Bankruptcy and Short Sales
BANKRUPTCY: There are two main choices in bankruptcy: Chapter 7 or Chapter 13.
CHAPTER 7: This is the most popular choice in the Bankruptcy Court, as it allows a person to “discharge” (wipe out) consumer debts such as mortgage debt, credit card debt, medical bills and business debts, such as rental property mortgages. YOU HAVE TO QUALIFY FOR CHAPTER 7 BANKRUPTCY. QUALIFICATION IS BASED ON YOUR INCOME AND HOW MUCH SECURED DEBT YOU OWE.
CHAPTER 13: This type of bankruptcy is a payment plan that lasts for 3 to 5 years. It allows a person to pay an affordable monthly payment to satisfy their creditors. Certain debts do not have to paid in full. IT IS CURRENTLY THE ONLY BANKRUPTCY WHICH ALLOWS A PERSON TO STRIP OFF (ELIMINATE) AN UNSECURED SECOND OR THIRD MORTGAGE DEBT.
SHORT SALE: This is a procedure where a person sells their house for less that they owe on the mortgage debt. It requires that the seller’s mortgage company(s) agrees to take less than full payment. It normally results in a tax liability arising from the “forgiveness of debt” by the mortgage lender (However, a Federal Law eliminates this type of tax, if the forgiven debt is under $2,000,000 and the mortgage debt is a “purchase money” or “home improvement loan” on a personal residence. NOTE: California tax law limits the amount of qualifying debt to $800,000). A short sale will cause damage to your credit report and credit score, because the debt is thereafter listed as being “satisfied by less than full payment”.
OK…YOU HAVE THE BASICS…HERE’S HOW IT ALL COMES TOGETHER:
If you are contemplating a short sale and may also need to file bankruptcy, it is almost always a good idea to not complete the short sale prior to filing for bankruptcy. Why? Because, the short sale may create a tax liability (which cannot be discharged in bankruptcy) and, by eliminating the secured debt (which you do by the short sale) you make it less likely that you will qualify for bankruptcy (at least Chapter 7).
If you wait to do a short sale until after the bankruptcy proceeding is filed, you get to claim the secured debt (mortgage debt) in your bankruptcy and it helps you qualify to file the bankruptcy. After you file the bankruptcy, you can still complete a short sale. If you do so, there is no tax liability, since the debt was eliminated in your bankruptcy, and there can be no claim of “debt forgiveness” which creates the tax liability.
Why do a short sale after filing for bankruptcy? One reason is that a “short sale” is not as bad a credit score hit as a “foreclosure” would be. Even though filing bankruptcy is a severe blow to your credit standing and credit score, the additional hit you take with a “foreclosure” on your credit makes it worse. Further, certain lenders have underwriting criteria which will prevent you from obtaining a mortgage loan in the future if you have a foreclosure on your credit report.
Also a benefit, many lenders and servicers provide moving incentive ranging from $3,000 to $10,000 after a short sale… which may not be the case after a foreclsosure.
A short sale, done correctly, can put you in the clear of all mortgage debts.
This situation results in a concept I have named: “Anticipatory Bankruptcy Filing”. This concept is simply realizing where your economic road is heading; understanding the requirements to qualify to file bankruptcy, and; filing for bankruptcy before you create a situation that disqualifies you from doing so.
Something to think about before you pull the trigger on a short sale.
The Ruhl Team (Top 1% on Trulia and Zillow 5 Stars)
REALTOR – Over 1000 Successful Short Sales
Lic# 01493664 / eXp Realty