Short sell your home to avoid foreclosure (© fotag/Getty Images)

© fotag/Getty Images

If your adjustable-rate mortgage has reset to an interest rate you can't afford, you've experienced a major financial setback such as losing your job or if you must sell a house that is worth less than your mortgage, foreclosure may not be your only option.

A short sale can salvage your credit and help you avoid bankruptcy. For homeowners who are left with few remaining financial options, it may be worth a try.

In real estate, a short sale occurs when homeowners in financial distress sell their property for less than what is due on the mortgage. The buyer is a third party, not the bank, and all proceeds from the sale go to the lender. The lender forgives the difference or gets a deficiency judgment against the borrowers. This requires the borrowers to pay the lender all or part of the difference between the sale price and the original value of the mortgage. In some states, this difference must be forgiven, by law. (Bing: Which states?)

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Alternatives to a short sale
Before resigning yourself to a short sale, talk to your lender about the possibility of a revised payment plan or loan modification. Either option may allow you to stay in your home and get back on your feet.

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You also could stay in your home if you have private mortgage insurance. Many homeowners who purchased homes with less than 20% down were required to purchase PMI. If the PMI company thinks your current financial situation could turn around, it may advance funds to your lender to bring your payments up to date. Eventually, you must repay this advance.

If none of these options is possible, be prepared to do a lot of work to complete a short sale. While a foreclosure essentially lets you walk away from your home — albeit with grave consequences for your financial future, such declaring bankruptcy and destroying your credit — completing a short sale is labor-intensive. The payoff may be worth it, however.

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Before you begin, try to understand your lender's perspective. The lender is not required to do a short sale and will complete one only at its discretion. Make sure that the source of your financial trouble is new, such as a health problem, job loss or a divorce. It should not be something you neglected to disclose when you applied for the loan. The lender won't sympathize with a dishonest borrower. If you think you were a victim of predatory lending, however, you could talk the lender into a short sale even if you have not had any financial catastrophes since buying the home.

Be aware of circumstances that may prevent the lender from wanting to do a short sale. Unfortunately, if you are not in default on your mortgage payments yet, the lender probably won't want to work with you, even if you see the thunderheads looming over your backyard. Also, if the lender thinks it can get more money from foreclosing on your home than from allowing a short sale, it could turn you down. Finally, if anyone has co-signed on your mortgage, the lender may want to hold that person responsible for payment rather than doing a short sale.

If you think your situation is ripe for a short sale, talk to a decision-maker at the bank. Don't just talk to a customer-service representative, who has no real authority. Immediately ask to speak with the lender's loss mitigation department. If you don't like what the first decision-maker says, try talking to another one on another day and see if you get a different answer. If the lender will consider a short sale, you're ready to move forward with creating the short-sale proposal and finding a buyer.

Proceed with caution
At this point, you should consult a lawyer, a tax professional and a real-estate agent. While you may think that these high-priced professional services are the last thing you can afford, making a mistake while handling a complex short-sale transaction yourself could mean even more financial trouble. Professionals accustomed to dealing with short-sale transactions can give you guidance on how to pay them.

To put yourself in a more convincing position to complete a short sale, stop purchasing non-necessities. You don't want to look irresponsible to the lender when it reviews your short-sale proposal.

When setting an asking price, factor the cost of selling the property into the total amount of money you must receive. Of course, you want to sell the home for as close to the value of your mortgage as possible. But in a down market, there is bound to be a shortfall. In some states, even after a short sale, the bank expects you to pay back all or part of that shortfall, but at least this amount will be significantly less than what you owed on your mortgage.

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Gather all of the documents you'll need to prove your financial hardship to the lender. These may include bank statements, medical bills, pay stubs, a termination notice from your former job or a divorce decree. It is up to you to come up with the short-sale proposal. Be aware that the lender ultimately must approve a short sale because it receives the proceeds. Your job is to find a buyer for your home.

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Once you have a buyer and the necessary paperwork, you can submit the buyer's offer and your proposal to the bank. Along with the documentation of your financial status, your proposal should include a hardship letter explaining the circumstances that prevent you from making your mortgage payments. You want to make it as convincing as possible and protect your interests while also appealing to the bank.

Be careful about submitting your financial information to a lender. If it does not approve the short sale, it may use your financial information to try to get money out of you in foreclosure proceedings. If you still have cash assets, you may be expected to use them to continue making mortgage payments or to make up some of the shortfall between the sale price and the mortgage amount. A lawyer experienced in completing short sales can help you navigate the tricky details.

Prepare to wait
Because short sales can take longer than regular home sales because of the need for lender approval, they often fall through. Be prepared for the possibility of the buyer finding another property while waiting for your answer.

Also, be aware that a short sale can still affect your credit score. The months of mortgage payments you missed before the short sale can show up as delinquent payments on your credit report. It is up to the bank to decide what to report, so it's in your best interest to try to persuade it to not report your defaulted payments. The bank is more likely to be generous if you brought up your hardship before you were significantly behind. Although this is somewhat damaging to your credit, it is certainly less damaging than foreclosure.

If the short sale closes, you can breathe a sigh of relief and start over with a major financial burden off your back. You probably won't even have to pay taxes on the shortfall. Under the Mortgage Forgiveness Debt Relief Act of 2007, mortgage debt forgiven by lenders will not be taxable if the discharged debt is on your principal residence. This applies only to debts from 2007 to the end of this year, to a maximum about of $2 million. The amount of debt forgiven still must be reported on your income-tax return using Form 982. You should receive a Form 1099-C from your lender stating this amount. Find more information on the Internal Revenue Service website.

Not all lenders are willing to do short sales. Even when they are, short sales don't always close. They are, however, an excellent alternative to foreclosure and are worth trying to complete. Without the stains of foreclosure and bankruptcy on your credit report, you can get back on your feet much faster.

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