How Short Sales Work

To simplify things, let's walk through the short sale process from the prospective of the buyer. As a buyer, the first step is to find short sale listings. Short sales are rarely listed as such, because they can't be approved until there's an offer on the table. Instead, sellers use euphemisms like "pre-foreclosure," "third-party review required" or "subject to bank approval" [source: Freddie Mac]. A good place to start is the pre-foreclosure section of a Web site like RealtyTrac, which carries listings in all 50 states.

Once you have a few listings in mind, compare the prices of similar homes in the area, especially those that recently sold. That gives you a better idea of the fair market value. With a price range in mind, the next move is to get a mortgage preapproval letter from your lender. As a buyer, this will not only lock in an interest rate for homes in your price range, but also show the seller's bank that you are a serious buyer.

When you find the home you want, the next step is to make an offer. As a buyer, you will sign a purchase contract for what you and your real estate agent believe is a fair market price. You will also be asked to supply earnest money, a refundable cash deposit that once again shows your commitment to buy.

In a traditional home purchase, this is where buyer and seller negotiate and arrive at a final purchase price. But that's not the case in a short sale. In a short sale, it's the seller's mortgage lender that needs to approve the sale price.

For that to happen, the seller first needs to prove that he or she cannot afford to pay the mortgage and that a short sale is the only option to avoid foreclosure. Required documents include:

The mortgage lender will then take weeks or months to consider the short sale [source: Toy]. During this time, it will seek approval from investors who bought the mortgage debt and conduct its own appraisal of the property value [source: Bank of America]. The bank might respond with a counteroffer or deny the short sale for a variety of reasons, including [source: Freddie Mac]:

If approved, the short sale will continue like a traditional home purchase with a closing. Keep in mind, though, if the home has a second mortgage, a home equity loan, or other liens on the property, this process will have to be repeated for each lender. Yikes.

The most significant advantage of a short sale is that the seller can avoid foreclosure. With a foreclosure in your credit history, you have to wait at least seven years before another lender will even consider you for a mortgage, whereas a short sale only puts you on the blacklist for as little as two years [source: Weston].

Contrary to popular belief, however, short sales aren't any better for your credit score than a foreclosure. According to Fair Isaacs, the company that calculates the FICO credit score, both short sales and foreclosures will cut a 780 credit score by 140 to 160 points [source: Gaskin].

The biggest advantage for the buyer is a chance to buy a home at slightly below the fair market value without having to enter the risky foreclosure market. With a foreclosure sale, there are a number of potential nightmare scenarios, including unpaid liens on the property and owners who fight eviction [source: White].

The biggest disadvantage for the buyer is time. Short sales take much longer than a traditional home sale because the seller's mortgage lender has to give the green light. This process gets even longer if there are multiple mortgages and liens involved. Even when all of the paperwork is in order and both buyer and seller agree on a price, there is no guarantee that the lender will approve of the short sale. Buyers need to be prepared for a long and uncertain process that could end in disappointment.

Another potential disadvantage for the buyer is higher closing costs. For example, in a traditional home sale, the seller is responsible for paying for a home inspection and any related repairs. In a short sale, the seller's mortgage lender feels less pressure to negotiate, so those costs are often shouldered by the buyer [source: Freddie Mac].

At the end of the day, both the buyer and seller hope that the mortgage lender sees the advantage of a short sale over foreclosure. Foreclosures, it turns out, can be costly for lenders, too. Lenders have to take care of the maintenance of empty homes, which might include expensive repairs in addition to regular upkeep like cutting the lawns and shoveling the driveways. Lenders might also have to pay back taxes on the homes and cover the cost of auctioning or selling them [source: Guerra].

Now let's look at some expert tips on buying or selling a home through a short sale.

The first buyer tip for a successful short sale is to use a real estate professional with short sale experience [source: Freddie Mac]. Short sales are complex real estate transactions that require a deep understanding of determining fair market value, how lenders work and what they need to see before they approve a short sale.

In general, avoid homes that carry multiple mortgages and liens on the property. Every additional lender will add months to the approval process and decrease the chances that the deal will ultimately go through. Save yourself some heartache and stick to the properties with only one mortgage lender.

Don't make a lowball offer [source: Toy]. The best you can expect on a short sale is a price slightly below the established fair market value. Remember, the lender is already taking a loss on a short sale, so he's in no mood to be making deals. Keep all offers within a range of comparable sale prices in the neighborhood.

Show that you're a serious buyer. Come with your mortgage preapproval letter and a sizable earnest money deposit, as well as your purchase contract and comp information to demonstrate your offer is realistic [source: Freddie Mac]. The bank will be more likely to approve a sale with a fully committed buyer.

Don't attempt to cheat the system by buying a short sale home from a friend or relative and renting the house back to them. That's illegal according to the rules of arm's length transactions. In real estate, the sales price must be determined by fair market value, not a "friendly" arrangement between two relatives [source: Investopedia]. A short sale between two family members or close friends will not be approved.

Submit all paperwork and documentation in a timely fashion, whether you are the buyer or seller. There is a certain amount of bureaucracy with any real estate transaction (if you've ever attended a closing, your wrist probably still hurts from all of the documents you signed). Short sales add an additional layer of documentation, particularly to prove hardship.

Sellers, be aware of the tax implications of a short sale. In most cases, the IRS treats canceled debt as income. If your lender forgives the $100,000 balance that you owed on your mortgage, the Internal Revenue Service will tax that $100,000 as income. There are exceptions to this rule if the home was your principal residence or you were financially insolvent before the debt was canceled [source: IRS]. Either way, it seems like a good time to call your accountant.