A short sale or foreclosure doesn’t always release the borrower from the obligation to pay the outstanding balance known as the deficiency balance. However, deficiency is waived when a short sale occurs under the HAFA (Home Affordable Foreclosure Alternatives) Program or if the lender agrees to write off the loss and forgive the debt. Lenders write off debt by issuing a 1099 to the borrower for the deficiency amount. Most borrowers do not have to pay taxes on the 1099 income under the Mortgage Debt Forgiveness Debt Relief Act of 2007.

What Is a Deficiency?

Most short sales and foreclosures in Colorado result in a deficient balance on the amount owed to the bank. Colorado law allows a lender to pursue a borrower for the deficiency balance for up to six years if the homes forecloses or sells via a short sale. Both scenarios create the same liability.

Deficiency Judgment

If the lender does not waive the right to pursue the deficiency, the borrower is at risk for a deficiency judgment from the court. A deficiency judgment is an unsecured money judgment against a borrower whose short sale or foreclosure sale did not produce sufficient funds to pay the loan in full.

How to Avoid a Deficiency Judgment

The most common way to avoid a deficiency judgment is to complete a short sale under the HAFA. Many Borrowers avoid paying a deficiency judgment by filing Chapter 7 bankruptcy to discharge the debt owed in the judgment. Bankruptcy is the main reason a lender chooses to write off deficiency balances instead of pursuing judgments against former homeowners.

For those lenders who do not participate in the Making Home Affordable Program, there isn’t a formal way to have the deficiency waived. However, most lenders have found that pursuing a borrower for a deficiency balance only leads to additional losses since most borrowers will file a Chapter 7 bankruptcy to avoid paying the judgment. Lenders typically forgive the debt and 1099 a borrower in the deficiency amount. This allows a lender to write off the loss incurred during a short sale or foreclosure.

The 1099-C and $0 Tax Liability

When a lender writes off a mortgage loss, the borrower is issued a 1099-C in the amount of the deficiency balance. The borrower must report this as income and pay income taxes or write off the entire amount tax free under the Mortgage Forgiveness Debt Relief Act of 2007. For example, borrowers selling a primary residence are not liable for income taxes.

Borrowers whose debt is reduced or eliminated receive a year-end-statement (FORM 1099-C) from the lender. By law this form must show the amount of debt forgiven and the fair market value of any property given through short sale or foreclosure. Borrowers need to check the 1099 carefully. Notify your lender immediately if any of the information is incorrect. Borrowers should pay particular attention to the amount of debt forgiven (BOX 2) and the value listed for their home (BOX 7).

Short Sale Credit Reporting, Future Loans

There are varying opinions on how credit is impacted after a short sale is complete. The impact primarily depends on the number of missed payments. A homeowner who has missed payments for 90 days prior to the short sale versus 360 days will have different impacts on their credit score. The general rule of thumb is a credit score drops 80-100 points.

Many sellers are able to avoid having a short sale reported on their credit report by negotiating with the lender. This requires a call to the lender and full cooperation during the short sale process. The old adage applies: “you can catch more flies with honey than with vinegar.”