A foreclosure sign in Pasadena. As the backlog of foreclosures has been worked through, borrowers who are less underwater are turning to short sales. But the expiration of a Bush era tax law could upset this market.
Distressed homeowners who are underwater on their mortgages, owing more than the house is worth, have two main options, if they don't try to pursue a government-sponsored modification program: foreclosure or short sale.
Financially, foreclosure makes more sense for borrowers who are way underwater, owing say $400,000 on a house that's now worth $300,000. Struggling to make the monthly payments, maybe because some financial cataclysm has befallen the family, just adds to the pain. Super-distressed homeowners quit making payments and wait for the bank to repossess the home. Unfortunately, this process tends to depress prices and lower overall home values if a region is particularly hard-hit.
If you want to look for places where foreclosures are in crisis mode, the bankrupt California cities of Stockton and San Bernardino are a good place to start (although the pace of foreclosures in those areas has slowed substantially in recent months).
However, we're now four years into the housing bust and a lot of the foreclosure activity that was absolutely, positively going to happen because many homeowners had no hope of rescuing the mortgage have already been foreclosed. That leaves homeowners who are underwater but not terribly underwater and who are struggling with their payments. For them, a short sale — with the lender agreeing to accept a sale of the house for less than what's owed — is a viable option.
At least for the moment.
This is from real-estate monitor DataQuick's latest release on the California foreclosure market, covering September and the third quarter:
[D]uring the past year, we’ve seen short sales overtake the foreclosure process as the procedure of choice to deal with homeowner distress. That may change after New Year’s because the temporary ‘debt forgiveness' feature in the tax code is set to expire as part of the so-called ‘fiscal cliff’,” [DataQuick President John Walsh] said.
Short sales – transactions where the sale price fell short of what was owed on the property – made up an estimated 26.0 percent of statewide resale activity last quarter. That was up from an estimated 24.0 percent the prior quarter and up from 22.9 percent of all resales a year earlier. The estimated number of short sales last quarter rose 19.0 percent from a year earlier.
A law from the Bush administration makes it possible for borrowers to avoid being dinged for debt that's forgiven through foreclosure, short sale, or refinancing via a loan modification. The forgiveness ceiling is $2 million, which is more than enough to cover most normal and even a lot of upmarket buyers. Here's the thing: If you get out of a debt owed to a lender, the IRS considers that "forgiven" debt income — which is actually a bit strange, unless you consider that the IRS also allows borrowers to deduct interest on a lot of different kinds of debt, such as mortgages.
Anyway, the looming "fiscal cliff" — the year-end expiration of several federal tax cuts and stimulus measures — places the 2007 law under threat. Unless Congress acts, it will expire, and short sellers would suddenly become liable (potentially) for forgiven debt.
This would obviously throw a wrench into the works of the accelerating short sale process, which wouldn't be good for borrowers or the banks. Short sales can be a great way for banks and borrowers to strike a good bargain.
Banks avoid an long and expensive foreclosure process that may end up with them owning degraded properties; and borrowers get to salvage some of their creditworthiness, placing them in a better position to get another mortgage down the line (although a short sell still means your credit score will take a decent hit).
For California, the transition from a foreclosure frenzy to a more stable market, in which short sales enable borrowers and banks to move toward a future market that's healthy, is welcome. The last thing the state needs is for Washington D.C. to undermine this process over political brinkmanship.
But it could happen. CNBC's excellent real estate reporter, Diana Olick, puts the chances of Congress extending the Bush-era law at 60-40. Not exactly overwhelmingly in favor of a bright future for short sales.