Short Sale vs Foreclosure: The Math Your Seller Needs to See

Jerad Larkin
7 hours ago
8 min read

Is a short sale better than a foreclosure in Colorado? Usually yes. A foreclosure adds the bank's costs to the debt and sells at a distressed price, which grows the deficiency the lender can pursue for six years. A short sale sells at market value and typically includes a deficiency release.

The instructor of the short sale class I sat in on said something that stuck with me. She said one of the things she learned from teaching this class over the years is how many real estate agents do not actually know what happens in a foreclosure.

That is not a dig. Most agents have never had a reason to learn it. But if you are sitting across from a homeowner who is deciding between a short sale and just letting it go, this is the conversation. It is the whole conversation. And if you cannot walk them through the numbers, someone else's bad advice will fill the gap.

So here it is with real numbers.

The Foreclosure Math

Let us use clean numbers.

Starting point: the homeowner owes $400,000. The house is worth $350,000.

Step 1: The bank forecloses. Foreclosing costs the lender somewhere between $30,000 and $50,000 in attorney fees, filing costs, and carrying costs. Call it $50,000 for easy math.

And here is the part people miss. All of that gets added to what the borrower owes. The homeowner signed a promissory note. The costs of enforcing it become their bill.

Balance is now $450,000.

Step 2: The bank sells it as a bank owned property. You know what those look like. It is a fire sale. The bank does not want to own real estate, they want it off the books. Say they get $300,000.

Step 3: Do the subtraction. They were owed $450,000. They recovered $300,000.

The deficiency is $150,000.

Step 4: They can pursue it. In Colorado, for six years.

The Short Sale Math

Same starting point. Owes $400,000, worth $350,000.

Step 1: You sell it for what it is actually worth. $350,000. Not a distressed fire sale price. Market price, with a real listing, real photos, and real marketing.

Step 2: Do the subtraction. Owed $400,000, recovered $350,000.

The deficiency is $50,000.

Step 3: On roughly 95% of approval letters, the deficiency goes away entirely. The approval letter contains language stating the lender will accept the net and will not pursue the borrower for the deficiency. This is nearly universal on the government programs, FHA and VA.

Side by Side

Owed at start: $400,000 - $400,000
Bank's costs added: plus $50,000 - none
Balance: $450,000 - $400,000
Sale price: $300,000 distressed - $350,000 market
Deficiency: $150,000 - $50,000
Pursued: Yes, up to 6 years - Usually released in writing

Two separate wins stacked on top of each other. First you cut the deficiency by two thirds just by selling the property properly instead of letting it get dumped. Then, in most cases, the remaining balance gets released.

"I'll Just Put the Keys in the Mailbox"

You will hear this. Politely, it is not a thing.

The idea that a homeowner can hand over the keys, walk away, and be done is something that got repeated so many times during the last cycle that people took it as fact. It is not.

They signed a promissory note. The bank taking the house back does not cancel the note. It just means the bank applies whatever it recovers against the balance, and whatever is left is still owed.

This is worth being direct about, kindly, because a homeowner who believes the myth will choose foreclosure and end up in a materially worse position than they had to be in.

What Happens to the Forgiven Debt

Do not skip this part in your seller conversation, because if you do, it becomes an unpleasant surprise in January.

When a lender forgives debt, they have to write it off, and to write it off legally they issue a 1099-C. So the seller receives a 1099-C for the forgiven amount.

Worst case, they owe income tax on it.

Put that in perspective for them:

Paying tax on $50,000 is better than owing $50,000
And it is dramatically better than owing $150,000 and having a bank chase it for six years

There is also the Mortgage Forgiveness Debt Relief Act, which allows qualifying forgiven mortgage debt to be excluded from taxable income. It has been extended every year since 2008. The wrinkle is that Congress tends to handle it late in the year and apply it retroactively, so you spend most of the year not knowing for certain.

The right advice here is simple: tell them to use an accountant the year they close. This is not the year to do it themselves. A 1099-C reported incorrectly means paying tax they may not have owed.

I am not a tax professional. You are not a tax professional. Hand that one off.

Credit: What Actually Causes the Damage

This comes up in every one of these conversations, and the answer is more nuanced than most people expect.

The short sale itself is not the ding. The missed payments are.

