Ethics of a Short Sale (Part 1)

Ethics of Short Sales (Part 1 of 3): A Seller’s Ethical Decisions

by Karina Gafford
MilitaryByOwner Staff Writer

Unfortunately, there is no denying that frustration pervades the entirety of a short sale situation. Even if the situation proceeds smoothly where the seller has received a clear pre-negotiated statement of what the bank will accept for the offer and the buyer offers the precise amount in cash with no contingencies, the sheer amount of time that it takes for the bank—not to mention any secondary or tertiary investors—to approve the sale can cause considerable anguish among each of the parties involved in the transaction. This is not to say that a frustrating situation should encourage poor ethical decision making; instead, when determining how to select the right ethical recourse in the case of a short sale situation, one must "Separate prudential, legal, and ethical concerns," as authors Ron Howard and Clinton Korver write in their recent book Ethics for the Real World. However, in such a situation, individuals should remain on high alert for any prospective instances that may make them either susceptible to making the poor ethical decisions or susceptible to becoming the recipient of the poor ethical decisions of another. 

This article proposes to analyze the roles of the seller, real estate agent, and buyer in determining whether a short sale is an ethically good decision and whether it involves ethically good decisions also. Though only the real estate agent is required to submit to a professional code of ethics, each party involved in the transaction has a role to play in the decision making process. 

Ethics and the Seller

In an article in the online press release magazine PR Log, acclaimed Las Vegas Real Estate Agent Tania Michaels asks rhetorically, "Is a short sale the act of dishonorable deadbeat or an act of grace by the lender?" Her article discusses a question that plagues many would-be sellers who are stuck in a severely depreciated post-recession home, particularly when they face the prospect of a financially crippling, upward swinging, Adjustable Rate Mortgage. These homeowners cannot refinance their ARM as a result of poor credit or negative home equity, meaning they simply owe too much to sell affordably and escape from the financial situation. Many would-be sellers, Michaels explains, remain concerned about the ethics of mutually agreed upon debt forgiveness when they expressly chose to accept the debt in the first place. She explained that she too, had to come to terms with ethically before making the decision to help these homeowners achieve debt forgiveness through short sales.

Affecting the Re-Sale Value of Your Neighbor’s Home

To better understand Michaels’ concerns, according to the National Association of Realtors, a short sale listing, otherwise known as a distressed listing, typically sells for 15 to 20 percent below market value, causing both the lender to lose money on its investment as well as the homeowners within the vicinity of the distressed property. Further, when one home in a neighborhood depreciates in value it, in turn, depreciates the value of surrounding homes.  Why would individuals purchase homes at a higher rate when cheaper ones exist?  This means that the individual selling the home at a lower value is also jeopardizing the value of his neighbors’ property, too.

Laws, morals and most religious principles require that individuals fulfill the terms of a contract; however, these requirements are a little less clear when, as Michaels describes, the situation is beyond an individual’s control, for instance, in the event of a depression or natural disaster. The agent concludes her analysis of the ethics of a short sale by explaining that in the event of a hardship, a short sale is the optimum ethical decision.  The short sale allows both the lender to choose to forgive the debt and the homeowner to accept the terms of the debt forgiveness without simply walking away and leaving behind the messy situation of a foreclosure for the bank to deal with later.

Is it Special Treatment?

One must also consider that by simply requesting the forgiveness of a debt, the homeowner is seeking special treatment.  As Michaels explains, determining the hardship does require that the seller has honestly disclosed his financial situation to the lender, including an honest disclosure of all accounts when applying for a short sale in order to determine that his situation is indeed dire. His neighbor, however, does not have a say in the transaction even though it will, in turn, depreciate his home further. The neighbor whose home is also likely severely depreciated may continue to make payments in order to fulfill his debt contract, choosing not to attempt to short sell or foreclose, but to the neighbor, the homeowner who does choose to short sell seems to be asking for an easy way out of a bad situation. 

