Effective January 1, 2011, a lender who approves a short sale of California residential property may not look to the seller for the shortfall. The addition to the California Code of Civil Procedure at Section 580(e) applies only to properties of one to four units and has an exception if the seller commits waste or fraud.
This closes a terrible pitfall in the short sale process that has distressed me for a long time. Borrowers with properties worth less than the debts secured by the property have pushed to sell the property rather than let the property be foreclosed. The “reasoning” (often, in my mind,fallacious) is that a short sale is less harmful to the borrower’s credit than foreclosure, a view chorused by realtors who see a commission in the deal for themselves.
My biggest objection to the short sale is that often the realtor has not explored with the borrower whether the lender is expected to forgive the debt not satisfied by the sale, or whether the lender expects the seller to sign a new note for the shortfall.
This new legislation puts an end to that choice: approval of a short sale is deemed to be a waiver of any right to collect the balance of the debt not paid from escrow.
Prohibiting collection of the shortfall brings with it another issue realtors often don’t point out to sellers: the amount forgiven by the lender will be reported to the IRS as income! Canceled debt is included in the seller’s income, just as though the seller had received that amount in cash, unless the seller is insolvent according to the IRS’s calculation, or the debt was earlier discharged in bankruptcy.
This is of necessity a summary of a complex issue and if this fact pattern applies to you, get thee to a tax advisor before concluding a short sale.
Sellers at short sales will now have certainty that they won’t be liable for the unpaid debt on the first mortgage. They will have to address the tax consequences of the sale and the rights of any holder of junior liens on the property sold.
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