When you are negotiating a short sale or note purchase through the bank on a defaulted property it’s easy to overlook the possibility of a mortgage judgment being filed against the homeowner after the sale. It can be common practice for a bank to file a judgment against homeowners fro the remainder of a mortgage after a property has been sold for less than its mortgage.

A typical short sale involves negotiating with the bank to let you buy a property at a lower price than what is left owed on the mortgage to the homeowners. This allows you to pick up a property cheap, the bank to unload a mortgage that the homeowners just can’t make payments on and the homeowners to get out from under a mortgage that’s downing downhill fast.

What Happens after the Short Sale?

Sometimes you’ll find that the homeowners don’t get away from this deal as Scott-free, as they were led to believe. The bank may say okay, we’ll let you buy this mortgage or this property for say $60,000 when the homeowners still owe $100,000, but we’re also going to court later on to get a judgment against the homeowner.

This judgment against the homeowner basically says that the now former homeowner still owes the bank $40,000, which was the amount of the write-off the bank took on the sale of that property to you. That judgment will remain attached to the homeowner for 2 years and can really mess up their ability to get into a new home. It can also attach to another house that the homeowner buys after selling you the property. So the homeowner automatically gets a $40,000 debt tacked onto their other mortgage.

The bank can also decide not get a deficiency judgment against the homeowner for the write-off on that defaulted property. While you are negotiating with the bank for that property you can also negotiate with them to not get that mortgage judgment against the homeowner. When the bank doesn’t get a judgment, it is required to send out a 1099 form to the homeowner. This 1099 form shows the $40,000 write-off by the bank as income for the homeowner for that year.

What to Do about the 1099 Form?

As you can imagine, most homeowners will be terrified by this possibility. Either they get a deficiency judgment against them for the remainder of the mortgage or the IRS views that $40,000 write-off as income. Be sure to tell the homeowner, that when they get this 1099 Form they need to see their CPA or someone who is certified to do their taxes.

The CPA will be able to tell them how to work with the IRS, so that this 1099 isn’t shown as income. The homeowner may qualify for an ‘exclusion’ from the 1099 for selling their own home if they have lived in that home for the past 2 out of 5 years.

In addition, there is a Form 982 that the homeowners may be able to fill out that shows they are ‘insolvent’ and have no funds from this sale. If they qualify through this form the IRS may not require them to pay taxes on that $40,000 write-off.

Don’t blame the banks for this little predicament that can pop up and ruin the homeowner’s deal. They are required by law to get a judgment against the homeowner or to send out a 1099 form to the homeowner. Just make sure that you lee the homeowner know in advance that if they take the short sale or note purchase deal they will face one of these two possibilities.