Understanding the Consequences of Foreclosure

If you are one of the millions of Americans who are facing the prospect of foreclosure, then you are already familiar with some of the consequences of pre-foreclosure:  Namely, the emotional stress of receiving mortgage bills you cannot pay, and the frustrating battle with phone calls from debt collectors. You may have also experienced frightening and confusing letters from law offices, Realtors, and investors that in the end are unable or unwilling to help you. The truth of the matter is that the pre-foreclosure experience alone, can cripple the spirit of even the strongest individuals.

Unfortunately, the reality is that if you continue down the road to foreclosure things get even worse before they get better. Depending on the state in which you reside, if the bank forecloses on your home it could be auctioned off in the sheriffs’ office or even on the front steps of your local court house. The bank’s representative will call out your first and last name for all to hear. They will announce the address of your former home and note the total amount of the outstanding debts. Then the whole room will proceed to bid for the house that was once yours.

At the close of the auction either the bank will have repossessed your home or an attendee at the auction will have placed a successful bid to buy it. For you, it doesn’t really make a difference. The sheriff, armed with a notice of eviction, will soon be paying you a visit. The time lines vary from state to state, but you can generally expect to have to vacate the property in 30 days or less (note, some states offer previous owners a redemption period in which they can retain ownership of the property if they are able to raise the funds necessary to pay off the previously outstanding liens).

So, now you’ve lost your home. Those were some tough times, thank God it’s over now…right? Well, not exactly. You still have at least two major hurdles to address; taxes and your personal credit ratings.

Let’s start with taxes. As we are not accountants, we will keep this discussion short and sweet. On a federal level, debt forgiveness is generally considered personal income. Therefore, when a person losses a property to foreclosure, and thus has the debt forgiven because they never repaid the lender(s), that person may be subject to paying taxes on the amount of forgiven debt reported on a 1099 form from the lender. Therefore, if you lost a house that had $200,000 in debt and your capital gains tax rate was 20%, you might owe the IRS $40,000 in taxes!

Notice that we deliberately used words like “may” and “might” because tax codes are convoluted and there are a number of factors that come together in determining what you will actually owe. Still, nobody wants to find themselves in a situation where they have to decipher tax codes and they certainly do not need any additional tax burdens.

Fortunately, short sales allow owners and their consultants to negotiate with lenders and request that no such tax liabilities are ever incurred!

Now, what about saving your personal credit? Truth be told, once you have missed even a single mortgage payment, maintaining an excellent credit score is probably no longer a realistic option. Note:  There are services such as credit wipes that may enable a person to clear their credit; owners can also place requests with lenders to have any past negative credit reports removed during a short sale process.

How to salvage, rather than save, your credit might be a more realistic conversation. With proper negotiating, a short sale can prevent you from experiencing the devastating credit effects of a foreclosure.

To illuminate our point on how a short sale can be far kinder to your credit then a foreclosure, see our Short Sale vs. Foreclosure chart.

Neither a short sale nor a foreclosure creates a perfect situation for re-establishing strong credit, but a short sale is far better than the alternative.