If you're having financial troubles with your house because your adjustable-rate mortgage (ARM) has reset to a rate you can't afford, you've experienced a major financial setback like losing your job, or you need to sell for whatever reason but your house is worth less than your mortgage, foreclosure may not be your only option. However, there is a last-ditch move that can salvage your credit and help you avoid bankruptcy. It's called a real estate short sale, and for those who are left with few remaining financial options, it may be worth a try. (For further reading, see What You Need To Know About Bankruptcy.)

SEE: How To Buy Your First Home

What is a Short Sale?
In real estate, a short sale occurs when a homeowner in financial distress sells his or her property for less than the amount due on the mortgage. The buyer of the property is a third party (not the bank), and all proceeds from the sale go to the lender. The lender either forgives the difference or gets a deficiency judgment against the borrower requiring him or her to pay the lender all or part of the difference between the sale price and the original value of the mortgage. In some states, this difference must legally be forgiven in a short sale.

Alternatives to a Short Sale
Before resigning yourself to a short sale, talk to your lender about the possibility of a revised payment plan or loan modification. One of these options might allow you to stay in your home and get back on your feet. Another possible option for staying in your home arises if you have private mortgage insurance (PMI). Many homeowners who purchased homes with less than 20% down were required to purchase PMI with their homes. If the PMI company thinks you have a chance at recovering from your current financial situation, it may advance funds to your lender to bring your payments up to date. Eventually, you'll have to repay the advance. (For more information on your housing payments, read Understanding Your Mortgage.)

If neither of these options are a possibility, be prepared to do a lot of work to complete a short sale. While a foreclosure essentially lets you walk away from your home (albeit with grave consequences for your financial future, such as having to declare bankruptcy and destroying your credit), completing a short sale is labor-intensive. However, the payoff for the extra work involved in a short sale may be worth it.

Before beginning the process, consider the likelihood that your lender will want to work with you on a short sale by understanding its perspective. The lender is not required to do a short sale; it will be allowed at the lender's discretion. Make sure that the source of your financial trouble is new, such as a health problem, the loss of a job or a divorce. The reason you are no longer able to afford the home should not be something problematic about your financial situation that you did not disclose when you originally applied for the loan. The lender won't be sympathetic to a dishonest borrower. However, if you feel you were a victim of predatory lending practices, you may be able to talk the lender into a short sale even if you have not had any major financial catastrophes since purchasing the home. (For related reading, see Saving Your Home From Foreclosure.)

Also, be aware of other circumstances that may prevent the lender from wanting to do a short sale. Unfortunately, if you are not actually in default on your mortgage payments yet, the lender probably won't be willing to work with you, even if you see the thunderheads looming over your backyard. Also, if the lender thinks it can get more money from foreclosing on your home than from allowing a short sale, again, the lender may not allow you to exercise this option. Finally, has anyone co-signed on your mortgage? If so, the lender may want to hold that person responsible for payment rather than doing a short sale.

If you think your situation is ripe for a short sale, talk to a decision-maker at the bank about the possibility of engaging in this type of transaction. Don't just talk to a customer service representative, who is often more like a spokesperson and has no real authority. To work your way up the phone ladder, immediately ask to speak with the lender's loss mitigation department. If you don't like what the first decision-maker says, try talking to another one on another day and see if you get a different answer. If the lender is willing to consider a short sale, you're ready to move forward with creating the short sale proposal and finding a buyer.

Proceed With Caution
At this point, you should consult an attorney, a tax professional, and a real estate agent. While you're probably thinking that the last thing you can afford is to pay for these high-priced professional services, if you make a mistake by trying to handle a complex short sale transaction yourself, you may find yourself in even bigger financial trouble. If you're already broke, perhaps you can pay these service fees out of the sale proceeds from your home. Professionals accustomed to dealing with short sale transactions will be able to give you guidance on how to pay them.

To put yourself in a more convincing position to complete a short sale, stop purchasing non-necessities. You don't want to look irresponsible to the lender when it reviews your short-sale proposal. (For help in getting your finances back in order, read Six Months To A Better Budget and Get Your Budget In Fighting Shape.)

When setting an asking price, make sure to factor the cost of selling the property into the total amount of money you need to get out of the situation. Of course, you want to sell the home for as close to the value of your mortgage as possible, but in a down market, there is bound to be a shortfall. In some states, even after a short sale, the bank will expect you to pay back all or part of that shortfall, but at least this amount will be significantly less than what you owed when you had a mortgage.

Gather all of the documents you'll need to prove your financial hardship to the lender. These may include bank statements, medical bills, pay stubs, a termination notice from your former job or a divorce decree. It is up to you to come up with the short sale proposal. Be aware that the lender ultimately must approve a short sale after receiving all the details because the lender is the recipient of the proceeds. Your job is to find a buyer for your home.

Once you have a buyer and the necessary paperwork, you are ready to submit the buyer's offer and your proposal to the bank. Along with the documentation of your distressed financial status, your proposal should include a hardship letter explaining the circumstances that are preventing you from making your mortgage payments. You want to make it as convincing as possible and protect your interests while also appealing to the bank. Be careful about submitting your financial information to a lender because if it does not approve the short sale, it may use your financial information to try to get money out of you in foreclosure proceedings. If you still have cash assets, you may be expected to use them to continue making mortgage payments or to make up some of the shortfall between the sales price and the mortgage amount. An attorney experienced in completing short sales can help you navigate the tricky details.

Hold Your Breath
Because short sales can take longer than regular home sales due to the need for lender approval, they often fall through. The buyer may find another property while waiting for an answer from you. Be prepared for this possibility.

Also, be aware that a short sale can still affect your credit score in the sense that the months of mortgage payments you missed prior to the short sale can show up as delinquent payments on your credit report. It is up to the bank to decide what to report, so it's in your best interest to try to convince the bank not to report your defaulted payments. Your bank may be more likely to be generous in this regard if you brought up your hardship before you were significantly behind. For credit purposes, while this is somewhat damaging, it is certainly less damaging than foreclosure. (For related reading, see The Importance Of Your Credit Rating to learn more.)

If the short sale transaction goes through, you can breathe a sigh of relief and start over with a major financial burden off your back. You probably won't even have to pay taxes on the shortfall. Normally, the tax code treats forgiven debt as taxable income, but on December 20, 2007, President Bush signed the Mortgage Forgiveness Debt Relief Act of 2007. Under this act, mortgage debt forgiven by lenders will not be taxable if the discharged debt is on their principal residence. This debt forgiveness only applies from 2007 to 2012, to a maximum about of $2 Million. The amount of debt forgiven still must be reported on your income tax return using Form 982. You should receive form 1099-C from your lender stating this amount. The IRS website can tell you more about how this legislation may affect you.

The Bottom Line
Not all lenders are willing to do short sales, and even when they are, short sales don't always close. However, they are an excellent alternative to foreclosure and are worth trying to complete. Without the stains of foreclosure and bankruptcy on your credit report, you will be able to get back on your feet much faster.

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