Shortfall Liability On A Short Sale

What happens to the unpaid debt in a short sale? This is a frequently asked question. Is the borrower still liable for what is not paid off in a short sale? Can the bank still come after the guarantors or the primary borrowers in a short sale situation? Yes, no, maybe!

Here is the reality – it is clear that there would be no short sale if the bank did not release the remaining debt owed and not paid off by the short sale. What would be the point? It is clear, however, that the bank could follow the borrowers and guarantors if they choose as a short sale may be allowed to sell or refinance the property and reduce the debt but the bank could continue to pursue the borrower if they chose. Probably pointless at that time, but possible.

I could imagine a borrower wanting to sell a property for less than the debt because it was worth less but if the borrower still had assets and net worth the bank could allow the sale and still demand additional payment or payoff from the borrower. This has happened and we do sometimes see this result. However, the savvy borrower in such a situation would make it clear to the bank that the short sale is contingent upon the bank releasing the borrower from any shortfall liability or costs of collection. If made clear, and appropriate paperwork stating this was agreed to and committed to by the bank, then the shortfall liability truly disappears.

I would not automatically assume this result prevails without a clear understanding and written statement supporting this contingency, in fact, I would make that part of the buyer’s offer to purchase, that the bank releases the seller from all shortfall liability which will then make it part of the deal and force the bank to accept it or counter.

In most cases, even if not discussed or added to the paperwork, the same result will be reached. But why leave it to guesswork? Why allow this important detail to be left incomplete? In addition, there is the issue of the conversion of forgiven debt to ordinary income for IRS purposes which will occur unless a 1099-C is added to your tax filing,  requiring the forgiveness of debt to be dealt with. Thus, it is an important issue for many reasons and must be included in any short sale.

Get a statement in writing forgiving the shortfall and then file the 1099-C to make certain it is not counted as ordinary income. Check with your accountant for the qualifying requirements for this.