Selling an underwater house in Maryland: how a short sale works, the deficiency question, and where a cash buyer fits

Most Maryland sellers we talk to have equity. A few do not. A second mortgage taken out when values were higher, a year of missed payments with fees piling on, a house bought at the top of a block that has since softened, or a roof and a furnace that failed in the same winter can all leave the mortgage payoff above what the house will sell for. That is an underwater house, and selling it is a different process from a normal sale, because the lender has to agree to lose money. This article covers how that agreement works, the two questions that decide whether it hurts you later, and where we fit.

Start with the real numbers

Underwater is a conclusion, not a feeling, and sellers get it wrong in both directions. Order a written payoff from every lien holder, not the balance on the statement, because the payoff adds accrued interest, late fees, escrow shortages and, once a foreclosure has been filed, the attorney’s fees and costs. Then put an honest price on the house as it sits. Our closing costs article covers the seller side of settlement, which also comes out of the price. If the price less costs covers every payoff, you are not underwater, you are a normal sale with a thin check, and the rest of this article does not apply.

What a short sale is

A short sale is a sale where the lender agrees to accept less than the full balance and release its lien anyway. You still own the house and you still run the sale. The lender simply has to sign off on the price and the settlement statement before closing. To get there you send the servicer a hardship package: a letter explaining why you cannot keep paying, recent pay stubs or proof of income, bank statements, tax returns, a financial worksheet, and a signed purchase contract with the buyer’s proof of funds. The servicer orders its own valuation, usually a broker price opinion or an appraisal, and compares the offer to it. If the offer is close enough to that number and the hardship is real, you get an approval letter.

Two facts about that process surprise people. First, it is slow. Weeks go by between each step, the file gets reassigned, and documents expire and have to be resent. Months is normal. Second, the buyer has to wait through all of it with no guarantee, which is why many retail buyers walk away from short sales before approval arrives. A buyer with no rate lock to lose and no other house riding on the timing is the one who stays.

The approval letter is the whole deal

Everything that matters to your future is in the approval letter, and most sellers never read it closely. Maryland allows a mortgage lender to pursue the borrower for a deficiency, the gap between what the house brought and what was owed. After a foreclosure that happens by a motion in the foreclosure case. After a short sale it happens only if the approval letter leaves the door open. Read for one sentence: the lender accepts the net proceeds in full satisfaction of the debt and waives any deficiency. If the letter instead says the lender releases its lien but reserves its rights, or asks you to sign a new promissory note for part of the balance, that is a different deal and you should know it before closing, not after.

A second mortgage or a home equity line is its own negotiation. The first lender’s approval does not bind the second, and the second lender knows that a foreclosure by the first would wipe it out, so it is usually willing to release for a small share of the proceeds. It should also waive its deficiency in writing. Our judgment and IRS lien article covers what happens when a judgment or tax lien sits behind the mortgage, which the lenders will also want cleared.

The tax question

Forgiven debt is income to the IRS. After a short sale the lender sends you a Form 1099-C for the amount it wrote off, and that number lands on your tax return unless an exclusion applies. Two exclusions do the work for most homeowners. The insolvency exclusion applies to the extent your total debts exceeded your total assets immediately before the discharge, which describes many underwater sellers. The qualified principal residence exclusion covers forgiven mortgage debt on a main home, and Congress has extended it in one or two year pieces rather than making it permanent, so whether it reaches a discharge in your year is a question for a tax preparer before you close. Maryland generally follows the federal treatment.

If foreclosure has already started

A short sale and a foreclosure sale date mix badly. The servicer’s loss mitigation department and its foreclosure attorney are two different offices, and the auction does not pause by itself because a short sale package is under review. Ask in writing for a postponement once the contract is in, and use the state’s foreclosure mediation program, which costs $50 to request and puts you in front of an administrative law judge with the lender required to attend. Our foreclosure timeline article walks through the notices and deadlines, and our foreclosure page covers the sale that pays the loan in full, which is the better outcome when the numbers allow it.

The alternatives to a short sale

A deed in lieu of foreclosure hands the house back to the lender and skips the auction. It usually needs the house to be free of other liens and the lender to agree, and the deficiency and tax questions above apply to it in the same way. A loan modification keeps the house by changing the terms, which only helps if you want to stay and can afford the new payment. Renting the house out to cover the mortgage works for some owners with a small gap; our tenant occupied page covers what that means later when you sell. And if you are in or considering bankruptcy, the sale runs under the court’s rules; our bankruptcy answer covers that path.

Where a cash buyer fits, honestly

A cash offer does not make a short sale unnecessary. If our offer is below the payoff, the lender still has to approve it, and we are the buyer who waits. What a cash offer changes is the quality of the package. The servicer sees a firm written price, proof of funds, no financing contingency, no inspection contingency and no appraisal that can fall short, which is the file its valuation department is most likely to approve on the first pass. We send the written offer within a day of seeing the house, with the math shown against a listing, and once the approval letter arrives we close in two to three weeks through a licensed Maryland title company that pays the lenders exactly what the letter says.

We will also tell you when a short sale is the wrong tool. If the gap is small, a sale that pays the loan in full with you bringing a check to settlement avoids the approval process, the credit mark and the 1099-C entirely, and we will show you that math side by side. If the house does not sell at any price, our article on houses that do not sell covers the other reasons that happens.

Being underwater is a numbers problem with a paper trail, not a character flaw. Get the real payoffs, get an honest price, read the approval letter for the waiver, and have the tax conversation before closing. Then pick the buyer who can wait.