A Helpful Q & A: What to do with Two Mortgages

June Fletcher is a staff reporter at The Wall Street Journal. Below, she answers a question for her House Talk column at Real Estate Journal:

Question: Could you please explain more about a short sale. I am stuck in my home with two mortgages and can’t get out. Please help. I cannot afford this house anymore and can’t work anymore due to health reasons.

Answer: I’m sorry to hear that you have health and financial problems. I hope this explanation helps.

In a declining housing market, the value of a home sometimes falls below what is owed on it. When you can no longer pay the amount owed, you have several options. You can try to hand over your deed to your first mortgage holder.

But they might not accept it because they’d still be on the hook for legal fees and taxes, as well as your second mortgage. Or you may just let the house fall into foreclosure. But that should only be a last-ditch approach because it hurts your credit rating. And it may not solve your financial problems, either, since you may be held liable for any difference between what you owe and what the house brings at auction.

Another alternative is a short sale - that is, a sale in which the proceeds fall short of what you owe. It can be a win-win situation for you, the lenders and the buyer (often an investor) of your house. However, since you’re asking lenders to accept less money than you promised to pay them, there’s no guarantee that they’ll go along with such a sale. And preparing for it will take considerable work on your part.

First, you must prove that you really can’t pay your home mortgage loans - and that the reason is new, not something that you concealed from your lenders when you originally applied for the loan.

Then you or someone else, such as a real estate agent, must find a buyer willing to purchase your house at market value. Market value can be determined through a formal appraisal (your lender may insist on one) or by an agent’s comparative market analysis.

You or your agent also must figure out all the costs of selling the property. That includes the balance of both loans, accrued interest up until the day of closing, closing costs and fees, and unpaid property taxes.

You then must present the facts to your first mortgage holder, which has the top lien position and gets paid first. If your plan will bring them more money than they’d get if the house were sold at auction, they’ll most likely go along with it - and sometimes pick up some of your costs as well, like real-estate commissions and closing costs.

However, it may be difficult to get your second mortgage holder to sign off on the deal because if they do, they might not be repaid what they’re owed. But they may be willing to go along with a short sale if the buyer or the first mortgage holder offers to pay them some money, especially if the amount you owe on your second mortgage is small.

Once you close the sale, your problems may not be over. Some hard-nosed mortgage lenders may insist that you pay the difference between what the buyer pays for the house and what you owe on the mortgage. Others may forgive that portion of the debt - but unfortunately, Uncle Sam won’t. “Forgiven” debt is considered taxable income.

As you can see, setting up a short sale is complicated and requires some negotiating finesse. Although money is probably tight for you right now, it would be worthwhile to consult local professionals with experience in the process, including an attorney, a tax advisor and a real estate agent.