Deed In Lieu Of Foreclosure vs. Short Sale

What are the pros and cons of accepting a deed in lieu of foreclosure in comparison to a short sale?

I need some advice on the pros and cons of accepting a deed in lieu of foreclosure in comparison to a short sale.

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Highlights


  • Understand how a deed in lieu of foreclosure works.
  • Compare a deed in lieu of foreclosure to a short sale.
  • Be aware of possible tax liabilities that relate to any forgiveness of mortgage debt.

Editor’s note: See the Bills.com resource Home Affordable Foreclosure Alternatives Program for an updated discussion of deeds in lieu of foreclosure and short sales.

Foreclosure Alternatives

Deed in lieu of foreclosure and "short sale" are alternatives to foreclosure. Because foreclosure is so devastating to a credit score, almost anything is better than foreclosure, and both of these alternatives result a somewhat lighter impact on a credit score, especially if you negotiate a resolution to the deficiency balance.

A deed in lieu of foreclosure and a short sale are very similar but there are some key differences that depend on the details of the situation. I will compare and contrast both in just a moment.

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What is a Deed in Lieu of Foreclosure?

As mentioned, a deed in lieu of foreclosure is an alternative to foreclosure. In a deed in lieu of foreclosure, the property owner gives the property to the lender voluntarily in exchange for the lender canceling the loan. The item transferred is the deed to the property. The lender promises not to initiate foreclosure proceedings, and to terminate any foreclosure proceedings already underway. The lender may or may not agree to forgive any deficiency balance that results from the sale of the property.

Potential Tax Liabilities

An overlooked downside to a deed in lieu of foreclosure is the possible forgiveness of the deficiency balance. Under federal law, a creditor is required to file a 1099C whenever it forgives a loan balance greater than $600. This may create a tax liability for the former property owner because it is considered “income.” However, the Mortgage Forgiveness Debt Relief Act of 2007 provides tax relief for some loans forgiven in 2007 through 2013.

The key issue in a deed in lieu of foreclosure is whether the lender is willing to forgive the deficiency balance. Read the contract carefully to see how the deficiency balance issue is handled. If the document is unclear, take it to an attorney with experience in property law. An attorney’s time is not cheap, but will be a bargain compared to signing an agreement you do not understand and are surprised later to realize its implications.

Here is the typical list of deed in lieu of foreclosure or short sale requirements: a) the residence must already be on the market for a certain number of days (90 days is typical), b) there can be no liens on the property, c) the property cannot already be in foreclosure, d) the offer of a deed in lieu must be voluntary, e) for a short-sale, the seller must have a hardship, f) the house must be priced reasonably.

Is a ‘Short Sale’ a Better Option?

Underwater home

On the other hand, the property owner and lender may choose to do a short sale on the home. Through a short sale the lender agrees to accept less than the balance owed on the mortgage at sale. The deficiency balance may be forgiven.

Bills.com readers report that mortgage companies ask borrowers to accept liability for the deficiency balance. The lesson here is if you are considering either a deed in lieu of foreclosure or a short sale you must review the terms and conditions carefully and make certain you understand whether the deficiency balance is forgiven.

Unlike a deed in lieu of foreclosure, the ownership of the property is not transferred to the mortgage holder, and remains with the owner.

Lenders choose short sales because they do not want to own distressed properties. They would much rather see the owner sell the property and lose the deficiency balance than be forced to take the property through foreclosure, as foreclosure is a costly and time-consuming process.

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Whether the lender picks a deed in lieu of foreclosure or a short sale depends on how the lender balances its risks and how it wants the distressed properties to appear on their books. Local laws may have an impact on the decision, too.

One last point regarding short sales: Like deeds in lieu of foreclosure, a lender is required to file a 1099C if the debt forgiven exceeds $600. As mentioned in the deed in lieu of foreclosure section above, The Mortgage Forgiveness Debt Relief Act offers former homeowners relief for forgiven debt.

ach state legislature created unique foreclosure and anti-deficiency laws. Follow the links just mentioned to learn the foreclosure rules relevant to you.

What If the Lender Rejects a Short Sale Or a Deed In Lieu Of Foreclosure?

If the lender will not allow a short sale or a deed in lieu of foreclosure, foreclosure is the last option, although it presents major problems. Foreclosure auctions tend to bring significantly less money than a normal sale would bring. If the sale brings less than the amount owed on the loan, the remaining balance of the loan is called a deficiency balance.

If the home falls into foreclosure, it is possible to mitigate the negative impact of a deficiency balance by filing bankruptcy. Generally speaking, deficiency balances are treated like any other unsecured debt in bankruptcy, meaning that they can be wiped clear by Chapter 7, and repaid over time through a Chapter 13. Although bankruptcy does not sound like a positive alternative, it may be the best solution if the mortgage lender will not allow the home to be sold through a short sale or a deed in lieu of foreclosure.

Lastly, I urge you to consult with an attorney experienced in bankruptcy law to understand all of your options to resolving your mortgage debt.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com

317 Comments

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  • RM
    May, 2013
    Randy
    I moved from my home last June and rented the home out and now this renter is being transfered and I can't afford to pay two payments I talked to the bank and they want to do a short sale I have great credit and need to know how much my credit will be hure and if I am applying for other Jobs how will it affect that also. Thanks
    0 Votes

    • BA
      May, 2013
      Bill
      Fair Isaac released information describing the impact a foreclosure, short sale, or bankruptcy has on a consumer's credit score. Follow the hyperlink I just mentioned to learn the details.

