For foreclosures filed after January 1, 2008, Colorado law no longer provides for an owner’s redemption period. (See Colorado Foreclosure Revolution (Part I). This article explains short pay-off transactions and the ramifications of the loss of owner’s redemption period.)
A “short pay-off” or “short sale” is a transaction in which a lender agrees to accept less than it is owed to permit a sale of the property which secures its note. (Throughout these materials, the term “lender” or “lenders” refers to the collection of institutions aligned on the “lender’s” side, which might include the holder of the note, a loan servicer, and a private mortgage insurance company.) HUD seems to call these sales “Pre-Foreclosure Sales.”
In a typical short pay-off, the lender agrees to accept the net proceeds from the closing (the sales price, minus the cost of closing the transaction, including your commission), perhaps with some additional consideration from the seller (such as a promissory note) in exchange for releasing its lien. Lenders do not agree to short pay-offs to be generous. In negotiating the short pay-off, the lender needs to be convinced that it will come out better than it would by foreclosing on the property and pursuing the seller/borrower for its losses. Though short pay-off procedures vary somewhat from lender to lender, most lenders need to be convinced of the following:
- The sales price under the proposed contract is equal to or higher than the amount for which the lender would be able to sell the property after a foreclosure. The lender will require a market analysis from the REALTOR® listing the property. The lender will often confirm the market analysis by contacting its own sources, such as an appraiser or the real estate agents which handle its REO sales.
- The commission under the proposed transaction is equal to or less than the commission it would pay its agent for selling the property after foreclosure. The lender will want to know as precisely as possible the amount of proceeds it can expect to receive from the sale. The more precise the estimate, the better.
- The lender will want an explanation of the circumstances which created the need for the short pay-off transaction. Common explanations include divorce, medical problems, death, birth of a child taking one wage earner out of the work force, birth of children making the existing home too small, loss of a job, or a job transfer creating the need for a move.
- That the seller doesn’t have the money to make up the shortfall on their own. To verify the financial condition of the seller/borrower, the lender will require: financial statements showing the seller’s assets, liabilities, income, and expenses; the seller’s tax returns for the previous two years; and the seller’s paycheck stubs for the most recent pay periods. The most common disputes which arise in short payoff sales concern the seller’s financial condition. On the one hand, the lender will be reluctant to approve a compromise without having the ability to analyze the financial strength of your seller. On the other hand, if this information is provided, there are potentially grave consequences for your seller if a short pay-off is not approved. The lender will have a significantly easier time pursuing your seller for a post-foreclosure deficiency. In certain circumstances, providing the financial information actually decreases the likelihood of closing on the short pay-off.
A borrower with minimal assets, little income, and a willingness to file bankruptcy has little to lose by providing financial information. However, most candidates for short pay-offs have some assets, a good job with garnishable wages, or a desire to avoid bankruptcy. Candidates for short pay-offs need legal advice regarding the advisability of submitting financial information to the lender. Though a refusal to submit financial information to a lender greatly decreases the chances of closing, a refusal to submit financial information does not necessarily preclude closing on a compromise sale.
Short Pay-Off Traps
When working on short pay-offs, certain issues and problems frequently arise. It is important to keep them in mind as you proceed.
Your seller is already facing a potential deficiency lawsuit from its lender; he does not want to be sued by a buyer also. A seller’s ability to close on a compromise sale is not within his control. It is important that in any contract which your seller accepts, his obligation to close is contingent upon successful negotiations with the lender.
Most sellers would like to protect their credit rating as much as possible. A substantial motivation for a short pay-off as an alternative to simply allowing the property to go into foreclosure is avoiding the detrimental credit consequences of a foreclosure. The seller should be advised to seek legal counsel regarding steps which can be taken to ameliorate the credit consequences of the work-out.
It is unlikely that your seller will receive any proceeds from the closing on a compromise sale. (Note, however, that in the HUD short pay-off program, borrowers may receive money out of the sale as an incentive to close.) Yet the closing is likely to force the seller to move. If the seller hasn’t already moved, or doesn’t have some other reason to move, closing on a short-pay might actually hurt the seller. The dawning realization of being homeless might make a short pay seller back out of a closing. Because the foreclosure process generally takes five or so months to run, it might be in the best interest for some owners to live in their home until the end of their redemption period in the foreclosure. Don’t embark on a short-pay transaction unless the seller has already moved out of the property or unless the seller has made an informed decision to move out earlier than he would otherwise need to do so.
These transactions often require a patient buyer. Working through the bureaucracy of the loan servicer, the investor, and the private or public mortgage insurance company takes time. Closing dates may need to be extended. It is important to work with buyers who have flexible closing needs and flexible dispositions.
As many as three entities may be involved on the lender’s side of a short pay-off transaction. It is not unusual for the mortgage insurance company, the investor, and the loan servicer to have several different departments working on the transaction. Errors may arise simply due to bureaucratic miscommunication. It is important to get the terms of the short pay-off transaction (release of liability, no adverse credit consequences … etc.) in writing.
You may occasionally run into a seller who initially does not care about the financial or the credit consequences of a short pay-off transaction because he has filed, or is about to file, bankruptcy. While this may seem to be a blessing, it should raise concern. Bankruptcy affects the seller’s ability to convey title and may disrupt a transaction which you have worked long and hard to put together. A seller filing bankruptcy will usually already have legal counsel. In these circumstances, the REALTOR®; needs legal advice.
A seller who has little concern for the financial and credit consequences of a short pay-off has little incentive to avoid these consequences. Often these sellers seem to be very agreeable until they realize that they will need to move out of the property sooner than if the property went into foreclosure These sellers may decide to let the foreclosure run its course, rather than close on a compromise sale.
Short pay-off transaction may involve the forgiveness of debt which may create detrimental tax consequences to the seller. While residential short pays rarely create capital gains problems for their sellers, a commercial short-pay is likely to cause a recapture problem for a seller. Sellers should consult their tax advisors.
Keeping the above factors in mind should increase your chances of successfully closing on short pay sale.
In Colorado, a lender can sue the borrower for the difference between the pay-off on the note and the highest bid at the foreclosure sale. This difference is called a “deficiency.” In the vast majority of foreclosure sales prior to 2008, there was no bidding competition from third party investors and the lender was the successful bidder at its own sale. As a consequence, a lender had much control over a borrower’s post-foreclosure liability.
One of the ways in which the pre-2008 statutes used to encourage fair bids was by giving the foreclosed upon owner redemption rights. The successful bidder at a foreclosure sale did not obtain title to the property. Instead, it obtains a receipt (the “certificate of purchase”) which entitled it to receive a public trustee’s deed after the expiration of all applicable redemption periods. Because the foreclosing lender was subject to the possibility of being redeemed out for its bid amount, the foreclosing lender had a reason to bid up to a fair price.
For foreclosures commenced after January 1, 2008, the holder of the certificate of purchase (i.e. the highest bidder at the sale) is still subject to the possibility of being redeemed out by junior lien holders. But one of the hopes of the new statute is that the elimination of the owner’s redemption period will encourage investors to compete against the foreclosing lender and bid at the foreclosure sale. If the new statute does encourage more competitive bidding by third parties, this will also keep foreclosing lenders honest in making their own bids. Only time will tell.