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Is a short sale compatible with bankruptcy?

Short sales during a bankruptcy may trigger more financial problems

While they are a sound alternative to foreclosures, short sales may do more harm than good for people who are filing bankruptcy.

Short sales, in which the lender agrees to approve selling a house for less than the full amount of the homeowner's loan, have become common in the depressed housing market.

According to Bankrate, short sales are most successful if a foreclosure is imminent because homeowners are well behind in their payments or have been served a default notice. Banks then become more motivated to grant a short sale. During this process, mortgage holders are forced to take less money than is currently owed on the home, but they are likely to lose more if the foreclosed home goes to auction.

However, if filing bankruptcy is planned, there's probably no reason to go through with a short sale. People who file under Chapter 7, a liquidation process, are likely to get an exemption to cover their home and a discharge of most - if not all - their other debts. Once that burden is lifted, many homeowners are able to concentrate on their mortgage payments. In cases when they are too far behind and may have to sell the home anyway, the foreclosure has at least been delayed while the bankruptcy is in process.

Short sale fallout

If homeowners in a bankruptcy case are also trying to sell their home in a short sale, they may start a chain of events that could leave them in another financial crisis, according to California attorney Michael G. Doan.

A short sale will cause the lender to issue a statement to the IRS of the income that the seller has received in the sale, according to Doan. To avoid a big tax bill, he advises that people who must surrender their home do it after the bankruptcy is filed.

"Under bankruptcy laws, there is no taxable event on a foreclosure after bankruptcy. The lender can only report [zero] balance bankruptcy discharge … whether you keep the home or not," he writes on BankruptcyLawNetwork.com. "The debt is finalized, you avoid wasting your time and money and you are able to stay in the property or rent it out longer."

For those who are in the process of a short sale before filing bankruptcy, Doan recommends they get out of the transaction and include any claims by a realtor or buyer among those to be discharged by the court.

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