Should I Do A Short Sale or File for Bankruptcy?

A large percentage of people considering filing for bankruptcy these days are those whose debt liability arises in some significant manner from an underwater or undervalued home, particularly in my area of southeastern Michigan. The question in such cases is always whether bankruptcy is the best solution for that particular problem, or whether a non-bankruptcy solution such as a short sale or a mortgage modification might be the best answer.

In general, the answer to the question, “Which should I do?” lies in your overall circumstances. There are some significant downsides and some significant advantages to each approach.

Primary factors to consider are:

• The entire picture of the individual’s debt. If you have other debt than that represented by the real estate in question, a short sale or mortgage modification may not be the best way to deal with it. A bankrutpcy is a mechanism that can deal with all of your debt-related problems in one sweep. If your credit card or medical debt alone is unamanageable, it is probably best to consider a Chapter 7 or Chapter 13 bankruptcy.
• The potential deficiency liability for a non-bankruptcy solution. In many states, including Michigan, you can be pursued for what is called a “deficiency debt.” This is the difference between what you owe for a secured debt such as a home mortgage loan under the terms of the note you signed securing and the amount that the foreclosing or short-selling bank sells the property off for. In some cases, this deficiency can be quite large, tens of thousands of dollars or more. If you incur a large deficiency through a mortgage modification or short-sale, you will either be collected from directly for that deficiency or you will receive a 1099 from the “forgiving” creditor. This 1099 means that the debt has been forgiven or charged-off, and such debt counts as taxable income for IRS purposes. You will have to pay taxes on this amount as if you earned it in income, should this occur. Unless the short-selling lender forgives your debt entirely in the short-sale agreement or manages to sell the property for the full amount that you owe, you will have a deficiency after a short sale.

  The surrender of property in bankrutpcy is an entirely tax-free event, and you cannot be pursued for any deficiency as a consequence. After a bankruptcy surrender, you can truly walk away from the property.

• The eligibility of the individual for forgiveness of deficiency tax liability. In some circumstances, under certain governmental programs, you may be eligible for forgiveness of tax liability arising from such a deficiency. You will want to discuss this with your accountant or CPA before agreeing to any short sale for a deficient amount.
• Whether the individual is eligible for a bankruptcy at all and, if so, what form.  It is possible that you may not be eligible for a bankruptcy or, based on your household income, eligible only for a Chapter 13 bankruptcy. If you have filed a bankruptcy anytime in the past 4 years and have received a discharge, you are not eligible to file again in the short term. There are other factors of eligibility to be considered as well, as well as the additional question of whether your income may make you eligible only for a Chapter 13 bankruptcy, a more involved form of bankruptcy than the straight Chapter 7 liquidation.
  
• Whether the home might actually be made more affordable and retained by the individual with a Chapter 13 bankruptcy. In some cases, a home that seems unmanageable may in fact be saved and made more affordable by the mechanisms available in a Chapter 13 bankruptcy. For example, if your home is worth less than you owe on a first mortgage, and it is a second mortgage or home equity loan that is making your home unaffordable, a Chapter 13 lien strip can liquidate the second mortgage entirely.

There are many other factors to consider as well, but the bottom line in making this decision is whether a bankrtuptcy can do as much or more for you as a short sale with less risk and liability. If the answer is “Yes” or even “Maybe,” you should consult a bankruptcy attorney to explore the full range of the available options.  If the house is your only real financial issue and you believe you can absorb any taxable consequences, a short sale may be worth exploring as an initial matter.

If you are a Michigan resident and have questions about the best way to handle undervalued real estate, please contact me at jhilla@aronofflinnell or (248) 977-4182 to schedule a free, initial consultation.