• A short sale is when a homeowner experiencing financial hardship opts to sell their property, with lender approval, for less than the amount owed on the mortgage.
  • Short sales typically occur when local home prices have declined sharply, and homeowners owe more on the mortgage than the property is currently worth. 
  • This type of sale can be beneficial for homeowners, allowing them to avoid foreclosure, while also benefiting homebuyers who are looking for properties that could be purchased at a discount.

In declining markets, short sales provide an alternative to foreclosure for homeowners who are struggling to make their mortgage payments. At the same time, they can provide unique opportunities for homebuyers and investors. 

Learn more about short sales, including what they are, how they work, and the pros and cons.

What Is a Short Sale in Real Estate?

A short sale is when a homeowner sells their property for less than the amount owed on the mortgage.

This can happen when a homeowner faces new financial hardships that prevent them from making their current payments while owing more on the mortgage than the property is worth (known as being underwater on the mortgage, also referred to as negative equity).[1]

Short sales occur more often in markets with sudden, sharp drops in home values. For example, during the Great Recession, short sales accounted for around 18% of real estate transactions.[2] Falling home prices combined with increased unemployment left many homeowners unable to make their mortgage payments or sell for a profit. 

In the modern market, short sales account for only around 5% of all single-family home sales.[3] While we have not seen dramatic home value drops since the Great Recession, it is common for values to dip periodically as part of the normal real estate cycle. When a buyer makes an extremely low down payment, like 3% down with a conventional loan or even 0% down with VA loans or USDA loans, it doesn’t take much of a market dip to create negative equity for that homeowner.

How Short Sales Work

Short sale transactions are similar to standard real estate purchase transactions, but short sales contain a few additional steps. 

Step 1: The Homeowner Contacts Their Lender

When a homeowner is struggling to pay the mortgage, they should immediately contact their lender. The lender may be able to provide solutions to help the owner keep the house if they wish to. If it is not possible to keep the house, or the owner doesn't want to, they can ask their lender about accepting a short sale. 

The lender needs to see documentation of financial hardship to consider a short sale. Employment termination letters, medical bills, and divorce decrees can all meet this requirement.  

Step 2: The Homeowner Finds a Buyer

The homeowner needs to find a willing buyer to sell the house to. However, the buyer pool may be limited as some buyers avoid short sales, knowing that they typically take longer to close due to lender approval requirements. To reach a wide audience of prospective buyers, many short-sale sellers hire a real estate agent to professionally market the house for sale. 

Homebuyers can often find short sales listed on the local multiple listing service (MLS), which is accessible through a local real estate agent. There are also online databases of short sale and foreclosure properties that cater to investor buyers. 

Step 3: The Homeowner Submits a Proposed Sale to the Lender

When a buyer makes an offer to purchase the property, the homeowner submits this information to the lender.

In some states, the homeowner is responsible for paying the deficiency, the difference between the proceeds from the sale and the amount due on the mortgage. However, the lender may be willing to waive the deficiency, particularly if the homeowner is unlikely to have the funds to pay it. Therefore, short sale proposals often ask lenders to accept a loss on their investment. This requires careful consideration from the lender, which can take time and require additional documentation or further negotiations. 

Buyers may terminate the purchase contract if the process takes too long or if they find another property while waiting for lender approval of the short sale. So, short-sale sellers may want to entertain backup offers in case the deal with the original buyer falls through. 

Step 4: If the Lender Approves the Sale, the Deal May Proceed To Closing

Once the lender approves a short sale, the transaction proceeds like any standard real estate transaction, with the buyer completing due diligence (getting a home inspection, having the property appraised, and having the title researched) albeit with additional lender-required documentation. 

The buyer completes the purchase, with the proceeds going directly to the seller’s lender, and the seller transfers ownership and possession of the property to the new buyer.

If the seller owes the deficiency to the lender, they need to arrange payment. The lender has the legal right to sue for the deficiency if it is not paid.[4]

If the deficiency is waived, the seller may be required by the IRS to claim the deficiency amount as earned income, which can increase their income tax liability for the year in which the sale occurred.[4]

Pros and Cons of a Short Sale for Sellers

Benefits of a short sale for sellers include:

  • Avoiding foreclosure. A short sale negatively affects the homeowner’s credit score but not as much as a foreclosure, in which the lender seizes the property, would.[5] The lesser credit impact can make it easier to buy another home sooner than would be possible following a foreclosure, although there will likely be a period of several years during which it would be very difficult to qualify for a new home loan. 
  • More control over the sale. Unlike foreclosure, where the lender takes full control, short sales allow homeowners to choose a buyer and engage in negotiations before taking the deal to the lender.
  • Potential debt forgiveness. Some lenders may waive the deficiency balance, relieving the homeowner from paying the difference between the proceeds from the sale and the mortgage balance.

Potential disadvantages of a short sale for sellers include:

  • Loss of the home. Short sales require the homeowner to sell the property.
  • Credit damage. Although less severe than foreclosure, a short sale can still negatively impact the seller’s credit score, making it harder to be approved for new loans.
  • Lender approval requirement. The bank must approve the short sale, which can take several months and may delay closing.
  • Potential for a deficiency judgment. Some lenders do not forgive the remaining debt and may sue the seller for the balance (subject to state law).

Pros and Cons of a Short Sale for Homebuyers and Investors

Whether buying a home or investing in real estate, short sales can provide benefits, such as:

  • Below-market purchase price potential. Sellers and their lenders may accept less than market value to avoid the hassle and expense of foreclosure. 
  • Less buyer competition. Many buyers avoid short sales due to the lender's involvement and longer timelines. Less buyer competition can increase negotiation leverage. 
  • Opportunity for a property in good condition. Unlike foreclosures, which may be abandoned or damaged, short-sale properties are often occupied and better maintained. However, there may be some deferred maintenance if the seller has not had the funding for proper upkeep.
  • Fewer risks than foreclosures. Short sales allow for due diligence, including inspections and appraisal before closing. This represents a lower risk than foreclosure auctions, which provide less opportunity for due diligence.

Potential disadvantages of a short sale for buyers include:

  • Lengthy process. Lender approval for a short sale can take months. 
  • As is condition. Most short-sale sellers are not in a position to make repairs before selling, so the buyer may be responsible for any deferred maintenance expenses or repair costs. This makes the home inspection especially important when buying short sales. 
  • The lender may counter or reject offers. Even if the seller accepts the offer, the lender could counter or reject it. 
  • Potential for other unpaid debts. Due to the seller’s financial hardship, short-sale properties may be more likely to have unpaid property taxes, HOA fees, or other debts that need to be resolved before closing.

Short Sale vs. Foreclosure

Short sales and foreclosures both result in the homeowner vacating the property and relinquishing ownership. However, the financial consequences of a foreclosure are more severe than a short sale. Foreclosures occur when a homeowner fails to repay the loan, and the lender is forced to seize the property and sell it in an attempt to recover their losses. Foreclosures result in a more significant credit hit, often making it difficult to qualify for a mortgage for up to seven years.[6]

The Bottom Line

Short sales may provide a favorable alternative to foreclosure for homeowners who are underwater on their mortgage and are unable to cover their mortgage payments. They provide an option for homeowners to maintain some control over the sale of the property and avoid the severe credit score damage done by a foreclosure.

While short sales require a lengthy lender approval process, they may be worth the wait for homebuyers and investors looking for a good deal on a property. With the seller and lender both motivated to mitigate their losses by selling the property, buyers may be able to negotiate a below-market purchase price.