Deed in Lieu of Foreclosure vs. Short Sale

Trying to decide whether to pursue a deed in lieu of foreclosure or a short sale? Read this article.

For many homeowners who're struggling to make their mortgage payments, keeping the home simply is not an option. The good news is that these homeowners don't have to wait for their lenders to foreclose. Two popular foreclosure alternatives are available: a deed in lieu of foreclosure or short sale.

What Is a Deed in Lieu of Foreclosure?

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.

Because a foreclosure and deed in lieu affects your credit in pretty much the same way—they're both really bad—it might not be worth bothering to complete a deed in lieu unless you can get the lender to agree to forgive or reduce any deficiency (or give you some cash as part of the deal, or agree to let you live in the home for longer than what you'd get if you let the foreclosure happen).

If your lender agrees to accept a deed in lieu of foreclosure and waive or reduce the deficiency, make sure that the agreement includes a waiver to this effect. (You should be aware that if the lender cancels part or all of the deficiency and issues you a IRS Form 1099-C, you might have to include the forgiven debt as taxable income—see below). If the 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 Steps to Completing a Deed in Lieu of Foreclosure.)

What Is a Short Sale?

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:

  • the requirement that the homeowner sign a promissory note for the difference between what is owed on the mortgage and the short sale amount (the deficiency), and
  • reservation by the lender of its right to seek a deficiency judgment after the closing of the short sale.

If you're 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. Though, again, be aware that if the lender forgives all or part of the deficiency and issues you a 1099-C, you might face a tax liability. (For more on short sales, see Risks of Using a Short Sale to Avoid Foreclosure.)

What About Second or Third Mortgages?

It's not unusual for a homeowner to have a second, or even a third, mortgage on the property. In order for a deed in lieu of foreclosure or short sale to work, all of the subordinate lienholders must agree to the terms of the deed in lieu of foreclosure or short sale agreement and release their liens on the property. This might be close to impossible to achieve, particularly with a deed in lieu of foreclosure. To encourage the subordinate lienholders to agree to a deed in lieu of foreclosure or short sale, the holder of the first mortgage might offer a financial incentive in exchange.

Consequences of a Deed in Lieu of Foreclosure or Short Sale

You will face some negative consequences after completing a deed in lieu of foreclosure or short sale.

Your Credit Score Will Drop

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. While it's a commonly-held belief that short sales and deeds in lieu of foreclosure have less of a negative impact on credit scores than foreclosure, in reality, the effect is basically the same.

Potential Deficiency Judgment

Another possible consequence of a deed in lieu of foreclosure or short sale is a deficiency judgment. As noted above, you should try to negotiate with your lender to include language in your deed in lieu of foreclosure or short sale agreement releasing you from liability for any deficiency that remains. 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. (Though, again, there could be tax consequences if the lender forgives part of the deficiency.) As a final resort, filing for bankruptcy could eliminate your deficiency debt. (For more on avoiding paying a deficiency, see our article How Are Deficiency Judgments Collected? To find out if bankruptcy is right for your situation, talk to a bankruptcy lawyer.)

Tax Consequences

As previously mentioned, if the lender decides to write off the the deficiency as a loss, you might owe income tax on the amount of the forgiven debt. However, there are exceptions to this general rule. For example, if you can prove that you were insolvent when the debt was forgiven, you would have no income tax liability. (If you need information about your potential tax liability, talk to a tax lawyer).

Getting More Information

If you need additional help working out a way to avoid foreclosure, or you want to learn about how foreclosure works in your state or about potential defenses to foreclosure in your situation, consider talking to a foreclosure attorney. To learn more about short sales and deeds in lieu of foreclosure, or to get help submitting an application to your servicer asking for one of these options, consider talking to a HUD-approved housing counselor.

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