real estate agent. ‘It helps out everyone.’”

But there’s a huge problem with this statement; a short-sale does not always “help everyone out.” It does help out the Realtor who typically makes much more in commissions from a short sale than from selling a bank-owned foreclosure. It does help out the lender who will save thousands on legal bills by avoiding the foreclosure process. From an accounting perspective, it is also advantageous for a lender to encourage a short-sale because it will not have to carry the foreclosed property on its books – a property that will have to be carried on a lower-of-cost or market basis, which is typically far below the fair value of the mortgage debt.

However, a short-sale can be absolutely devastating for troubled borrower because of its potential tax implication. Depending on their personal situation, a troubled borrower could end up paying a massive tax bill following a short bill. Jonathan Alper, an Orlando attorney, does a great job of explaining the potential tax implication in his article, Income Tax Liaibility From Deed In Lieu Or Short Sale. In another article, he explains:

“Many people who invested in real estate at the end of the boom are in financial trouble. I have been getting more and more inquiries from individual investors facing foreclosures of their investment properties. Often, people tell me they are discussing “short sales” with their mortgage lenders. In a short sale, the lender allows the house to be sold for less than the mortgage balance. The borrower avoids a deficiency judgment. The lenders would rather get most of their mortgage through a sale arranged by the owner then take the property back at a foreclosure sale. Borrower should beware of short sales.”

“The problem for the borrower in a short sale is that the difference between the payment to the mortgage company and the full mortgage balance is a forgiveness of debt for tax purposes. The mortgage company is forgiving the debtor’s liability for the deficiency. The IRS considers forgiven debt to be taxable income to the borrower. The mortgage lender may send the borrower a Form 1099 for the amount of the deficiency. Most borrowers who cannot afford mortgage payments can even less afford additional tax liability. Owing money to the IRS is usually worse than owing money to a mortgage lender. Many mortgage lenders will not pursue debtors for deficiency judgments; the IRS will always pursue unpaid taxes. For that reason, most borrowers will fare better by letting their property go to foreclosure, even if the foreclosure may result in a deficiency liability.”

I just wish that every consumer that was considering a short sale would read this before they went forward with a short sale. However, the vast majority will enter a short sale completely ignorant of the potential tax implications.

The problem lies with most Realtors® and lenders. Both parties have a vested interest in talking homeowners out of foreclosure and into a short sale. They do so without any disclosure requirements on the tax implications whatsoever. In many cases, the consumer learns about the about the IRS debt forgiveness rules for the first time when they receive their 1099 at the end of the tax year.

Even if the consumer is aware of the potential tax liability, I have seen many Realtors® and lenders give completely false information. Usually, it's poor advice on Internal Revenue Code (IRC) 121 insolvency rules, rules that allow certain taxpayers to avoid recognizing the debt forgiveness as income. A consumer should know that these rules are highly complex and does not exclude most assets (including tax-deferred retirment accounts) from the calculation. Many CPAs, tax attorneys, and the IRS themselves have problems with these calculations – having a completely unqualified Realtor® or lender provide advice on these matter is, without a doubt, foolhardy.

Lately, I have heard that some Realtors® explain that new rules passed by Congress allow homeowners to exclude the forgiven debt. Beware of this advice as well. The Mortgage Cancellation Tax Relief Act of 2007 (H.R. 1876) is nowhere near passage. And, even if it does pass, it will probably not be retroactive.

Going forward, I will be broken record on this issue: If you're having trouble with your mortgage, whatever you do, do not trust a Realtor® or a lender to provide you with financial advice. Remember, it was probably a Realtor® or lender that helped you get into this mess, relying on one to get you out is simply foolish.

If you are having problems, seek out a qualified CPA or an attorney before you talk to anyone else.

By saying all this, I am in no way saying that a short sale is always a poor choice for all troubled borrowers. For many troubled borrowers, short sales are the optimal choice. However, Realtors®, lenders, shill media writers, and even this humble blogger should not make that decision. Again, seek qualified, professional advice from a CPA or an attorney.