Short Sales and Deeds in Lieu of Foreclosure

A short sale or deed in lieu may help avoid foreclosure or a deficiency.

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Many homeowners facing foreclosure determine that they just can't afford to stay in their home. If you plan to give up your home but want to avoid foreclosure you might consider a short sale or a deed in lieu of foreclosure. These options allow you to sell or walk away from your home and may help you avoid incurring liability for a "deficiency."

To learn about deficiencies, how short sales and deeds in lieu can help, and the advantages and disadvantages of each, read on. (To learn more about foreclosure, including other options to avoid it, see Nolo's Foreclosure area.)

Short Sale

In a "short sale" you get permission from the lender to sell your house for an amount that will not cover your loan (the sale price falls "short" of the amount you owe the lender). In many states, lenders can sue homeowners even after the house is foreclosed on or sold, to recover any remaining deficiency. A deficiency occurs when the amount you owe on the home loan is more than the proceeds from the sale (or auction) -- the difference between these two amounts is the amount of the deficiency. If you live in a state that allows lenders to sue for a deficiency, get your lender to agree (in writing) to let you off the hook.

How will a short sale help? The main benefit of a short sale is that you may be able to get out from under your mortgage without liability for the deficiency. In order for this to work, however, you must either live in a state that doesn't allow deficiencies after short sale or get the lender to agree to waive the deficiency. (See States That Don't Allow Deficiency After Short Sale.) Some states don't allow a deficiency after a foreclosure, so in some situations you might be better off with a foreclosure rather than a short sale if you can't get your lender to waive the deficiency. (To find out how your state treats deficiency after foreclosure, see our articles on deficiency after foreclosure in each of the 50 states.)  

You also avoid having a foreclosure or a bankruptcy on your credit record. Keep in mind, however, that a short sale will damage your credit -- although it may cause less damage than a foreclosure or bankruptcy. 

What are the drawbacks? You've got to have a bona fide offer from a buyer before you can find out whether or not the lender will go along with it. In a market where sales are hard to come by, this can be frustrating because you won't know in advance what the lender is willing to settle for.

What if you have more than one loan? If you have a second or third mortgage (or home equity loan or line of credit), those lenders must also agree to the short sale. Unfortunately, this is often impossible since those lenders won't stand to gain anything from the short sale.

Beware of tax consequences. A short sale may generate an unwelcome surprise: Taxable income based on the amount the sale proceeds are short of what you owe (again, called the "deficiency"). The IRS treats forgiven debt as taxable income, subject to regular income tax. The good news is that thanks to the Mortgage Forgiveness Debt Relief Act of 2007, there are some exceptions for the years 2007 to 2013. To learn more about this Act and your tax liability, see Nolo's article Canceled Mortgage Debt: What Happens at Tax Time?

Deed in Lieu of Foreclosure

With a deed in lieu of foreclosure, you give your home to the lender (the "deed") in exchange for the lender canceling the loan. The lender promises not to initiate foreclosure proceedings, and to terminate any existing foreclosure proceedings. Be sure that the lender agrees, in writing, to forgive any deficiency (the amount of the loan that isn't covered by the sale proceeds) that remains after the house is sold.

Before the lender will accept a deed in lieu of foreclosure, it will probably require you to put your home on the market for a period of time (three months is typical). Banks would rather have you sell the house than have to sell it themselves.

Benefits to a deed in lieu. Many believe that a deed in lieu of foreclosure looks better on your credit report than does a foreclosure or bankruptcy. In addition, unlike in the short sale situation, you do not necessarily have to take responsibility for selling your house (you may end up simply handing over title and then letting the lender sell the house).

Disadvantages to a deed in lieu. There are several downfalls to a deed in lieu. As with short sales, you probably cannot get a deed in lieu if you have second or third mortgages, home equity loans, or tax liens against your property.

In addition, getting a lender to accept a deed in lieu of foreclosure is difficult these days. Many lenders want cash, not real estate -- especially if they own hundreds of other foreclosed properties. On the other hand, the bank might think it better to accept a deed in lieu rather than incur foreclosure expenses.

Beware of tax consequences. As with short sales, a deed in lieu may generate unwelcome taxable income based on the amount of your "forgiven debt." To learn more, see Nolo's article Canceled Mortgage Debt: What Happens at Tax Time?

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by: , J.D.

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