A foreclosure hits a homeowner twice: first by taking away the home, then wrecking his credit.

To avoid a black mark on credit scores, an increasing number of homeowners are working with lenders to sell their homes for less than what they owe. This process is known as a short sale, and while it can offer a good alternative to foreclosure, it's not without a few pitfalls.

A short sale is frequently an option when home values have declined, leaving a homeowner owing more than the home is worth. The lender, which must approve such a sale, receives the proceeds from the short sale and the debt is considered settled.

Even though the homeowner will lose his home, a short sale has its benefits: Done well, the bank gets most of its money back and avoids a costly foreclosure process, and the homeowner avoids an unsightly blemish on his credit report.

But not all short sales go smoothly. Indeed, the condition of your credit after a short sale depends largely on how your lender chooses to report the status of the account. If it reports the account as "satisfied," your credit should be fine. But if the lender reports the account as "settled for less than the full amount," your credit score will take a hit.

How big of a hit? That depends on the specifics of your credit history. Your credit score may survive better if you have a number of other accounts in good standing and a long history. A short sale may not drop your credit rating by the 200 or 300 points expected from a foreclosure, but it may make you less attractive to future lenders or others that may look at your credit score.

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To reduce the impact on your credit score, negotiate the reporting terms with your lender. A lender can report your account as "satisfied," agree to leave the account unreported or delete it altogether, all of which will have relatively neutral effects on your credit score. Make sure to get your lender's terms in writing, and consider hiring a real estate lawyer to help with negotiations. (To find a local real estate lawyer, ask around with friends and family, search online at www.lawyers.com or check the member roster of the American College of Real Estate Lawyers.)

Settling the Debt

In most cases, the remaining unpaid debt is forgiven by the lender and written off as a loss. Normally, that unpaid debt is a tax liability for a homeowner since the amount of forgiven debt is taxable as regular income. In response to the current housing crisis, however, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007. The Act removes the tax liability from $1 million or less of debt forgiven on a primary residence during 2007, 2008 and 2009. Most homeowners will qualify for the tax break, provided that the lender chooses to write off the debt. Check out the IRS Web site for more information.

In negotiations with the lender, make sure the debt will be forgiven. The lender has the option to sue to recoup the unpaid balance, even after the short sale is concluded. Without the written promise to forgive the debt, a homeowner could still find himself on the hook for the remainder of the loan.

Before agreeing to a short sale, lenders often request proof of real financial hardship in the form of medical bills, lost wages or a divorce. And in most cases, lenders won't agree to a short sale until you're already behind on payments. But by ensuring that any short-sale agreement includes conditions for credit reporting and debt forgiveness, it may be the best solution to a difficult situation.
Peter McDougall is a freelance writer who lives in Freeport, Maine, with his wife and their dog.