Short Sales and Deeds in Lieu of Foreclosure Under the Law
If you are willing to move out of your home, you might be able to avoid a foreclosure by arranging for a short sale or a deed in lieu of foreclosure. Either of these options can help you prevent the lender from pursuing a deficiency judgment against you. A deficiency judgment is when the foreclosure sale fails to generate enough funds to pay off the balance on the loan, and the lender pursues the borrower for the remainder. However, both short sales and deeds in lieu of foreclosure have certain drawbacks of which you should be aware.
Understanding Short Sales
A short sale involves agreeing with the lender to sell your home for a price less than the remaining balance on your loan. This is similar to a foreclosure sale except that the lender agrees to refrain from pursuing you for any deficiency. Some states prohibit deficiency judgments after short sales by law, while borrowers in other states must arrange with the lender to waive the deficiency. (You may want to find out whether your state allows a deficiency judgment after a foreclosure, since going through a foreclosure may be no worse than going through a short sale if your state prohibits a deficiency.)
Drawbacks of Short Sales
If you have taken out multiple mortgages to refinance your home, you must get those lenders to agree to the short sale as well. There is no reason for them to agree because they get nothing out of the short sale, so people with multiple mortgages usually cannot use this option.
You cannot propose a short sale unless you have a bona fide offer from a potential buyer that you can present to the lender. This can be challenging because neither the buyer nor you will be able to foresee what the lender will demand, so a buyer may be reluctant to make an offer.
The IRS considers forgiven debt, such as a deficiency waived by a lender, to be taxable income. This may increase your tax liability and put further stress on your finances. If you are legally insolvent at the time of the short sale, though, you will not need to pay tax based on the deficiency. Legal insolvency means that your total debts are greater than your total assets. The Mortgage Loan Forgiveness Debt Relief Act also provides some exceptions for loans made between 2007 and 2017.
Understanding Deeds in Lieu of Foreclosure
A deed in lieu of foreclosure is different from a short sale because it transfers the property to the lender instead of selling it to a new buyer. The homeowner should get the lender to agree to refrain from starting a foreclosure (or to terminate any existing foreclosure) and to waive any deficiency based on the sale price of the home. Most lenders find this option less appealing than a short sale because they will need to handle the logistics of the sale instead of the homeowner. However, if you list your home for sale and cannot sell it after a few months, the lender may accept a deed in lieu of foreclosure.
Similar to a short sale, a deed in lieu of foreclosure likely will not damage your credit as severely as a foreclosure or a bankruptcy. As noted above, the burden of selling your home shifts to someone else, so it may be more appealing than a short sale.
Drawbacks of Deeds in Lieu of Foreclosure
A deed in lieu of foreclosure shares some of the same disadvantages as a short sale. This option probably is not available if you have additional mortgages or liens on the property. It also can have negative tax consequences because it leads to a “forgiven debt.” Exceptions to tax liability are the same as those for short sales.
During a period with a high rate of foreclosures, a lender may find a deed in lieu of foreclosure less attractive than a short sale or a foreclosure because it would prefer money rather than property. (However, it does avoid foreclosure costs by accepting this alternative.)