Deed-In Lieu vs Short Sale
By: Elaine VonCannon ABR, SRES, REALTOR, Notary, Team Leader, Residential and Commercial Property Manager, Managing Partner VonCannon-Starke Commercial Division, Member of the National Association of Residential Property Managers, Award Winning Agent, RE/MAX Hall of Fame, Licensed in Virginia, Member of Commercial Council VAR
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 much lighter impact on a credit score.
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.
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 2012.
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 (although by no means inclusive) list of deed in lieu of foreclosure or short sale requirements:
1. The residence must already be on the market for a certain number of days (90 days is average).
2. There can be no liens on the property.
3. The property cannot already be in foreclosure.
4. The offer of a deed in lieu must be voluntary.
5. For a short-sale, the seller must have a hardship.
6. The house must be priced reasonably.
Is a "short sale" a better option for you?
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 is forgiven, typically.
Some mortgage companies are asking borrowers to agree to accept liability for the deficiency balance. The lawyer told my clients to refuse to do this and the bank backed down in order to close. 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. Also consult a lawyer.
Unlike a deed in lieu of foreclosure, the ownership of the property is not transferred to the mortgage holder, and remains with the owner.
Some lenders choose short sales because they do not want to own the distressed property. 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.
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. State 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.
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.
I urge you to consult with an attorney experienced in bankruptcy law to understand all of your options to resolving your mortgage debt.
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