If you're having trouble making your mortgage payments and the loan holder ("lender") has denied your request for a repayment plan, forbearance, or loan modification, or if you're not interested in any of those options, two other ways to avoid a foreclosure are by completing a short sale or a deed in lieu of foreclosure.
Because short sales and deeds in lieu are similar transactions, many people get them confused, but there are differences. Read on to learn about short sales and deeds in lieu, the differences between the two, and how arranging one of these options could help you prevent a foreclosure.
A short sale occurs when a homeowner sells his or her home to a third party for less than the total debt remaining on the mortgage loan. With a short sale, the lender agrees to accept the proceeds from the sale in exchange for releasing the lien on the property. (Learn more about short sales to avoid foreclosure.)
The lender's "loss mitigation" department must approve the short sale before the transaction can be completed. (The process of finding a way to avoid foreclosure is called "loss mitigation.")
To get approval for a short sale, the seller (the homeowner) must contact the loan servicer—the company that manages the loan account—to ask for a loss mitigation application. The homeowner then must send the servicer a complete application, which usually includes:
The purchase offer. A short sale application will also most likely require that you include an offer from a potential purchaser. Lenders often insist that there be an offer on the table before they will consider a short sale, but not always.
A second mortgage holder must agree to the short sale. If there is more than one mortgage on the property, both mortgage holders must consent to the short sale. The first mortgage holder will offer a certain amount from the short sale proceeds to second mortgage holder to release their lien, but the second mortgage holder can refuse to accept the amount and kill the deal. (To learn more about completing a short sale if you have multiple mortgages, see Short Sales With Multiple Mortgages.)
Most homeowners who complete a short sale will face a deficiency judgment, though a few states disallow them after short sales.
What is a deficiency? Because the sale price is “short” of the full debt amount in a short sale, the difference between the total debt and the sale price is the “deficiency.”
Example. Say your lender gives you permission to sell your property for $200,000, but you owe $250,000. The deficiency is $50,000. In many states, the lender can seek a personal judgment against you after the short sale to recover the deficiency amount.
Anti-deficiency laws. While many states have enacted legislation that prohibits a deficiency judgment following a foreclosure, most states do not have a corresponding law that would prevent a deficiency judgment following a short sale. California is an example of a state that does, in fact, have specific legislation prohibiting a deficiency judgment following a short sale—but most states have no such prohibition. (To find out more about short sale anti-deficiency laws, see States That Prohibit Deficiency Judgments Following Short Sales.)
How to avoid a deficiency with a short sale. To ensure that the lender can't get a deficiency judgment against you following a short sale, the short sale agreement must expressly state that the transaction is in full satisfaction of the debt and that the lender waives its right to the deficiency. (Learn more about how to avoid a deficiency judgment following a short sale.)
Possible tax consequences. If the lender forgives some or all of the deficiency and issues you a IRS Form 1099-C, you might have to include the forgiven debt as taxable income. (Learn more about short sale tax implications.)
Another option to avoid foreclosure is by completing a deed in lieu of foreclosure. A deed in lieu of foreclosure is a transaction in which the homeowner voluntarily transfers title to the property to the lender in exchange for a release from the mortgage obligation. Generally, the lender will only approve a deed in lieu of foreclosure if there aren't any other liens on the property.
Just like with a short sale, the first step in obtaining a deed in lieu of foreclosure is for the borrower to contact the loan servicer and request a loss mitigation application. The application will need to be filled out and submitted along with documentation about your income and expenses including usually:
Listing the property for sale. The lender might require that you try to sell your home before it will consider accepting a deed in lieu, and require a copy of the listing agreement as proof that this has been done.
If approved for a deed in lieu of foreclosure, the lender will send you documents to sign. You will receive:
The estoppel affidavit sets out the terms of the agreement and will include a provision that you are acting freely and voluntarily. It might also include provisions addressing whether the transaction is in full satisfaction of the debt or whether the lender has the right to seek a deficiency judgment.
With a deed in lieu of foreclosure, the deficiency amount is the difference between the fair market value of the property and the total debt. In most cases, completing a deed in lieu will release the borrowers from all obligations and liability under the mortgage, but not always.
Anti-deficiency laws. Most states don't have a law that prevents a lender from obtaining a deficiency judgment following a deed in lieu of foreclosure. This means that a lender may try to hold you liable for a deficiency following the transaction. However, Washington is one state that does have case law that states a lender may not obtain a deficiency judgment after a deed in lieu of foreclosure. (Thompson v. Smith, 58 Wn. App. 361 (1990).)
How to avoid a deficiency with a deed in lieu of foreclosure.To avoid a deficiency judgment with a deed in lieu of foreclosure, the agreement must expressly state that the transaction is in full satisfaction of the debt. If the deed in lieu of foreclosure agreement does not contain this provision, the lender might file a lawsuit to obtain a deficiency judgment. Again, you might have tax liability for any forgiven debt.
To learn more about short sales and deeds in lieu of foreclosure, consider talking to a HUD-approved housing counselor. 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.