Let's say that house you bought a few years ago at the height of the market is now worth much less, significantly less than what you owe on the mortgage. And let's say that you've finally gotten sick of paying for more house than you've got, and you want to be rid of it.
I applaud you for reaching the point where you're ready to be rid of an underwater house. Many people never get there.
One of your options is simply to stop paying the mortgage and wait for the bank to foreclose. There are pros and cons to that approach, but I won't discuss them here.
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A second option is to do a "short sale." You find a buyer, you convince the bank that your buyer's price is the best you can get, you convince the bank that it should release you from any deficiency on the mortgage, and you conduct the transaction.
I have several qualms with short sales. The first has to do with second mortgages, where you're damned if you do, damned if you don't. The lender on the second mortgage does not have to release you from that obligation. Even if the first mortgage holder decides to forego any deficiency left over after the short sale, the second mortgage holder might decide to continue holding you liable.
On the other hand, if the second mortgage holder does decide to release you, then the debt they've foregone could be considered income, and that income could be taxable. Many states and the federal government have passed laws saying they won't collect that tax, but those laws often lapse and the legislatures don't always renew them immediately. If your short sale takes place during a lapse period, you could be facing a substantial tax bill. (One of my clients received a tax bill for over $100,000 after a second mortgage was released in a short sale!)
Second, I don't really see how a short sale benefits you. It clearly benefits the bank: Maybe they won't get the full amount they're due under the mortgage, but there's no way they were going to get that amount anyway. More important to them, a short sale gets a new homeowner in there right away, right now. The bank avoids having to wait months for the legal processes to conclude before they see any money.
Short sales benefit the bank in another critical way: A short sale puts all the responsibilities and headaches of conducting the transaction on you. You have to find a buyer. You have to get bank approval. You have to ensure that sale closes successfully. All that is quite a hassle, and the bank is happy to have you do it instead of them.
But there's a third way to get rid of an underwater house that avoids these problems: surrendering it in a bankruptcy case.
When you file a case with the Bankruptcy Court and have an underwater house, you have two main options: You can either keep the house and keep the debt, or you can get rid of the house and get rid of the debt. The latter is called "surrendering" the house.
When you surrender a house as part of a bankruptcy case, the Bankruptcy Court cuts your obligation to pay the mortgage. The bank still has to take title, which they can do either by foreclosing on the house or accepting a deed in lieu of foreclosure, but you are out of the picture. What's more, there is no issue with any second mortgage. The first mortgage holder gets the house in full satisfaction of that debt, and the second mortgage becomes unsecured debt, like a credit card or a medical bill, and it is similarly dealt with by the Court. Both mortgages are gone, and there is no question of any tax liability.
Additionally, surrendering a house as part of a bankruptcy case puts all the responsibilities back on the bank. There is no question of them accepting or rejecting the transaction; you are basically forcing the house on them. They are the ones who have to worry about taking title to the property and then conveying it to someone else. The house becomes their problem.
If you don't have any other debt besides your mortgage, then maybe filing a bankruptcy case isn't a good idea. But if you have any other debt issues, that's another benefit that surrendering a house offers over a short sale: the Court deals with all your issues in one all-encompassing package.
If you're considering a short sale and have any other debt problems, I would urge you to contact a bankruptcy attorney as soon as possible. Everyone's factual situation is different, and a lawyer can help you sort out all the pros and cons of filing a bankruptcy case.
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