I am often surprised how many chapter 7 bankruptcy debtors who want to file bankruptcy just before a foreclosure sale to stop the sale, ask the following question: Can I short sale my house after I file bankruptcy?
Although it can be done, it rarely makes sense. The reason is because a home mortgage short sale after filing chapter 7 bankruptcy rarely makes sense.
When I ask clients why they want to short sale their house after filing bankruptcy, the response I usually get back makes clear that the debtor does not fully understand the ramifications of their bankruptcy filing and the relief it afforded. Unless a chapter 7 debtor reaffirms their secured debt in the bankruptcy, then the debt is discharged.
For example, lets say the debtor owns a house worth $130,000 and has a mortgage at $150,000. The house has negative equity, so if the debtor was not filing bankruptcy and wanted to get out from the house, the debtor would have to either sell it for a $20,000 loss and pay the difference at closing or get the bank to approve a mortgage short sale to forgive the deficiency.
However, now take the same numbers, but put the debtor in a chapter 7 bankruptcy. In this scenario, the debtor does not have to worry about trying to get a short sale approved to cover the deficiency, because the debtor can simply choose not to reaffirm the mortgage within the bankruptcy. By not reaffirming the mortgage, there is no balance owed to the bank, and the debt is discharged in the bankruptcy. Since the debt is discharged in the bankruptcy, then there is no incentive for the debtor to work a short sale, as the debtor can walk away without financial repercussions as to the note at any point.
It is important to distinguish that the lender only loses its rights as a creditor on the mortgage note when the debtor does not reaffirm. The lenders lien remains, so the lender can still foreclose on the property, and the debtor does not own it free and clear. However, since a debtor makes no money in a short sale anyway, why would the debtor bother trying to conduct a sale that makes no money when the debtor can pack up and move just as easily for the same no profit scenario?
The primary scenario where it might behoove the debtor to conduct a short sale either during or after a chapter 7 bankruptcy is when the debtor has been working with a realtor for a good bit of time on a short sale prior to filing bankruptcy, but was unable to complete the sale prior to filing. The debtor might feel some incentive to get the realtor a commission by conducting a sale, as opposed to just letting it ultimately go to foreclosure. It is important to note in this scenario that it is the realtor, and not the debtor, who gains. Furthermore, the debtor will still not want to reaffirm the note in this case, as the note does not need to be reaffirmed for the debtor to sell the house, because the debtor would still be on title. Finally, the debtor would have to check with an accountant to verify there would be no tax consequences in this sale, particularly if the debtor is trying to sell an investment property.
I thought of a couple reasons, but they go beyond the scope of debt liability.
Reason 1: More time in your home.
Short sales don’t stop foreclosure, but they can manipulate it. A short sale can postpone the auction sale for months while awaiting completion. Most who file a chapter 7 BK could probably use a few extra months of free rent, beyond the point that the house would have otherwise been foreclosed and they removed from the property. In Utah, homes can be foreclosed in just under 4 months after the notice of default is filed by the foreclosing attorney. Working a short sale usually takes 6-9 months these days. An owner could easily expect to gain an extra 2-4 months or longer of rent-free living from a short sale. “A penny saved is a penny earned.”
Reason 2: Avoiding the foreclosure.
“I’m just gonna let it go back to the bank.” … that means foreclosure on top of the bankruptcy. Yes their credit sucks anyway, but many would rather not have a foreclosure show up on their credit in addition to the BK. They can’t borrow money any time soon, but they will want to borrow again in a few years.
Reason 2.5 (applies to only a few of us): The reason banks consider short sale offers is because they would expect to receive even less if they take the property to auction. They get more of their money back, so it benefits them more than foreclosing.
Short sales tend to be long and drawn out. They’re generally not a bucket of fun. Although there is usually no legal way to get any money out of the deal (other than occassional bank-offered seller incentives), there still might be something in it for you. Money saved, foreclosure avoidance, and (for some) the idea that the bank got a few extra bucks (… I’m not personally a bank-lover). With nothing to lose, don’t just brush the option off the table.
Perry, thanks for commenting. You have an astute understanding of the topic. My comments in order:
- Reason #1: The lien holder has the right to foreclose upon default, so if they really wanted the house they could just take it regardless of the debtor approaching them regarding a short sale. So while the debtor could hope that suggesting a short sale will accomplish what you say, there’s no guarantee it will.
- Reason #2: A non-reaffirmed note in bankruptcy is discharged. Any foreclosure would be occurring once the debtor no longer has any liability. Therefore, any credit report that reports the note as being foreclosed would be reporting it inaccurately.