      How your credit history impacts your credit score depends on the type of job you apply for and your future employer's policy. The vast majority of jobs do not require a person to have a spotless credit score, and as a consequence, employers do not check an applicant's credit history when making a hiring decision.
      0 Votes

  • KW
    Apr, 2013
    Kathy
    I am over 20 mos behind in my mortgage. My lender stopped sending me mortgage statements once I was about 3 payments behind. At the time I had financial problems which are now over. I would like to save my home and wonder what options I have if any?
    0 Votes

    • BA
      Apr, 2013
      Bill
      Contact the mortgage servicer immediately and share what you explained in your comment here. Learn what, if any, options you have to remediate your loan.

      If you get nowhere with the servicer, get a free foreclosure avoidance consultation with a HUD-approved counselor, such as one at HOPE NOW. Its telephone number is 888-995-4673.

      It may also make sense to consult with a lawyer in your state who has experience in negotiating modifications, short sales, and settlements with mortgage lenders.

      If you call the servicer, take accurate and complete notes of your conversation. Place all of your notes and correspondence to and from the lender in a file, which you keep in a safe place. You may needs this file later if the lender breaks a promise, and you need to file a lawsuit against the lender.
      0 Votes

  • DK
    Apr, 2013
    Dee
    We live in Home #1. We bought Home #2 (separate mortgage) and owned it 3 yrs. We regraded the property, landscaped, new roof, and fixed the garage. Time came to remodel inside and assumed only kitchen and minimal in two bathroom(s). Although noticed health (difficulty breathing) whenever working inside house ... we pulled off the drywall on back side of bathroom. Black mold (large section) and insulation was blown in. House built around 1979. Mid to late 1970's when asbestos came off market. Husband and I both allergic to mold. We have now encountered a huge problem that will cost thousands of dollars to fix ... which we don't have. What are our options? Will bank take the house back? Can we stop making payments on House #2 with these serious problems?
    0 Votes

    • BA
      Apr, 2013
      Bill
      Before you stop paying your mortgage on House 2, take these two actions:
      1. Bring in a contractor with mold remediation experience, and ask him or her to give you an estimate of the cost to repair the damage. What you described may be the tip of the iceberg, so to speak, or a very localized issue. Ask him or her to describe in the report the cause of the damage. Was it due to poor maintenance? Or was it a construction defect?
      2. Take the contractor's report to a lawyer with experience representing homeowners in construction-defect litigation. Believe it or not, this is a lucrative legal specialty.

      A construction-defects lawyer will explain any cause of action (legal reason to file a lawsuit) you may have against the previous homeowner or the home builder. He or she will also describe the consequences of a strategic default in your state.

      0 Votes

  • SM
    Apr, 2013
    S
    I had a Chapter 7 discharged in August of 2010 and my first and second TD's were included. I have not reaffirmed either loan and I am considering letting the home go. We owe $56,000 and the house is worth $45,000 at the most. If I let the house go into foreclosure will it show up on my credit as a foreclosure or will only the BK appear? Would it be better to short sell or deed in lieu instead of foreclosure in my case?
    0 Votes

    • BA
      Apr, 2013
      Bill
      A bankruptcy discharge removes a borrower's personal liability for a home loan. That is why mortgage servicers are not permitted to report activity on a home loan from the moment the discharge including the loan is issued by the bankruptcy court. From a credit report perspective, it is as if the loan ceases to exist from that moment forward.

      Some lenders report foreclosures on home loans discharged by bankruptcy. This is an error based on the lender either not understanding the homeowner's personal liability for the loan was discharged by bankruptcy, or not caring it should not issue this information to the consumer credit reporting agencies.

      If the consumer credit reporting agencies publish a foreclosure after bankruptcy, file a dispute with each of consumer credit reporting agency that publish this information and the lender that made the report. Consult with a lawyer in your state who has consumer law experience if the consumer credit reporting agencies do not remove the foreclosure from your credit report(s).

      You asked about a deed-in-lieu-of-foreclosure and short sale. From a legal perspective, you need not consider these options for the reason I mentioned several times above. From a financial perspective, you may wish to consider a deed-in-lieu or short sale if you plan to apply for a mortgage in the foreseeable future. See the Bills.com article Mortgage After Bankruptcy, Short Sale or Foreclosure to learn the rules lenders follow when considering an applicant who experienced a recent financial mishap.
      0 Votes

  • JR
    Apr, 2013
    Jamia
    We need a bigger home as we have a new child. The neighborhood is no longer what it once was and we really need to move. We are under water as we purchased in the height of the bubble paid 126,000 homes around us selling for 40 max. My husband has great credit and wants the least impact to it. Even though I lost my job. We are making the payments on time and have never been behind. We are worried we wont be able to buy a new home if we short sale or deed in lieu our current property. What is our best option?
    0 Votes

    • BA
      Apr, 2013
      Bill
      Your options are limited, as the article above explains. Unfortunately, the FICO and VantageScore credit scoring models offer harsh treatment to consumers who elect a short sale or deed in lieu. If your highest priority is maintaining a high credit score, then your only option is to avoid a short sale, deed in lieu of foreclosure, or foreclosure.

      If you are considering a short sale or deed in lieu, then make sure that you work with your lender in an attempt to minimize the harm to your score. Explain your circumstances and your need to move. Most likely your credit score will be harmed, and even more so if you make late payments. (Some lenders will not consider a short sale if there is no late payment, although that is not a necessary condition for a short sale).

      If you want to buy a home after a short sale then you will need to wait between 2-7 years, depending on the type of loan (FHA, Fannie Mae, etc) and your LTV. For more information about getting a mortgage after the short sale, read the Bills.com article mortgage after foreclosure and short sales.
      0 Votes