Explaining Negative Equity, Short Sales and Foreclosures

Negative equity exists when the value of an asset used to secure a loan (like a house) is less than the outstanding balance of that loan. Near-negative equity means that the borrower has less than 5 percent equity. Negative equity becomes a problem when the borrower would like to refinance because the banks will often refuse to refinance a loan that is underwater (another term for negative equity).

If a homeowner wants to sell their property and they owe more than they will be able to sell the house for, they have options. The first option is for the homeowner to pay they difference to the bank between what they owe on the property and the price for which it sells. This option, though painful, has many advantages. The first advantage is that the homeowner won't take a huge hit to their credit score, as they would with a short sale or a foreclosure. The second advantage is that they can move on with their life, as opposed to always living under the threat of having to one day pay back the difference (the deficiency, see below). Thirdly, they won't have to wait either three (for a short sale) or seven (for a foreclosure) years before they can get another mortgage. Finally, they won't owe income tax on that deficiency (see the short sale explanation below).

A short sale is when a bank agrees with the borrower to accept less than the full amount owed on a debt. The unpaid balance balance is called the deficiency. What many people don't understand is that having a short sale does not necessarily release them from the obligation to pay back the deficiency. In order to have that happen, the bank must agree to forgive the deficiency. The borrower's credit score will also take a serious hit, though exactly how much depends on the lender and the credit bureau. It will be significant but not nearly as high as it would be with a foreclosure. And the seller will have to wait at least three years before being able to finance another home.

A foreclosure happens when a borrower falls behind on their mortgage payments and the lender then seizes the home in order to sell it and recover as much of the debt as possible. If the sale price does not cover the outstanding balance of the loan then the lender can file for a deficiency judgement, which means that the borrower will still owe that difference. With a deed in lieu of foreclosure, the borrower gives the lender the title to the property and the debt is forgiven. Otherwise, the lender must sue the borrower in state court for defaulting on the loan. States in which foreclosures must go through the courts have much slower foreclosure processes than states that do not require it. A foreclosure will result in a serious penalty on the borrower's credit score and the borrower will have to wait seven years before being able to obtain another mortgage.

For either a short sale or a foreclosure, the amount of debt that is forgiven in the deficiency judgement counts as income and the bank will issue the borrower a 1099. The borrower will then owe income tax on that debt.