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Short payoffs and Short Sales are alternative techniques to allow an owner to close on the sale of property worth less than the debts secured by it. Depending on the circumstances surrounding a particular property and seller, either alternative may be possible with each option having its own pros and cons.

A "short payoff" or "short sale" is a transaction in which a lender agrees to accept less than it is owed to permit a sale of the property which secures its note. (Throughout these materials, the term "lender" or "lenders" refers to the collection of institutions aligned on the "lender's" side, which might include the holder of the note, a loan servicer, and a private mortgage insurance company.) HUD seems to call these sales "Pre-Foreclosure Sales."

In a typical short payoff, the lender agrees to accept the net proceeds from the closing (the sales price, minus the cost of closing the transaction, including commissions, escrow, pre-payment penalty, etc.), perhaps with some additional consideration from the seller (such as a promissory note) in exchange for releasing its lien. Lenders do not agree to short payoffs to be generous. In negotiating the short payoff, the lender needs to be convinced that it will come out better than it would by foreclosing on the property and reselling it in the near future. Though short payoff procedures vary somewhat from lender to lender, most lenders need to be convinced of the following:

1. The sales price under the proposed contract is equal to or higher than the amount for which the lender would be able to sell the property after a foreclosure. The lender will require a market analysis from the REALTOR® listing the property. The lender will often confirm the market analysis by contacting its own sources, such as an appraiser or the real estate agents which handle its REO sales.

    

2. The commission under the proposed transaction is equal to or less than the commission it would pay its agent for selling the property after foreclosure. The lender will want to know as precisely as possible the amount of proceeds it can expect to receive from the sale. The more precise the estimate, the better.  This is typically obtained from information on the seller's HUD-1 net sheet, prepared by the escrow company handling the sale transaction. 

    

3. The lender will want an explanation of the circumstances which created the need for the short payoff transaction. Common explanations include divorce, medical problems, death, birth of a child taking one wage earner out of the work force, birth of children making the existing home too small, loss of a job, or a job transfer creating the need for a move.  Also, in the majority of situations I deal with today, the seller has had a low 1-4% "teaser" start rate on their mortgage with a negative amortization clause adding unpaid interest onto the original principal balance.  Once the principal balance grows to over $125% of the initial balance, the loan may "recast" with a new, substantially higher, payment.  Additionally, the seller may not be able the refinance, due to a pre-payment penalty and insufficient equity due to a depreciating market.

    

4. That the seller doesn't have the money to make up the shortfall on their own. To verify the financial condition of the seller/borrower, the lender will require: financial statements showing the seller's assets, liabilities, income, and expenses; the seller's tax returns for the previous two years; and the seller's paycheck stubs for the most recent pay periods. The most common disputes which arise in short payoff sales concern the seller's financial condition. On the one hand, the lender will be reluctant to approve a compromise without having the ability to analyze the financial strength of the seller.

A borrower with minimal assets, little income, and a willingness to file bankruptcy has little to lose by providing financial information. However, most candidates for short payoffs have some assets, a good job with garnishable wages, or a desire to avoid bankruptcy. Candidates for short payoffs need legal advice regarding the advisability of submitting financial information to the lender. Though a refusal to submit financial information to a lender greatly decreases the chances of closing, a refusal to submit financial information does not necessarily preclude closing on a compromise sale.

When working on short payoffs, certain issues and problems frequently arise. It is important to keep them in mind.

A seller's ability to close on a compromise sale is not within his control. It is important that in any contract which the seller accepts, his/her obligation to close is contingent upon successful negotiations with the lender.

Most sellers would like to protect their credit rating as much as possible. A substantial motivation for a short payoff as an alternative to simply allowing the property to go into foreclosure is avoiding the detrimental credit consequences of a foreclosure. The seller is advised to seek legal and tax counsel regarding steps which can be taken to ameliorate the credit consequences of the work-out.

It is unlikely that a seller will receive any proceeds from the closing on a compromise sale. (Note, however, that in the HUD short payoff program, borrowers may receive money out of the sale as an incentive to close.) Yet the closing is likely to force the seller to move. If the seller hasn't already moved, or doesn't have some other reason to move, closing on a short-pay might actually hurt the seller. The dawning realization of being homeless might make a short pay seller back out of a closing. Because the foreclosure process generally takes five or so months to run, it might be in the best interest for some owners to live in their home until the end of their redemption period in the foreclosure. >

These transactions often require a patient buyer. Working through the bureaucracy of the loan servicer, the investor, and the private or public mortgage insurance company takes time. Closing dates may need to be extended. It is important to work with buyers who have flexible closing needs and flexible dispositions.

As many as three entities may be involved on the lender's side of a short payoff transaction. It is not unusual for the mortgage insurance company, the investor, and the loan servicer to have several different departments working on the transaction. Errors may arise simply due to bureaucratic miscommunication. It is important to get the terms of the short payoff transaction (release of liability, no adverse credit consequences ... etc.) in writing.

You may occasionally run into a seller who initially does not care about the financial or the credit consequences of a short payoff transaction because he has filed, or is about to file, bankruptcy. While this may seem to be a blessing, it should raise concern. Bankruptcy affects the seller's ability to convey title and may disrupt a transaction which you have worked long and hard to put together. A seller filing bankruptcy will usually already have legal counsel. In these circumstances, the REALTOR®; needs legal advice.

A seller who has little concern for the financial and credit consequences of a short payoff has little incentive to avoid these consequences. Often these sellers seem to be very agreeable until they realize that they will need to move out of the property sooner than if the property went into foreclosure These sellers may decide to let the foreclosure run its course, rather than close on a compromise sale.

Short payoff transaction may involve the forgiveness of debt which may create detrimental tax consequences to the seller. While residential short pays rarely create capital gains problems for their sellers, a commercial short-pay is likely to cause a recapture problem for a seller. Sellers should consult their tax advisors.

Keeping the above factors in mind should increase your chances of successfully closing on a short pay sale.

In some states, other than California, a lender can sue the borrower for the difference between the payoff on the note and the highest bid at the foreclosure sale. This difference is called a "deficiency." In the vast majority of foreclosure sales, the lender is the successful bidder at its own sale. As a consequence, a lender has much control over a borrower's post-foreclosure liability.

The foreclosure statutes are written to encourage lenders to bid a property's fair market value at a foreclosure sale. One of the ways in which the statutes encourage fair bids is by giving the foreclosed upon owner redemption rights. The successful bidder at a foreclosure sale does not obtain title to the property. Instead, it obtains a receipt (the "certificate of purchase") which entitles it to receive a public trustee's deed after the expiration of all applicable redemption periods.

A failed attempt at a short payoff can actually put a seller in a worse position than he would have been had a short payoff not been pursued at all. The efforts to document the property's fair market value (the market analysis and the proposed offer) help the lender justify biddi

Short Payoff Advantages:

Depending on the interplay of a variety of circumstances, it is sometimes best not to aggressively pursue the short payoff, and to instead allow the property to go into foreclosure as quickly as possible. Of course, this strategy has its dangers. Once the property goes to foreclosure sale, the seller has lost the short payoff alternative. It has put all of its "eggs" in the "redemption basket." Decisions regarding how aggressively to pursue a short payoff, when to give up pursuing a short payoff, and the likelihood of a redemption are decisions which should be made after careful consideration between the REALTOR®, the seller, tax advisor and the seller's lawyer. 

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Disclaimer -- Content is general information only.   Information is not provided as advice for a specific matter, nor does its publication create an realtor-client relationship.   For legal advice on a specific matter, consult an attorney and/or tax professional.  Information deemed reliable but not guaranteed.