Someone who fell six months behind on everything is going to have damaged credit regardless of how the property is resolved. Someone who stayed current on their other obligations and only missed a couple of mortgage payments before the short sale closed comes out in far better shape.

There was an example in the class of a seller who missed roughly two payments, stayed current on everything else, and bought again about a year later.

There is also a real world case worth knowing about: an active duty service member with a security clearance who cannot afford to miss a payment, because the clearance depends on his financial record. So the negotiator was working on whether the lender would review a short sale while he stayed current. That is not the normal path and it may not work, but it shows the point: the credit consequence tracks the payment history, not the label on the transaction.

And in the lending world, a short sale reads as taking care of your business. It is not the same as paying off the loan. But compared to a foreclosure or a deed in lieu, a short sale is viewed as the borrower having stuck with it and settled up.

Waiting periods to buy again vary by loan program and by how much credit damage occurred. Send them to a lender for the real answer rather than quoting a number.

What About a Deed in Lieu?

A deed in lieu is sometimes called a friendly foreclosure. The borrower hands the property to the bank rather than making them foreclose.

Two things to know.

First, it does not reliably come with a deficiency release. It is generally understood as a way to save the bank three months of foreclosure process, not as a settlement with release language. If someone is being offered one, that is the question to ask.

Second, taking it early gives up your runway. If the Notice of Election and Demand has not even been filed, the homeowner still has roughly three months in the property and three months to find a solution. Handing over the deed ends that.

There was a good example of this in the class. An FHA file got a bad appraisal, roughly $50,000 too high, before a coordinator got involved. It sat for the full 120 days with no interest, and the lender contact was ready to offer a deed in lieu. Instead the negotiator asked whether a new appraisal could be ordered if she brought an offer, got a yes, dropped the price to what the property was actually worth, got an offer, and the file got done.

Sometimes a deed in lieu is the right answer. But it should be the last option considered, not the first.

How to Actually Have This Conversation

A few things that make it land better.

Be a counselor, not a salesperson. These people are in one of the worst stretches of their life. Divorce, job loss, a death. The instructor's phrasing was that you want to show up as a counselor, an advocate, and a resource rather than as an agent who needs a commission.

Use their actual numbers. Pull up what they owe and run the two scenarios out loud. The abstract version does not land. Their own house with their own balance does.

Explain the 1099-C before they sign, not after. They will find out either way. Better it comes from you.

Do not promise the deficiency release. It is on roughly 95% of approval letters, and it is close to universal on FHA and VA. But smaller lenders occasionally issue an approval without release language. If that happens, the short sale is still better, because a smaller deficiency is better than a larger one and foreclosure would guarantee the pursuit.

Tell them the truth about how long it takes. Several months. The foreclosure date will move, usually about a month at a time and often at the last minute, which is terrifying if nobody warned them. And the first buyer will probably walk. All of that is normal, and all of it is much easier to handle if it was predicted in month one.

Frequently Asked Questions

How long can a lender pursue a deficiency in Colorado?

Up to six years. This is one of the main reasons a short sale with deficiency release language in the approval letter is generally a better outcome than a foreclosure, where the deficiency is both larger and collectible.

Does a short sale always release the deficiency?

Not always, but usually. Roughly 95% of approval letters contain language stating the lender will not pursue the deficiency, and it is close to standard on FHA and VA files. Some smaller lenders issue approvals without release language, in which case the short sale is still preferable because the deficiency is far smaller than it would be after a foreclosure.

Will a seller owe taxes on forgiven mortgage debt?

Possibly. The lender issues a 1099-C for the forgiven amount, which is potentially taxable income. The Mortgage Forgiveness Debt Relief Act has been extended each year since 2008 and can exclude qualifying forgiven mortgage debt. Sellers should work with an accountant the year the short sale closes.

Is a short sale or a foreclosure worse for credit?

The credit damage comes primarily from missed payments rather than the transaction type. Beyond that, lenders view a short sale more favorably than a foreclosure or a deed in lieu, because the borrower worked through the process and settled with the lender.

Can the bank take a seller's 401k in a short sale?

No. Retirement accounts are protected. The lender may request statements as part of reviewing the financial picture, but they cannot require a borrower to liquidate an IRA or 401k to make a payment.

This post is part of a series I built from a three hour short sale CE class. The full walkthrough is here: Short Sales in Colorado: The Complete Guide for Real Estate Agents.

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