Short Sales and Deeds in Lieu: Differences and Tax Implications

A short sale or deed in lieu of foreclosure might help you avoid a deficiency judgment. But you could face tax consequences.

Many homeowners facing foreclosure determine that they just can't afford to stay in their homes. If you plan to give up your property—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 might help you avoid incurring liability for a deficiency.

What Is a Short Sale?

In a short sale, you get permission from the lender to sell your house for an amount that won’t cover your loan. The sale price falls "short" of the amount you owe the lender.

Upsides to a Short Sale

In many states, lenders can sue homeowners, even after the house is foreclosed or sold in a short sale, 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—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 judgment after a foreclosure or following a short sale, get your lender to agree in writing to let you off the hook for the deficiency as part of the short sale agreement. Avoiding a deficiency balance is the main benefit of a short sale.

Another advantage of a short sale is that you’ll avoid having a foreclosure on your credit record. Keep in mind, though, that a short sale will still damage your credit—although it will probably cause slightly less damage than a foreclosure.

Downsides to a Short Sale

As far as downsides, you've generally 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. Also, 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, it might be difficult to convince those lenders to agree to the deal because they won’t gain much, if anything, from the short sale.

What Is a Deed in Lieu of Foreclosure?

With a deed in lieu of foreclosure, you give the deed to your property to the lender. In exchange, the lender agrees to cancel the loan and to release the lien on your home. The lender promises not to initiate foreclosure proceedings, or to terminate any current foreclosure proceedings. In this kind of transaction, you should also make sure that the lender agrees, in writing, to forgive any deficiency that remains after the house is sold. (With a deed in lieu of foreclosure, the deficiency is the difference between the total debt and the fair market value of the property.)

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

Upsides to a Deed in Lieu of Foreclosure

One benefit to a deed in lieu of foreclosure, unlike in a short sale situation, is that you don’t have to take responsibility for selling your house. Instead, you hand over title and then the lender sells the house.

Many believe that a deed in lieu of foreclosure looks better on your credit report than does a foreclosure. But any difference is pretty minimal. So, it might not be worth completing a deed in lieu unless the lender agrees to forgive or reduce your deficiency, give you some cash as part of the agreement, or let you live in the home for longer than you could if you let the foreclosure go through.

Downsides to a Deed in Lieu of Foreclosure

You probably can’t do a deed in lieu if you have second or third mortgages, home equity loans, or tax liens against your property. And getting a lender to accept a deed in lieu of foreclosure is sometimes challenging. Many lenders want cash, not real estate—especially if they own hundreds of other foreclosed properties. On the other hand, the lender might think it better to accept a deed in lieu rather than incur foreclosure expenses.

Income Tax Liability in Short Sales and Deeds in Lieu of Foreclosure

If your lender agrees to a short sale or to accept a deed in lieu of foreclosure, you might owe federal income tax on any forgiven deficiency. The IRS learns of the deficiency when the lender sends it a Form 1099-C, which reports the forgiven debt as income to you.

How to Avoid Paying Taxes on Forgiven Mortgage Debt

Generally, homeowners using short sales or deeds in lieu are required to pay tax on the amount of the forgiven debt—but not if they qualify for the Qualified Principal Residence Indebtedness (QPRI) exclusion. The QPRI exclusion was first introduced in the Mortgage Forgiveness Debt Relief Act of 2007, and I.R.C. § 108(a)(1)(E) was added to the Internal Revenue Code. The exclusion originally applied to mortgage debt on a principal residence that was forgiven in the years 2007 to 2010. Several extensions expanded that period, and the Bipartisan Budget Act extended the exclusion through 2017. (It also applied the exclusion to debt discharged in 2018 if the borrower entered into a written agreement in 2017.) The exclusion expired at the end of 2017.

Then, the federal Further Consolidated Appropriations Act, 2020, signed by the president on December 20, 2019, extended the exclusion through the year 2020. So, the QPRI exclusion applies to debt discharged before January 1, 2021, and it applies retroactively to debts that were forgiven in 2018 and 2019. The exclusion also applies to debts forgiven as the result of a written agreement entered into before January 1, 2021, even if the actual cancellation happens later. (To learn more about the QPRI exclusion and how to qualify for it, read Canceled Mortgage Debt: What Happens at Tax Time?)

If you don't qualify for tax relief under the QPRI exclusion, you might qualify for another kind of exception or exclusion, like:

  • if the debt has been discharged in bankruptcy (before it's forgiven)
  • you're insolvent when the debt is forgiven
  • the debt is a certain kind of farm debt, or
  • if the property was subject to a nonrecourse debt.

Getting Help

If you need help determining which option is best for your situation or you want to learn about potential defenses to a foreclosure that might apply in your circumstances, consider talking to a foreclosure attorney. If you’re considering completing a short sale or deed in lieu of foreclosure that has tax implications, talk to a tax attorney or tax accountant to get advice specific to your circumstances.

To get help with an application for a short sale or deed in lieu of foreclosure, and to learn more about these transactions, consider talking to a HUD-approved housing counselor as well.

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