How to Determine if the Decision is Ethical

In order to consider whether it is ethically right for the seller to proceed with the sale, therefore, it is important to consider whether the decision he is making is honest, does not involve stealing, and does not involve cheating. Assuming that the seller has honestly disclosed of all accounts, is not concealing any financial information from the bank, such as an upcoming promotion or an inheritance windfall, that would cause the bank to otherwise refuse the sale, and that by his short sale, his neighbor could also choose to attempt to short sell his own home, then the seller’s application for a short sale is not an unethical decision. 

Outside of disclosing accounts, an additional important disclosure remains in the hands of the seller: The property disclosure. Keeping in mind that the property is valued at less than what the seller owes, providing the homeowner the financial motivation to sell, the incentive for the homeowner to fail to disclose any issues with the home remains strong. Assuming that a true hardship exists, it is likely that the homeowner has not had the financial capacity to conduct regular maintenance on the systems—air conditioning, gas, water heater, pool cleaning motor, and etcetera—or features of the house—roof tiles after storms, gutter cleaning, mold inspections, termite inspections, and etcetera. The homeowner may, therefore, be reluctant to disclose that he has not remained current on all necessary maintenance in the event that it scares away any prospective buyers. 

Given, though, that a prospective buyer of a distressed property should expect to be on high alert for maintenance issues, and that any failure to conduct regular maintenance will be clearly evident either by the condition of features such as the lawn or to the third party inspector, it does not seem unethical if a homeowner fails to note that he has neither had a bi-annual air conditioning inspection nor an annual termite inspection. If, however, the homeowner has painted over apparent mold in the bathroom with the intention to conceal a water damage problem, knowing that the new buyer will have to remedy this problem, then the homeowner has acted unethically. Though it may be prudent for the homeowner to conceal the water damage problem, it is neither ethical nor legal, as the homeowner acted to deceive and is still subject to a lawsuit by the buyer for concealing this information.

The Ethics of Tax Advantages

An additional form of financial special treatment must be considered in light of the recent plethora of short sales across the country: Tax advantages. Initially, a homeowner remained responsible for the tax implications of a short sale, meaning that he would be responsible to pay tax on the deficiency of a sale, as if the deficiency amounted to earned income. For example, if a home mortgage was $300,000, but the home sold through a short sale for $210,000, then the seller would eventually have to foot the tax bill for the $90,000 deficiency. Ouch! Expensive! The Homeowner Foreclosures Alternative Act (HAFA), however, has made the tax implications redundant. Though lenders will continue to send out warning letters, reminding sellers that they may be responsible for the deficiency, recent legislation has instead permitted sellers to simply walk away from the tax burden. Many consider this disparate tax treatment both imprudent and unjust, rewarding those who leave behind their financial obligations without providing incentives for those who remain in their homes and continue to make payments. The ethics of the situation, however, require further consideration.

When determining the ethical implications of the seller’s situation, one must first consider if this is deceiving anyone, but as this tax situation does not involve intentional lying, one must then consider if it involves stealing or cheating. As there is no intentional cheating involved on behalf of either the seller or the lender, then this does not merit the label of cheating. Determining whether this situation involves stealing, however, is a little more difficult. On the one hand, the seller is not illegally stealing, as the law does not require him to pay tax on the deficiency. On the other hand, however, the tax code would require anyone in the situation of a conventional sale where he has financially benefited to pay tax on the increased value.  In a short sale, no increased value exists, but the seller has financially benefited by the lender agreeing to a lower value, which in turn suggests that the deficiency amount—the $90,000 in our example—is essentially an earned profit that requires a tax payment. Now, the likelihood that the seller can actually afford the tax payment is minimal, meaning that the seller would most likely end up in an even worse financial situation. Therefore, even though the seller has financially benefited, the financial benefit is not the same as if he has earned cash in hand, making him able to remit a tax payment. Given this understanding, the seller is not acting unethically by not paying taxes on the deficiency amount.

As Michaels concludes, it is ethically correct for a seller to commence with the process of a short sale in the event that he faces a hardship that warrants the sale of a primary residence. The seller, however, is not the only party involved in the process of a short sale. In our next article, we will look at the role of the real estate agent, the licensed professional bound to uphold a code of ethics in real estate transactions. 

Related Articles:

Article 2 of 3: A Real Estate Agent’s Ethical Decisions 
Article 3 of 3: A Home Buyer’s Ethical Decisions