A short sale can be a great way to avoid foreclosure.  However, there are also some negatives that must be considered prior to moving forward with a short sale transaction.

Forgiveness of Debt - 1099-C

The most favorable outcome in a short sale transaction is the forgiveness of debt.  In this situation, the bank accepts a short payoff and forgives the remaining debt.  This is great for most homeowners, especially with the passage of the Mortgage Debt Relief Act in 2007.  However, if you have a recourse loan, the bank will issue a 1099-C with the amount forgiven.  They will also do this on a foreclosure so in this case a short sale is usually a better option than foreclosure. 

Keep in mind, however, that if the home you are selling short is an investment property, the Mortgage Debt Relief Act does not apply.  Also, there are parameters that the home and your financial situation must fall into to avoid tax consequences.  You should consult with your accountant about your specific financial sitaution before determining that a short sale is the best option for you.

Deficiency Judgments

Arizona has anti-deficiency laws that affect most of the mortgages (Deeds of trust) here.  This means that the bank's only recourse against a borrower that has defaulted is to take the property.  However, there are some loans where other terms have been agreed to.  In fact, many cash-out refinances are considered to be recourse loans so it is vitally important to find out what kind of loan you have.  Additionally, our anti-deficiency statutes do not apply to certain types of property, so it is vitally important to double-check on this before moving forward.  Consulting a Real Estate Attorney is a great way to get to the bottom of whether or not you may have a deficiency judgment after the fact.

If your loan is a recourse loan (meaning the bank could come after you for the difference) you can still do a short sale.  However, knowing what type of loan you have will help your agent when he/she negotiates with the bank and will help you know what terms you should be willing to accept.  In this case, your agent may be able to negotiate better terms than you would have allowing the home to foreclose.

NOTE: If your loan is a recourse loan, the bank can pursue a deficiency judgment after foreclosure so it is usually better to short sell these loans as the deficiency amount will be reduced.  Banks spend a hefty sum on foreclosure costs as well as typically selling the home for less after they foreclose.  These costs are added to the amount they will attempt to collect from you or added to the amount they forgive (see previous topic on debt forgiveness).

Credit Ramifications

Because a short sale means that a lender is accepting a payoff that is less than the balance owed your credit score will go down if you short sell.  In addition, the months of getting behind on your payments all add up to bring your score down.  Under current FHA guidelines (January 2010) a person cannot purchase a home for approximately 2 years if he/she has a short sale on his or her record.  However, a foreclosure doubles that time to at least 4 years.  Keep in mind that these are only the current lending guidelines and are subject to change as banks tighten or relax their guidelines. 

IMPORTANT NOTE:  If you are in the process of doing a short sale and your lender starts foreclosure proceedings it will be considered a foreclosure for mortgage lending guidelines even if you complete the short sale.  However, it will not be listed as a foreclosure on your credit report and will be on your credit for a shorter length of time than an actual foreclosure would be.  In addition, there are tax benefits that should be considered before simply abandoning the short sale process.  See Benefits of Selling Your Home through a Short Sale.