Bankruptcy and Short Sales: California

by Bankruptcy Law Network (BLN)

April 5, 2009

Every week we get clients filing for bankruptcy protection asking questions whether they should proceed with a short sale on their real estate.  The bottom line, is that if you are filing for bankruptcy, you should forget about a short sale in most situations.

Lets first define what a short sale is.  When you sell real estate “short,” you are asking the lender to approve the sale without receiving the full amount of their loan, very common now in this depressed real estate market.  For example: you bought a home in 2005 for $500,000 with a first mortgage of $400,000 and second mortgage of $100,000.  The property is now worth $300,000 and you have a buyer willing to close escrow in 30 days for $300,000.  If the first mortgage agrees with the sale, they will receive about $100,000 less than their current debt and the second will receive $0.  Typically the second signs off with a nominal payment such as $5,000.00.

The short sale then triggers a host of problems that the borrower does not discovery until later. But if you are filing bankruptcy, there is usually no reason for the short sale.  In fact, the short sale generally hurts more than helps for at least five reasons.

First, the short sale triggers a taxable event and allows the lender to issue a 1099-A or 1099-C.  This is sent to the IRS and essentially states that you received income that you now need to pay taxes on.  In the forgoing example, you would then need to pay taxes on $100,000 of income.  There are ways to get around this, but you need to qualify.

Second, it will damage your credit.  Since you are breaching the contract, the lender has the right to report that you did not pay the balance in full.  It is has almost the same effect your credit report as a foreclosure, and is usually far worse on credit reports than any bankruptcy filing. This can lower your credit score by as much as 200 points.

Third, there may be no need to do the short sale in light of 580b and 580d.  In other words, since the lender probably has no other recourse against you since the loan was purchase money or will foreclose non-judicially, the short sale is not changing any liability issues.

Fourth, you are wasting your time and money.  The only party really benefiting here is the realtor and buyer.  Since all the work, worries, and monies you provide do not benefit you at all, the entire short sale process is usually done in vain.  Instead, the realtor gets a fat commission at your expense.

Fifth, you will be losing time in your property.  Since the typical foreclosure process can usually last over a year when a bankruptcy is filed, you may be losing a substantial amount of equity recoupment or rents.  If your mortgage is $4000 per month and you short sale now as oppose to allow foreclosure a year from now, you lose about $50,000.00.

Instead, it is usually best to surrender the home after the bankruptcy is filed.  Under bankruptcy laws, there is no taxable event on a foreclosure after bankruptcy (except possibly a capital gain in rare cases in today’s economy), the lender can not report to credit bureaus foreclosure but can only report “$0.00 balance, bankruptcy discharge” (which by the way gets reported in all bankruptcy cases whether you keep the home or not and is generally better than foreclosure or short sale in terms of effecting your credit score), the debt is finalized as non-recourse, you avoid wasting your time and money, and you are able to stay in the property or rent it out longer.

Thus, at least in California, it is advisable in almost every case to avoid a short sale if a bankruptcy case is being filed.  If you are currently in a short sale process and your bankruptcy has not been filed yet, you may want to get out asap.  To the extent any buyer or realtor tells you you can not, simply list them as a creditor in your case and any claims they have will then be discharged as well.

Written by Michael G. Doan San Diego Bankruptcy Attorney

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Last modified: April 16, 2012