OBSERVATIONS ON DISTRESSED TRANSACTIONS
It wasn’t that long ago that there were many Realtors® who vowed they would never get
involved with short sales. They believed, as did most, that it was a passing aberration, and the disadvantages (e.g. delays, confusion, complications, etc.) outweighed any possible advantages.
Why not just concentrate of the sale of homes where the owners had equity (aka “equity sales”)?
Throughout most of 2009 and into 2010 however, as reality set in, most Realtors® were still not fully prepared to discuss with their clients the pros and cons of doing a short sale versus permitting the home to go into foreclosure or executing a deed-in-lieu of foreclosure. While the best practice is always to recommend that clients secure outside professional assistance, e.g. with an attorney, CPA, or similar expert, it is also useful for Realtors® to have a passing familiarity with the basic issues raised in distressed sales transactions.
Today, short sales comprise 30% to 55% of all sales – depending upon where in Oregon you live. In light of these numbers, short sales, as frustrating as they can be, have to be given serious consideration and attention, even for those who have still never done one. They have now become an inherent part of the real escape transactional landscape, and Realtor® survival means becoming familiar with all of the various conditions now existing in the marketplace. Additionally, today, most Realtors® have now run across a variety of distressed ownership situations where they are being called upon to also be familiar with the Oregon foreclosure
process, since timing is everything – and a short sale means nothing if it can’t be closed before
the date of an impending foreclosure.
To that end, I’ve listed below some answers to several basic distressed transaction questions. These are my answers alone, and people are free to disagree. One caveat – these answers are
general in nature and not intended to replace advice from an expert familiar with one’s specific
Question: If the owner’s home is going into foreclosure, is it better to sign a deed-in-lieu of foreclosure than to let the foreclosure process play itself out?
Answer: Each situation is different. If the buyer’s credit is already severely tarnished and they have nowhere else to go, some might say that letting the legal process take its course, which could take several months (5+ on the short side and 8+ on the long side), might be a reasonable course of action. Plus (as discussed below) the foreclosure of a primary residence will automatically extinguish any liability under the promissory note. This is because there can be no deficiency judgment in the foreclosure of a residential trust deed. Undoubtedly, the deed-in-lieu and a foreclosure will negatively impact the owner’s credit rating since in both cases, since the lender is not receiving any further payment on the loan. But, on the upside, foreclosure avoids all risk of deficiency liability under the promissory note, whereas the deed-in-lieu does not. And remember, the lender selected this particular security document and foreclosure method, knowing the pros and cons of the trust deed law. So, permitting the foreclosure process to take its course means that the distressed owner could remain in the home for several months, presumably making no further payments, banking the money or using it for other necessities and trying to make the best of an unfortunate situation. While some may look down on this from a “moral” perspective, others may say that from a business perspective (which is what banks do), this was the bargain the lender struck when they first made the loan.
Question – What if the owner signed a deed-in-lieu rather than wait out the foreclosure? Would this change the above answer?
Answer: Yes, it could. While Oregon law prohibits the lender from getting a deficiency judgment (i.e. a judgment for the remaining unpaid sum due under the promissory note plus costs and attorney fees), as noted above, if the foreclosure is on a primary residence, there is not the same insulation from deficiency liability when a deed-in-lieu is given to the lender, since an actual “foreclosure” has not occurred. It is the “foreclosure” that cuts the deficiency liability off, since Oregon law prohibits any further action under the note. For this reason, if a deed-in-lieu is signed, it is important to make sure that it the homeowner is relieved of all remaining indebtedness under the promissory note. Unfortunately, most lenders are not agreeing to do so. In some cases, they simply decline to commit, which means that upon signing the deed-in-lieu, the borrower has no certainty about future liability. Incidentally, a written agreement with the lender to take no deficiency judgment or otherwise make any further claims under the promissory note should be attempted in all deed-in-lieu situations, regardless of whether it is a primary residence. Note also that a second home does not qualify as a “primary residence.”
Question: In a short sale, how do I deal with the additional liens behind the first mortgage?
Answer: They cannot be ignored if the seller is to pass clear title to his/her buyer. This means that somehow, the holders of seconds and thirds are going to have to consent to remove their liens from the public record. The problem is that if the seller has negative equity, i.e. they are “underwater,” there is, no money left from closing once the first is paid off. So what incentive does the holder of a subordinate lien have to cooperate? Some lenders can be short-sighted on this issue, while some take a more practical view. It is true that the subordinate lienholder may get little or no money out of the closing. But if they kill the short sale through non-cooperation they do themselves a greater disservice. Banks do not like nonperforming assets because it merely increases their capital requirements, which the banking regulators watch closely. The holder of a junior lien has a lien on a nonperforming asset (the note and trust deed) that they could get off their books by cooperating with the short sale process. Perhaps they can get the holder of the first – and possibly others with “skin in the game” (such as the Realtors® or other creditors in closing) – to give them pennies on the dollar to cooperate. But if the subordinate lienholders refuse to cooperate, the holder of the first trust deed will simply foreclose everyone, thus cutting off the junior’s rights anyway. (Note: if the junior lienholder is foreclosed, however, they may still have a claim under the promissory note against the owner. So it is always in the owner’s interest to get everyone to cooperate in the short sale process by releasing all indebtedness under their respective promissory notes – even if this means signing a new promissory note, perhaps for a discounted amount, on the deficiency for the second.)
Question: In a short sale, what is the difference between the “debt-relief” issue and the “promissory note liability” issue?
Answer: These are two distinctly different concepts. The debt relief issue deals with how the IRS treats situations in which a debtor is relieved of liability under the promissory note. So in a short sale, deed-in-lieu, and even in a foreclosure, there are potential “debt relief” consequence in which the IRS could treat any unpaid indebtedness as income. This means that the lender could issue a 1099 to the IRS, with a copy to the owner, and a tax could be assessed. Whether, and in what amount, there is a tax issue, is for the experts, i.e. the CPAs and/or tax attorneys. It is important to know, however, that at the end of 2007, there was a federal law passed eliminating any tax on debt relief arising out of the forgiveness of purchase money debt on a primary residence. However, the debt must have been used for “purchase money” of the residence. A refinance would qualify, but only to the extent of the original purchase money note and trust deed. A piggy-back loan (e.g. 80% and 20%) would similarly qualify if the funds were solely for purchase money of the residence. If the loan proceeds are used for non-purchase money, e.g. a HELOC to finance a vacation or automobile, it would not qualify. Neither would this protection extend to a rental or vacation home, since neither are a “primary residence.”
The promissory note liability issue deals with the lender, and arises if they agree to a short sale or deed-in-lieu where payment of the remaining note balance is not expressly excused. However, remember, if the owner agrees to pay back all of the remaining indebtedness to the lender, the debt relief issue becomes moot.
Question: How do these various distressed transactions impact one’s credit score?
Answer: That is the $64,000 question. Every case is different and since the credit companies’ algorithms are proprietary, the calculations are not made public. Undoubtedly, there will be some negative impact, and anyone who says otherwise should be asked to point to any authority supporting that proposition. All one has to do is look at the “myfico.com” website to get some sense of the factors that come into play. Distressed homeowners should be directed to the website. A distressed owner with a perfect credit who completes a short sale is likely to have less of a negative impact on their FICO score than one whose credit record shows multiple late payments to multiple creditors – especially on credit cards.
© 2010 QUERIN LAW, LLC