Wish I had ten dollars for each time I've been asked by my buyer clients and friends to explain options they might have in purchasing short sales or foreclosures, and to explain the notations they see on the MLS regarding various property types. Listing clients, as well, are starting to come to me with similar questions regarding various options to sell their home in the current market.

Hawaii has one of the lowest foreclosure rates in the nation, but recently, one of the highest rates of increase in foreclosures. As usual, we in Hawaii are behind the curve, and Buyers and Sellers in many places on the mainland have been going through what we in Hawaii are just now starting to go through. And our property values, while not having suffered like those on the mainland, are down, as well to about 2005 levels. So I will clarify here, for the Hawaiian readers who may not have seen as many of these, four different property types that are starting to come up more frequently, amidst the regular Hawaii homes for sale:

(1) short sales (2) distressed properties (3) foreclosures and (4) REO homes.

First, Short Sales. A short sale is the sale of a home where the sale price agreed upon between the Buyer and Seller (and any involved lenders) of a home is less than the total costs of the sale. For example, where a home is sold for $750K and $780K is owed between a first and second mortgage, plus other costs of sale like closing costs, other liens, realtor comissions, etc, AND the seller does not come up with the extra cash toward the price and costs, you have a short sale. A home subject to short sale may or may not be distressed or in foreclosure at the time of the sale. The owners of a short sale property may, in many cases, be current on all the payments. The only issue is price, because either the market price has decreased since they bought the home, or the owenr has taken out one or more mortgages or lines of credit on the property and the market value has decreased since that time. All short sales must be approved by the mortgage holders because typically they will be getting paid less than they are owed. 

Buyers making offers on short sales should beware that it may take several weeks to months to get an answer from the bank as to whether their offer is acceptable. And the banks may not be very flexible as to terms. Many banks also will not negotiate back and forth, so if the bank rejects an offer, the buyers have to either try again or move on. Not all banks have similar procedures or requirements for short sales. In fact, they are all over the board on these. Short sales are becoming increasingly common in Hawaii and tend to affect those that bought or refinanced in 2005, 2006 or early 2007,  when prices were higher, especially if they used a VA or other low downpayment loan.

Sellers of Short Sale properties will generally take a hit on their credit scores, as a result of the short sale, particularly when they have payments in arrears (I have read, approximately 80-100 pts or so). However, the effect is less extreme than a foreclosure, which apparently costs the homeowner 200-300 pts on his or her credit score. Short sales will remain on a seller's credit report for approximately 3 years and may hurt their ability to purchase another home for 18 months or more.

To help preserve a seller's credit, it is important to try to negotiate with the bank that any shortfall between the amount owed by the seller and the purchase price be forgiven (if the seller is unable to pay), and that the notation on the seller's credit as to the loan balance indicate "paid as agreed upon." It used to be that any shortfall forgiven to the seller of property by the lender would be considered taxable income to the seller (via 1099). The Mortgage Debt Relief Act of 2007 changed this and now many homewoners with debt forgiven through a short sale or a loan modification will not be taxed on these amounts. Certain conditions, such as having the property as your principal residence, do apply. If the MDRA does not apply to you, there may be other provisions under which your forgiven debt may not be considered taxable income - for example, if you are deemed "insolvent." Please check with your tax experts to see how this may affect you. Not all shortfalls will be forgiven by the bank, however, particulalry when the seller has considerable other assets or earning potential enabling them to repay the bank using a payment plan.