Deed in Lieu of Foreclosure Consequences

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A deed in lieu of foreclosure, often shortened to "deed in lieu," is an alternative to the foreclosure process. Simply put, executing a deed in lieu means you're turning the property over to the lender, transferring title from yourself to the bank. The bank, in turn, will not need to foreclose. The deed in lieu of foreclosure process is far shorter than foreclosure, particularly in states with judicial foreclosure. However, a deed in lieu may have tax consequences, and it's not an ideal solution in every case.

Tips

  • A deed in lieu of foreclosure may help you avoid going through foreclosure and a sheriff's sale. However, if the bank forgives any of the debt, there will be tax consequences, and if the bank doesn't forgive some of the debt, you might still be liable for a deficiency balance.

What Is Foreclosure?

Foreclosure is what occurs when you default on your mortgage loan. When you borrow money to buy a house or refinance an existing home loan, you grant a mortgage on the property to the lender. The mortgage gives the lender the right to take the property and sell it if you don't make your payments or otherwise breach the terms of the mortgage and loan.

Before the lender can sell the property, it must go through the foreclosure process, which varies from state to state. Less than half the states use judicial foreclosure, which requires the filing of a foreclosure lawsuit and can take years; the rest use various state law proceedings outside of court, or nonjudicial foreclosure, which still can take several months.

What Happens After a Foreclosure?

After the formal foreclosure process is finally complete, the lender will have the ability to sell the property. Depending on the state in which you live, you might have the chance to redeem the property by paying the full amount due, although the time you have to do that may vary, and some states don't allow redemption.

If the mortgage lender sells the house for less than what you owed on it, the lender might sue you for the difference, which is called a deficiency balance.

What Is a Deficiency Balance?

A deficiency balance is what's left over on a loan when the lender sells any collateral securing the loan. Home loans, car loans and any other loans with security may end up with a deficiency after the lender sells the collateral.

For example, if you owe $200,000 on your mortgage and the lender forecloses then sells the property at sheriff's sale for $150,000, the lender may decide to collect that $50,000 difference. That difference is the deficiency.

Mortgage lenders, unlike car lenders, often don't pursue the deficiency balance on residential mortgages; however, if you want a lender to waive the deficiency, you should get something in writing from the bank to protect yourself. If your mortgage is on a commercial property, the bank is far more likely to pursue the deficiency.

What Is a Deed in Lieu of Foreclosure?

A deed in lieu of foreclosure is a way to pass title to the lender without going through the rigmarole of a foreclosure. You deed the property to the bank, and the bank becomes the owner.

Procedurally, a deed in lieu is quicker and more straightforward. The bank will have to do some legwork, but the homeowner will simply have to sign documents and walk away. In truth, it's not much more complicated than closing on a regular home purchase, and it's often far simpler than that. However, if the property has a lot of other liens on it, like second and third mortgages, judgment liens, tax liens or liens for association dues, the process might take longer as the bank works to clear title.

Benefits of a Deed in Lieu

A deed in lieu of foreclosure offers two main benefits to homeowners who don't intend to keep their homes:

  • Expediency. You don't have to wait for the foreclosure process to complete to have your ducks in a row, and you don't have to try to sell your house.
  • Flexibility. You can negotiate with the lender on the timing for executing the deed, and you can obtain an agreement that the lender won't pursue a deficiency. 

When Might a Lender Agree to a Deed in Lieu?

If you've fallen behind on your mortgage and you don't want to try to keep your property, you can contact the lender and see if it will agree to do a deed in lieu. A bank might even suggest a deed in lieu if there are no other liens on the property and it seems like a foreclosure will cost more than it's worth.

On the other hand, if the property has more than one mortgage or has tax liens, judgment liens and condo or association fees attached to it, the lender is unlikely to do a deed in lieu because if it does, the lender will have to pay all those liens.

Deed in Lieu of Foreclosure Consequences

If you do execute a deed in lieu in favor of your mortgage lender, you'll need to leave the premises. You can usually confer with the bank and set a date by which you need to leave. You'll also need to prepare for the effect it will have on your credit score, the possibility of an action to collect the deficiency and the potential tax consequences of the deed.

Deeds in Lieu and Your Credit Rating

A deed in lieu of foreclosure affects your credit score, just like a bankruptcy or a foreclosure affects your credit score. However, a deed in lieu will have a much smaller impact on your credit score than a bankruptcy or a foreclosure will, particularly if your score is already on the low side. According to FICO, a person with a credit score of 680 will lose only 50–70 points from his credit score, while a person with a credit score of 720 will lose 95–115 points. These figures apply if the bank does not pursue a deficiency, however. If a deficiency balance remains, the scores will drop just as low as they would if the bank had foreclosed.

Deficiency Balance After a Deed in Lieu

If you give a deed in lieu and the bank doesn't agree to waive the deficiency balance, you might find yourself facing a demand for money. If you give up your house through a deed in lieu and the bank sells it for less than what you owed, it could come after you for the difference.

Fortunately, many homeowners are able to negotiate a deed in lieu whereby the bank agrees that it will accept the deed in full satisfaction of the debt. This means that if you agree to give the bank the deed in lieu, you won't owe the bank any more money, regardless of how much or how little the bank ultimately sells the house for.

For example, if you owe $250,000 to the bank and you execute a deed in lieu, and the bank agrees in writing to waive the deficiency balance, if the bank sells the house for $150,000 later, the $100,000 difference is not your responsibility.

Be warned that if the bank waives the deficiency, you might have to pay taxes on that amount as income.

Forgiven Debt as Taxable Income

When a creditor forgives a debt, the forgiven debt is generally taxable income. If you borrow $1,000 and the lender tells you the debt is forgiven, it essentially gave you $1,000, and that is income on which you have to pay taxes.

From 2007 to 2016, the Mortgage Forgiveness Debt Relief Act protected homeowners from having to pay taxes on their deficiency balances after a foreclosure, short sale or deed in lieu. The Act was extended to include 2017. If your debt was forgiven prior to January 1, 2018 (or if it was forgiven pursuant to an agreement entered into prior to January 1, 2018), you can exclude up to $2 million ($1 million if married filing separately) of canceled debt as long as the debt was used to purchase or improve your principal residence.

Deed in Lieu Tax Consequences 2018

Any mortgage debt forgiven after January 1, 2018 is subject to reporting as taxable income. However, you may qualify for certain exceptions, such as:

  • Bankruptcy. If you file bankruptcy and then give a deed in lieu to the bank, any deficiency balance is discharged in the bankruptcy case. Debts discharged in bankruptcy are not taxable income.
  • Insolvency. If you can show the IRS that you were insolvent when the debt was forgiven, you can exclude the forgiven debt as taxable income. Insolvency means that your assets were worth less than your debts as of the date of the debt forgiveness.

You will also have to report the transfer of the property as a gain or a loss, just as you would if you'd sold the house. Generally, your gain or loss will be the difference between what you paid for the house (your basis) and the smaller of the fair market value or the balance due on the loan when the foreclosure occurred.

For example, if your home was worth $200,000 when the foreclosure occurred but you owed $250,000, you would use the fair market value figure because it's lower. If you paid $300,000 for the house, you have a $100,000 loss: the difference between the fair market value and your basis in the property.

References

About the Author

Rebecca K. McDowell is an attorney focused on debts and finance. She has a B.A. in English and a J.D. She has written finance and tax articles for Zacks and eHow.