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Deed In Lieu Of Foreclosure vs. Short Sale

Deed In Lieu Of Foreclosure vs. Short Sale
Mark Cappel
UpdatedAug 21, 2009
Key Takeaways:
  • 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.

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.

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.

Each 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

10 Comments

jjimmy, Sep, 2022
My mother passed away in March of 2021. Her mobile home is on our land and now we want to sell our land. At her passing she owed $30000. The mobile home is not worth close to that. I have talked to the mortgage company a couple times and they will not move the mobile home because they say we have to short sell or DIL. What are our options.
TTed, Sep, 2022
Hi Jimmy, I love to assist you in anyway I can. Please, do not take my answer to be legal advice as I am not an attorney. Only attorneys can offer legal advice. First, I am sorry to hear your mother passed away. I pray that your family heals and is able to move forward. Quick questions, what part do you play in the $30,000? Is the mobile home part of the $30,000? Also, is the goal just to move the mobile home from the property? Please get back to me ASAP. Thank you.
DDi, Apr, 2014
When my husband died in 2011 my children and I left the home and lived in an apartment. I was going to file bankruptcy but I would always stop. The home went vacant for 2 years. I tried to short sale it 3 times and there was always something that the mortgage company would not approve. I was allowed to move back into the home this past year and we tried different modifications, none of which they approved. Now they tell me they ran out of options and want me to either sell it short sale, deed in lieu or sell for full price. However there is a lien on the house from a credit card, and the IRS said a while ago that they would get their part for my husbands gambling debt totaling $110,000 from his winnings in 2009. I have no clue what to do other than file bankruptcy Chapter 7 and walk away.. But if I do I get no relocation money promised by the mortgage company, and we need that. Any suggestions on this mess?
BBill, Apr, 2014
I believe you are not taking action because you do not have enough information.

Consult with a lawyer in your state who has bankruptcy experience. He or she will review your options, including removing your liability for the mortgaged home, and will explain how the bankruptcy will impact the IRS debt.
VVerna Demeter, Apr, 2014
My husband and I are no longer able to afford a second house we own; it is currently vacant, and we owe more than it is worth. This is the home we used to live in, and it is double mortgaged; both mortgages are held by the same lender. My husband started the deed in lieu process, to avoid foreclosure proceedings. However, this was not the option I was comfortable with; therefore I did not sign any of the paperwork. They are proceeding with the DIL process. How can they do this, since my name is on both the deed and the mortgage, as a co-borrower? Don't they need my permission? Further, I would like to explore the short sale option, because I am concerned about the implications of a DIL on our credit. I know short sale will impact our credit also, I was just hoping not as much. However, my husband said that with a short sale we would still be responsible for paying off the second mortgage, or any amount agreed upon with the lender for the short sale, that may fall short of covering BOTH mortgages. Is this accurate? We obviously cannot afford to keep the property, nor can we make a payment on a property that we no longer own. Please advise if possible. Thank you!
BBill, Apr, 2014
As we try to explain above, lenders offer excellent short sale deals and terrible deeds-in-lieu-of foreclosure deals. They also offer terrible short sales and excellent DILs. Without reading the proposed contract, no one can say if the deal in your spouse's hand is fair or one-sided in the lender's favor.

What to do? Find a lawyer who has experience litigating with mortgage lenders. Drag your spouse and the contract to your appointment with the lawyer and ask him or her to read the contract and explain what it means. If it's a great deal, you'll both sleep easier. If it's a terrible deal, then your lawyer can step in to negotiate something better.

Like you, I'm surprised the lender is talking to just one of you about a short sale or DIL. Perhaps the negotiator on the other side of the table assumes you will appear at the closing to sign the final title transfer.
JJuan Liu, Mar, 2014
I already filed bankruptcy in 2009, I was told the house was foreclosure by my bankruptcy lawyer. Now the old lender cancelled the foreclosure and sold the loan to the other lender. Now we agreed to proceed to the deed in lieu. The new lender ask me to fill in "Uniform Borrower Assistance Form". I am not sure to fill in this form or not, because I filed bankruptcy before, I don't want they know my financial status. Do I need to fill in this form? Thank you for any advice.
BBill, Mar, 2014
You are wise to be suspicious.

Anyone who filed a successful bankruptcy petition should be very cautious about completing any form a creditor asks them to complete. It would be easy for an unscrupulous creditor to slip in fine print that reinstates the consumer's liability for a debt discharged in bankruptcy.

Bring the form you mentioned, and any other documents the lender wants you to sign, to your bankruptcy lawyer and ask him or her if you should sign and return them to the lender.
JJo, Mar, 2014
I went through a divorce in Jan 2013 after my wife had moved out in 2012. She refused to stop contributing to the mortgage and, as of November 2012 was unable to continue to make mortgage payments. I have been working with the lender yet the process has seemed to grow to a halt. The balance on the mortgage is approximately $300,000 (House is probably worth $240,000) and $47k behind in payments plus $14k in outstanding taxes. The lender has started the foreclosure process but the case keeps getting extended. Now extended til April 29. I'm trying to decide if a DIL, Short Sale, or foreclosure would be my best option and limit 1099 tax implications. Should I consider Chapter 7 or 13? My pay has been cut dramatically so a remod probably won't help. Any feedback or suggestions are welcome. Thank You!!!
BBill, Mar, 2014
Consult with a bankruptcy lawyer immediately. Bankruptcy may or may not be your best option, but it will eliminate your personal liability for the mortgage, any consumer debt such as credit cards and other debt. Regarding the house, he or she will review your options, including a short sale, deed-in-lieu-of foreclosure, and strategic default (foreclosure).