If you're having trouble making your mortgage payments and the loan holder (the "bank") 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 completing a short sale or a deed in lieu of foreclosure ("deed in lieu").
One benefit to these options is that that you won’t have a foreclosure on your credit history. But your credit score will still take a major hit. A short sale or deed in lieu is almost as bad as a foreclosure when it comes to credit scores. For some people, though, not having the stigma of a foreclosure on their record is worth the effort of working out one of these alternatives. Another upside is that some banks offer relocation assistance—often a thousand dollars or more—to help homeowners find new housing after a short sale or deed in lieu.
Read on to learn how short sales and deeds in lieu work, the differences between the two, and the pros and cons of arranging one of these options to prevent a foreclosure.
A short sale occurs when a homeowner sells the property to a third party for less than the total mortgage debt. With a short sale, the bank agrees to accept the sale proceeds in exchange for releasing the lien on the property.
The bank's loss mitigation department must approve the short sale before the transaction can be completed. To get approval for a short sale, the seller (the homeowner) must contact the loan servicer 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. Banks often insist that there be an offer on the table before they'll consider a short sale, but not always.
A second mortgage holder must agree to the short sale. If the property has one mortgage on it, like a first and second mortgage, both loan holders must consent to the short sale. The first mortgage holder will usually offer a certain amount from the short sale proceeds to the second mortgage holder to release their lien. But the second mortgage holder can refuse to accept the amount and kill the deal.
Many homeowners who complete a short sale will face a deficiency judgment, though a few states disallow them after this kind of transaction.
What is a deficiency? The difference between the total debt and the sale price is called a “deficiency.” For example, say your bank gives you permission to sell your property for $300,000, but you owe $350,000. The deficiency is $50,000. In many states, the bank can seek a personal judgment against the borrower 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 with specific legislation prohibiting a deficiency judgment following a short sale—but most states have no such prohibition.
How to avoid a deficiency judgment after a short sale. To ensure that the bank 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 bank waives its right to the deficiency. Avoiding a deficiency balance is the main benefit of a short sale. (If you can't get the bank to agree to waive the deficiency entirely, you might try negotiating a reduced deficiency amount.)
Possible tax consequences. If the bank forgives some or all of the deficiency and issues you an IRS Form 1099-C, you might have to include the forgiven debt as taxable income.
Another way to avoid a foreclosure is by completing a deed in lieu. A deed in lieu is a transaction in which the homeowner voluntarily transfers title to the property to the bank in exchange for a release from the mortgage obligation. One benefit to a deed in lieu, unlike with a short sale, is that you don’t have to take responsibility for selling your house.
Generally, a bank will approve a deed in lieu only if the property isn't subject to liens other than the mortgage.
Because the difference in how a foreclosure or deed in lieu affects your credit is minimal, it might not be worth completing a deed in lieu unless the bank agrees to:
Banks sometimes agree to these terms to avoid the expense and hassle of foreclosing.
If you have a lot of equity in the property, though, a deed in lieu usually isn't a good way to go. In most cases, you'll be better off by selling the home and paying off the debt. If a foreclosure is imminent and you don't have much time to sell, you might consider filing for Chapter 13 bankruptcy with a plan to sell your property.
Like with a short sale, the first step in obtaining a deed in lieu is for the borrower to contact the servicer and request a loss mitigation application. As with a short sale request, the application will need to be filled out and submitted along with documentation about income and expenses.
The bank might require that you try to sell your home before considering a deed in lieu and require a copy of the listing agreement to prove this has been done.
If approved for a deed in lieu, the bank 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 completely satisfies the debt or whether the bank has the right to seek a deficiency judgment.
With a deed in lieu, the deficiency amount is the difference between the property's fair market value 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 bank from obtaining a deficiency judgment following a deed in lieu. Washington, though, is one state that prohibits a bank from getting a deficiency judgment after this kind of transaction. (See Thompson v. Smith, 58 Wash. App. 361 (1990)).
So, the bank might try to hold you liable for a deficiency following a deed in lieu. If the bank wants to preserve its right to seek a deficiency judgment, it generally must clearly state in the transaction documents that a balance remains after the deed in lieu. It must also include the amount of the deficiency.
How to avoid a deficiency with a deed in lieu. To avoid a deficiency judgment with a deed in lieu, the agreement must expressly state that the transaction is in full satisfaction of the debt. If the deed in lieu agreement does not contain this provision, the bank might file a lawsuit to obtain a deficiency judgment. Again, if you can't get the bank to agree to waive the deficiency entirely, you might try negotiating a reduced deficiency amount. And, you might have a tax liability for any forgiven debt.
If you need help figuring out which option is best for your situation or you want to learn about potential defenses to foreclosure that might apply to your circumstances, consider talking to a foreclosure attorney. To get help with an application for a short sale or deed in lieu, consider talking to a HUD-approved housing counselor.