Is this really the ultra-savvy financial move it is made out to be, or are real estate agents and foreclosure rescue firms glossing over the ugly tax and credit implications of a short sale?
Why Care About My Credit if I Already Have Late Payments?
If you have already taken some hits to your credit score from late mortgage or credit card payments in the last couple of years, all is not lost. It is still wise to do everything in your power to minimize further damage.
Whether you like using it or not your credit is one of your most valuable assets. You won’t just pay more on car loans and future home loans if you have a poor credit score, you may not even be able to rent an apartment or finance a washing machine when yours breaks down. Human resources managers now also openly admit that unless you have good credit, your job application is going straight to the shredder. Already have a job? You may not once reviews come around and the boss finds out you just went through a foreclosure.
Fair Isaac spokesman Craig Watts recently pointed out that, “The lending industry tends to regard an account differently when it has become 90 or more days late,” and “a single one-time black mark results in steep drops, but it is when they fall further behind that things get really harsh.”
So is a short sale the best route for minimizing the credit implications of a default?
Credit Implications of a Short Sale: The Real Deal
Real estate agents, investors and foreclosure rescue websites are hounding underwater homeowners with the message that electing to do a short sale does far less damage than going through a real foreclosure and that even those not at risk of becoming delinquent are smart to use short sales as part of a “strategic default.”
Some say that credit reporting agencies treat foreclosures, a deed-in-lieu of foreclosure or a short sale equally when modeling credit scores; others claim there is a big difference.
So what’s the real deal?
The credit bureaus have recently begun to break the silence and provide more insight into their modeling systems to make it easier for homeowners to analyze their options.
However, the main problem and reason for all the confusion is that credit scores are the result or incredibly complicated mathematical equations and depend on a huge number of variables. Even Maxine Sweet, Experian’s VP of public education, states that, “Some borrowers will fall much more steeply than others for the same payment problem.” It has a lot to do with where you are starting from and how much credit history you have. Clearly, if you have a ton of good credit, one late payment won’t hold you back forever versus those who only have a mortgage in foreclosure on their reports.
FICO®’s cheat sheet for the average hit your credit score will take for mortgage issues:
- 30 days delinquent, 40 to 110 points
- 90 days delinquent, 60 to 135 points
- Short sales, foreclosure or deed-in-lieu, 85 to 160 points
- Bankruptcy, 130 to 240 points
However, Fair Isaac’s principal scientist, Frederic Huynh, also disclosed that the amount of damage done to credit scores from foreclosures has a lot to do with whether there is a deficiency balance left over. In other words, if the outstanding debt is forgiven in a short sale, an individual starting with a 680 credit score may see a drop as small as 50 points. In contrast those allowing their homes to be foreclosed on and sold off by the bank, resulting in some of the debt remaining outstanding, will find themselves taking the biggest hits.
This is another critical factor for homeowners to keep in mind. Many states still allow lenders to obtain and pursue borrowers with deficiency judgments even after taking possession of the property. This means borrowers who do not choose short sales could both lose their homes and still owe on the mortgage! Not a position you want to be in.
So the credit implications of a short sale can potentially be less harmful than other options or doing nothing.
Tax Implications of a Short Sale: Ready for a Giant Tax Bill?
Will selecting a short sale as a way of avoiding foreclosure land you with a killer tax bill?
The only reason you weren’t held liable for taxes on the money you received from your lender to buy your home was because the IRS believed you were going to pay it back. If a lender forgives any debt you owe, it instantly becomes income. What would an extra $100,000, $250,000 or $1 million do to your tax return without any additional write-offs to balance it out?
If you are in the 35 percent tax bracket for 2012, just $100,000 more in income means an extra $35,000 you’ll owe the IRS!
That’s just federal income tax; if you’ll owe state income tax too, you may just want to hole yourself up in your bunker and prepare for a stand-off.
Fortunately, thanks to the passing of the Mortgage Forgiveness Debt Relief Act of 2007, those choosing short sales can get a tax break if they complete the transaction by the end of 2012. This act gives those completing short sales on their primary residence exclusion on any taxes due on up to the first $2 million of forgiven debt. Note that this does not apply to other properties owned.
Borrowers who are struggling with their mortgage payments or who are choosing to default or complete short sales for other reasons also need to be aware of the coming tax tsunami at the end of this year dubbed “Taxmageddon” when billions in tax credit programs expire, making it essential to get on that short sale immediately.
The Bottom Line
Borrowers weighing the tax and credit implications of the short sale do have some tough decision making to do. However, it is clear that – for those who act quickly – a short sale can easily be the best option.
This is on top of the fact that many lenders are dishing out up to $20,000 or even more to help homeowners relocate if they are willing to do a short sale. This could be your only chance to walk away, owe nothing and actually get money in your pocket.
You’ll also be happy to know that short sales also normally enable borrowers to qualify to get a new home loan much faster, ranging from immediately to three years down the road depending on the details.
What is critical is to have a plan for getting your finances and credit back on track. Make a plan to re-establish good credit and you could see your credit score return to its glory day in as little as three years, though blemishes can remain for up to seven, and some will find it takes longer to mend.