5 Important Short Sale Road Rules on Settling Deficiency

by Joseph C. Alfe

How do you avoid a deficiency in a short sale? In his latest blog, Joseph C. Alfe explains how with five rules.


One of the most frequently asked questions I get, from both brokers and sellers, is how to avoid deficiency in a short sale. The answer is both complex and simple, but deficiency can be managed a large percentage of the time by using some of these techniques:

1. What is Deficiency? – Deficiency is simply the difference between what is owed and what the lender nets on a short sale. How a lender reacts to a deficiency is determined by lien status and who the investor is. First lien holders are increasingly waiving deficiency, or issuing a 1099 as a forgiveness of debt. This is why it is so important for the seller to be represented by competent legal counsel, because agents should not be presenting or explaining approval letters to a seller.

In fact, most state attorneys general advise that this is practicing law. The language on an approval is basically a contract, and that can determine the seller’s liability. In a perfect case, the waiver of deficiency is clearly spelled out on the approval letter. In many cases, however, the language can be vague or misleading. In some cases, you can negotiate with a lender to have them clarify the deficiency waiver or add language detailing the intention of issuing a 1099 in lieu of a deficiency waiver.

2. 1099’s – This opens up an entirely new concern: tax liability. This is different from a deficiency. To make it simple, the deficiency is what you owe the lender, and the tax liability is what you owe the IRS. Generally, if a lender issues you a 1099, they waive the right to collect the deficiency so they can write off the loss against their revenue.

In other words they cannot double dip. The Mortgage Debt Release Act of 2007 states that, in most cases, that the seller of a primary residence is protected against tax liability. The safest course of action is to urge the seller to speak with an attorney or CPA regarding tax liability because there may be exceptions to this rule.

3. Lien Position Makes a Difference – What I am seeing more and more is purchase money or first lien holders waiving deficiency. In fact, recent Fannie, Freddie and HUD guidelines prohibit deficiency in most cases. Again, there are exceptions to these rules. Generally, I feel pretty safe with a one lien situation that deficiency will be released or that a 1099 will be issued, unless certain investors are involved. When there is a second lien, depending on the type, deficiency is more common.

Purchase money seconds are more apt to release deficiency or issue the 1099, but Home Equity Lines of Credit (HELOC’s) almost never do. What many don’t realize is that a HELOC is not really a mortgage. Yes, it is secured by property, but a HELOC is treated like consumer debt, and it is not extinguished in a foreclosure. In a foreclosure, the lien position of the second is wiped out, but not the debt, and they will pursue collection activity in most cases. The only option in many cases is settlement of some kind.

Again, don’t be fooled by the recent government guidelines. Just because the senior lien may be an FNMA and therefore exempt in most cases from a deficiency, don’t count on the junior lien rolling over and releasing deficiency as well. You have to fight them for it.

4. Mortgage Insurance – Perhaps the most insidious of investor is the mortgage insurance companies, or MI/PMI. Mortgage insurance investors almost always demand deficiency.

There is a difference, as private mortgage insurance, or PMI, is usually clearly stated on the mortgage statement as borrower paid. Mortgage insurance, or MI, is sometimes lender paid. Basically, this is secret insurance taken out and paid for by the lender or investor without the knowledge of the buyer.

Regardless of insurance type, PMI/MI can be difficult to predict and deal with, and they almost always demand a deficiency, cash contribution or promissory note, or all three. Fortunately, due to the consolidation of distressed mortgage paper under Fannie Mae, PMI interference is becoming less and less a problem.

5. Deficiency Settlement Techniques – It is important to realize that in some cases, no amount of negotiation can settle a deficiency, and that is part of the risk of doing a short sale. Sellers should be honestly apprised of these risks before the property is listed, and a seller who refuses the possibility of deficiency should raise a red flag and the broker should seriously consider not taking the listing. There can be no guarantee that deficiency will be waived in a short saleThere are two main techniques to settle deficiency:

  • Cash Settlement – This is the most powerful technique. Brokers should anticipate this need once it is known that there is a HELOC or MI/PMI, or other consumer liens involved, and this cash contribution need should be clearly communicated to the buyer at time of contract. That’s right, the buyer. There is no reason that buyer’s won’t contribute to settlement if they are disclosed this fact early.
  • Like in all short sale negotiations, compensate the buyer by allowing them to lower their offer. Most HELOC’s will settle at anywhere between 5 to 20 percent of outstanding balance. Sometimes, the investor will come right out and demand a “seller contribution,” or a promissory note. If so, you can offer a fraction of that amount in cash. For example, I had one MI Company demand a $10,000 cash contribution or a $24,000 promissory note. I offered $2,000 cash contribution, and we settled on $2,400 to 10 percent of the note amount.
  • Promissory Note – A promissory note is a written promise to pay. It is a legal contract and should always be reviewed by an attorney. Basically, a promissory note can be used as a tool to get the deal done. If the seller has the ability to pay the note, and the lender refuses to meet the offer price, offer a note to cover the difference.
  • Generally, a note can be negotiated at a fraction of the deficiency amount, and is usually at zero percent interest, and terms are generally from 60 to 120 months. If your seller is not delinquent and wants to preserve their credit, the note is leveraged to do so. Have the attorney demand that the note state in writing that as long as the terms are met, the borrower’s credit will remain untarnished. With the new guidelines, notes still have their place but are becoming less common.

While you cannot guarantee that a seller will have no deficiency in a short sale, by using these techniques, you can many times find a way to eliminate or reduce deficiency. Always have the sellers seek legal counsel to make a final decision regarding deficiency.

joseph-halfe-short-sales-chicago-real-estate-agent Joseph C. Alfe worked as a mortgage lending executive with a leading mortgage lender before starting his short sale negotiation company, Short Sale Processors, in 2005. Since then, he has stayed at the forefront of this constantly changing industry as one of the only truly independent, third-party negotiation firms, and has consistently innovated and developed cutting edge negotiation techniques and best practices.

Joseph and his associates have closed nearly 1,000 short sales, and he continues to be active as a short sale coach, consultant, and speaker. SSP is based in Chicago, and negotiates short sales throughout the country. Joseph resides in the northwest suburbs of Chicago with his wife and 5 children.

For more short sale road rules and information about the author, visit his Facebook fan page and website.

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