For many homeowners who are struggling to make their mortgage payments, keeping their home simply is not an option. The good news is that these homeowners do not have to wait for their lenders to foreclose. Two popular foreclosure alternatives are available to them: a deed in lieu of foreclosure or short sale.
A deed in lieu of foreclosure is a negotiated remedy between a defaulting borrower and a lender. The borrower transfers title to the property to the lender, and the lender cancels the foreclosure.
If your lender agrees to accept a deed in lieu of foreclosure, you should make sure that your deed in lieu of foreclosure agreement includes language stating that your lender is waiving its right to recover any deficiency that remains. If your lender refuses to include such a waiver, and nothing in your state's laws prohibit lenders from suing borrowers for the deficiency after a deed in lieu of foreclosure, you could later find yourself facing a lawsuit filed by your lender to recover the difference between the amount you owe and the fair market value of the property.
For more on deeds in lieu of foreclosure, see our article, Deed in Lieu of Foreclosure.
Like a deed in lieu of foreclosure, a short sale is also a negotiated remedy between a defaulting homeowner and the lender. The borrower sells the house for an amount less than the outstanding mortgage debt, and the lender agrees to accept this lesser amount and cancel the foreclosure.
Lenders sometimes impose conditions on its acceptance of a short sale. The most common conditions are:
If you are pursuing a short sale, you should do your best to negotiate with your lender to remove these conditions from your short sale agreement and to include language releasing you from liability for any debt that remains after the short sale closes. For more on short sales, see our article on Short Sale Risks.
It is not unusual for a homeowner to have a second or even a third mortgage on the property. In order for a short sale or deed in lieu of foreclosure to work, all of the subordinate lienholders must agree to the terms of the short sale or deed in lieu of foreclosure agreement and release their liens on the property. This may be close to impossible to achieve, particularly with a deed in lieu of foreclosure. To encourage the subordinate lienholders to agree to a short sale or a deed in lieu of foreclosure, the holder of the first mortgage may offer a financial incentive in exchange.
You will face some negative consequences after completing a deed in lieu of foreclosure or short sale. One negative consequence is a drop in your credit score. Keep in mind, however, that your credit score would also have dropped after a foreclosure, and it is a commonly held belief that short sales and deeds in lieu of foreclosure have less of a negative impact on credit score than foreclosure (though probably not by much).
Another possible consequence of a short sale or deed in lieu of foreclosure is a deficiency judgment. As noted above, you should try to negotiate with your lender to include language in your short sale or deed in lieu of foreclosure agreement releasing you from liability for any deficiency that may remain. If your lender refuses to do so and is successful in suing you for a deficiency judgment, try to negotiate a settlement for less than the amount of the judgment or to pay off the judgment over time. As a final resort, bankruptcy will eliminate your deficiency debt. (For more on avoiding paying a deficiency, see our article How Are Deficiency Judgments Collected?)
If your lender decides to write off the amount of the deficiency as a loss rather than sue you, you may owe income tax on the amount of the forgiven debt. However, there are exceptions to this general rule. For example, if you meet the requirements set out in the 2007 Mortgage Debt Relief Act or you can prove that you were insolvent when the debt was forgiven, you would have no income tax liability. To learn more, read our article Income Tax Liability for Deficiencies.