Selling your home in a short sale is better than going into foreclosure, but you might face a deficiency judgment from your lender.

Q: In one of your recent columns, you referred to the term deficiency judgment when discussing a short sale. What if you closed on a short sale, but the lender reserved the right to file a deficiency judgment against you for the difference between the short sale price and the balance owed on the mortgage. How do you know if the state you live in prevents a lender from going after you for a deficiency judgment? What’s the point of doing a short sale if the lender can still hold you liable for the full amount of the mortgage?

A: These are good questions. If you sell your home and the sales price is insufficient to pay off the mortgage lender along with all the other closing costs from the sale, you can say that you are short of funds to close. Ordinarily, you wouldn’t be able to close unless you are able to convince the real estate broker, the lender or anybody else that will receive funds from the sale to take less from the sale.

In general, if you were short about $1,000, you might have the money to put into the sale to allow the sale to proceed. If you truly don’t have the money, you’d have to find out if the buyer, real estate agent or other party to the sale would be willing to take less money to close the deal.

If the shortage is significant, you’d have to see if your lender is willing to take less than the full payment to pay off the loan. At this point, the lender has options. The first might be to deny the request of the homeowner to pay less than what is owed on the debt owed to the bank. The second is to allow the borrower to proceed with the sale of the home but not release the buyer from the debt owed the lender. The third is to allow the buyer to sell the home, pay the lender whatever comes from the sale of the home and release the buyer from any obligation to pay the lender what is still owed on the debt.

Let’s assume you purchased a home for $300,000 and in the process, took out a loan, on which the balance is now about $250,000. If we assume you are now selling the home for about $200,000 and have about $20,000 in closing costs, you will be short about $70,000 to pay your lender.

If the lender allows you to proceed with the short sale and forgives the balance of the debt, you’re free to go on with your life without the burden of what you still owe on that debt. Except that the forgiven debt could be considered income for federal income tax purposes. In the example we went through, the bank would send you and the IRS a tax statement indicating that they forgave $70,000 of debt you owed.

If you were selling your primary residence, you wouldn’t have to worry. At least not this year. Temporarily, Congress is allowing homeowners though December 31, 2012 to ignore any forgiveness of debt for federal income tax purposes on short sales of their primary residences.

But starting on January 1 of next year (unless Congress renews this homeowner tax benefit), this release of indebtedness is taxable to homeowners. Moreover, you can see how adding $70,000 to your income taxes could cause you to pay the IRS anywhere between $10,000 and $20,000, or more, in additional tax.

If you want or need to sell your home, you’re probably better off going down the short sale route over allowing the home to go into foreclosure. In our example, we assumed you were able to get a willing buyer to pay you $200,000 for the home. Frequently, if not most of the time, sellers get better prices from buyers through a short sale than allowing the home to go into foreclosure and then having the lender sell the home. You might see the home sold through foreclosure for far less than the $200,000 you might receive.

If the lender has the ability to go after you for more money after the short sale, that amount should be less through a short sale. If you are inclined to pay the debt back to the bank, you’re better off paying back the smaller amount.

On the other hand, if your presumption is that the homeowner has no intention of repaying that debt, the homeowner might still have a federal income tax bite and should want to get rid of the home for as much money as possible.

All around, we tend to feel it’s better for the homeowner to try to maximize the amount that comes out from the sale of the home. Naturally, from a credit history perspective, a short sale looks a tad better than a foreclosure. You should also know that during the course of a short sale, you could negotiate with the lender and request that the lender waive their right to collect any deficiency that comes about through the short sale. In a foreclosure, the lender’s right to go after you might be limited by the laws in the state in which you live.

Just be sure to get all those promises in writing.

There is quite a bit of information on the Web on deficiency judgments and a comparison on a state-by-state basis. You can search your state on the web to get more information. You should know that a majority of the states allow deficiency judgments. Some states like California, Arizona and North Carolina prevent deficiency judgments on residential owner-occupied homes in general, while a dozen or so of other states have lesser limitations that may still allow lenders to obtain a deficiency judgment against the borrower.