What Is a Distressed Sale and How Does It Work?

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What Is a Distressed Sale?

A distressed sale occurs when someone sells property, securities, or other assets in an urgent manner ─ usually at a loss ─ to cover substantial debts as quickly as possible. In this article, we’ll be focusing specifically on distressed real estate sales. 

The most common example of a distressed sale is when a property owner sells a piece of real estate to satisfy their mortgage requirements and avoid foreclosure. In most cases, the seller will take a loss on the property, but they meet their goal of resolving their debt rapidly. Other common situations that lead to distressed sales include divorce and relocation.

Advantages and Contingencies

Individuals rushing to sell their property will likely achieve their short-term objectives: Sell the property, satisfy the debt, and avoid foreclosure without decimating their credit. In most cases, these distressed sales will take the form of “short sales” ─ transactions in which lenders allow owners to sell their properties for less than what they owe while also canceling the remaining loan balance.  

The amount of the cancelled balance may be taxable if the owner’s mortgage agreement holds them liable for the full loan amount. If the lender chooses not to pursue a personal judgment to recover the debt that remains after the short sale (which they will usually try to accomplish through wage garnishments or bank levies), then they submit a 1099-C to the IRS to report the cancellation of the debt.  

(If you receive a 1099-C cancellation of debt for an amount over $600, there is a way to minimize your debt. The home must be your primary residence, and the loan must have been to purchase the home or for home improvements. If done correctly, you could potentially zero out the tax. Contact our office to learn more!) 

In these instances, capital gains taxes don’t apply to the cancelled amount because the value of the home is less than the outstanding balance on the mortgage. However, the cancelled debt will be considered taxable income unless you: 

  • Are eligible for the Mortgage Forgiveness Debt Relief Act of 2007 
  • Have discharged your debts through bankruptcy 
  • Are insolvent at the time of the debt cancellation 

Disadvantages of a Distressed Sale

The most obvious disadvantage of a distressed sale is that you are selling off property for less than its full value. Not only that, but you’re also missing out on potential future gains if the property’s value goes up. 

In addition, a distressed sale will probably have a negative effect on your credit score, although not nearly as much as a foreclosure. Your lender will most likely mark you as “satisfied” or “paid” vs. “paid in full,” which looks more favorable on a credit report. Foreclosures can damage your credit by more than 250 points, while a short sale will likely only cause about a 100-point reduction — not great, but definitely something you can overcome with time.

And in most cases, individuals who opt for a short sale can apply for a reasonable mortgage rate within 18-24 months. Meanwhile, people who go into foreclosure usually have to wait several years.

Requirements to Execute
a Short Sale

In general, your lender will only consider you eligible for a short sale if you have experienced at least one of the following hardships that may prevent you from meeting your mortgage obligations: 

  • Divorce 
  • Bankruptcy 
  • Medical bills 
  • Unemployment 
  • Depreciating real estate value 
  • Business failure 
  • Health problems that prevent you from maintaining gainful employment 
  • Death of your spouse 

In most instances, you won’t have to pay any out-of-pocket fees to conduct a short sale ─ the lender will cover the cost of any real estate or attorney fees rendered. 

Executing a distressed sale obviously isn’t an ideal situation, but it’s also not the end of the world either (and it’s certainly better than a foreclosure). However, be sure to research your options and evaluate the tax consequences of performing a short sale before signing on the dotted line.

Contact Distressed Houses Sales for a Free Consultation

If you’re considering a distressed sale of your property or other assets, please contact Distressed Houses Sales today. In addition to the information in the primer above, we can provide specific input and guidance regarding your unique situation during a free consultation with one of our skilled attorneys. Our lawyers and support staff have been supporting Maryland taxpayers for decades, and we strive to deliver effective and empathetic tax representation for every client we serve. 

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