Tom Kelly: State moves to halt short-sale whammy

Homebuyers may be attracted to the big bargains that foreclosures and pre-foreclosures can offer. But distressed properties can involve tricky, lengthy transactions, and there’s a lot to think about before jumping in.

In fact, some home shoppers have shunned short sales altogether, preferring a more reliable process to a reduction in price. Getting all parties to agree to a short-sale price can be problematic, and lenders have been known to change their minds when more bidders surface.

Given the difficulty and uncertainty of negotiating a short-sale transaction, you would think lenders would bend over backward to make things easier for the consumer once the deal is finally done.

But it appears some lenders are seeking an additional pound of flesh long after the frustrated, exhausted and often financially drained seller has moved on.

Short sales occur when owners, often in distress, sell their homes for less than the amount they owe their lenders. The lender may then write off the remainder of the debt and receive tax benefits.

Some lenders, however, will also assign or sell the remaining debt obligation to third-party debt collectors, often for pennies on the dollar. The third-party debt collector can then use the legal system to continue to pursue the former homeowner for the balance owed.

The problem has become such an issue that legislators in Olympia have taken action. SB 6337, proposed by David Frockt, D-Seattle, would protect short-sale sellers from being pursued by lenders or their assignees for the difference between the sale price and remaining loan balance.

“The banks will basically have to make a choice,” Frockt said, “to either write off the amount and take the tax benefit or pursue the owner, but they cannot do both.”

When a lender agrees to a short sale, it can either retain the ability to collect from the short-sale seller the amount of mortgage debt owed by the seller that is not satisfied by the purchase price, or it can discharge all or a portion of the unsatisfied debt amount.

If a lender discharges debt, it reports this discharge of debt to the Internal Revenue Service on a 1099-C Cancellation of Debt Form. The issuance of the 1099-C allows the lender to take a tax deduction for the loss represented by the amount of debt discharged, and this same amount of debt discharged becomes taxable income to the short-sale seller.

After the taxpayers bailed out the mortgage industry, many borrowers are still unable to get a loan modification to stay in their homes. Now the industry has a sketchy-to-lousy national reputation and more stringent qualifying standards are not helping their case. In light of all this, how can some lenders knowingly seek both a tax deduction for the mortgage debt not paid while also seeking to collect that same mortgage debt?

“Yes, we have heard of this happening,” said Deborah Bortner, director of consumer services for the Washington State Department of Financial Institutions. “I hear it mostly from attorneys or others who assist those in obtaining a short sale. I understand that the documentation provided by the institutions doesn’t always make it clear whether they will pursue a short sale or not. The consumer only finds out later when contacted by someone trying to collect the deficiency.”

In some instances, mortgage debt collection rights have been referred to third-party debt collection companies, even though short-sale sellers have paid income tax on the amount of this discharged debt.

“This is another step to help the short-sale process that is keeping many homeowners from the tragedy of foreclosure,” said Faye Nelson, president of the Washington Association of Realtors. “Nearly 40 percent of the inventory in the Puget Sound region right now is short sales. State legislators recognize that protecting this process is critical to homeownership and the housing market.”

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