Deed in Lieu of Foreclosure in Plain English
Many homeowners facing foreclosure determine that they just can’t afford to stay in their home. If you plan to liquidate your home but want to avoid a foreclosure (including the negative blemish that will appear on your credit report as a result of a repossession by your lender), consider a short sale or a deed in lieu (DIL) of foreclosure. These options, short sale or deed in lieu of foreclosure, in most cases will allow you to sell or walk away from your home without incurring liability for a “deficiency balance” if you are what is commonly referred to as being “under water.”
What is a Deed in Lieu of Foreclosure
With a DIL 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. The lender generally agrees, in writing, to forgive any deficiency (the amount of the loan that isn’t covered by the sale proceeds) after the house is sold.
Sometimes a video about the topic might make things more clear.
Before the lender will accept a DIL of foreclosure, they 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. If you receive an offer during the time your home is listed for sale, yet the offer does not cover the balance of the liens against the property including real estate commission, real estate transfer tax, attorney fees, etc, you are engaging in a short sale. All short sales are subject to bank approval; they typically take 3-6 months in the process phase. During the processing time and while your home is listed for sale, you are expected to maintain the property, pay insurance, HOA and real estate taxes, assuning your real estate taxes were not escrowed at the time you financed your home.
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Pros or Benefits to doing a Deed in Lieu (DIL).
Many believe that a DIL of foreclosure looks better on your credit report than 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 the title and allowing the lender to sell the house.
Cons or Disadvantages of doing a Deed in Lieu
There are several downfalls to a DIL. As with short sales, you probably cannot get a DIL if you have second or third mortgages, home equity loans or tax liens against your property. With regards to enaging in a short sale, several local NJ Realtors reported that when a second lien holder is involved, a short sale can often be delayed by these additional lien holders who will not accept charge offs, making a short sale closing near impossible. Agents are quickly learning how to negotiate a piece of the pie for these additional lien holders to facilitate a faster closing; although a DIL of foreclosure is very undesirable for 2nd and 3rd mortgage holders because they stand to gain very little or in some cases nothing in return. However, if a foreclosure is eminent, they have nothing to gain since a REO-Real Estate Own or bank own sales proceeds are likely to compensate only the 1st lien holder.
In addition, getting a lender to accept a DIL 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 DIL rather than incur long term foreclosure expenses.
For a homeowner, a DIL might seem attractive at first. Technically, you may be able to remain in your home if you ask your lender for a deed in lieu with an option for lease, which is called a deed for lease program.
Although some sellers are afraid or hesitant to do a short sale because of:
- a. The potential embarrassment or time commitment that comes with marketing a home as a short sale.
- b. The uncertainty regarding the deficiency balance.
The team at Weichert Realtors and njretoday markets and processes short sale discreetly putting your mind to ease. We have a section on our website that describes our discrete short sale process in more detail. Visit that discrete short sale section for more information about how you can move on discretely.
Beware of tax consequences. As with short sales, a DIL may generate unwelcome taxable income based on the amount of your “forgiven debt.”
Income Tax Liability in Short Sales and DILs
If your lender agrees to a short sale or to accept a DIL, you might have to pay income tax on any resulting deficiency. In the case of a short sale, the deficiency would be in cash and in the case of a DIL, in equity.
Here is the IRS’s theory on why you owe tax on the deficiency: When you first got the loan, you didn’t owe taxes on it because you were obligated to pay the loan back (it was not a “gift”). However, when you didn’t pay the loan back and the debt was forgiven, the amount that was forgiven became “income” on which you owe tax.
The IRS learns of the deficiency when the lender sends it an IRS Form 1099C, which reports the forgiven debt as income to you.
No tax liability for some loans secured by your primary home.In the past, homeowners using short sales or DILs were required to pay tax on the amount of the forgiven debt. However, the new Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) changes this for certain loans during the 2007, 2008 and 2009 tax years only.
The new law provides tax relief if your deficiency stems from the sale of your primary residence (the home that you live in). Here are the rules:
- Loans for your primary residence. If the loan was secured by your primary residence and was used to buy or improve that house, you may generally exclude up to $2 million in forgiven debt. This means that you don’t have to pay tax on the deficiency.
- Loans on other real estate. If you default on a mortgage that is secured by property that isn’t your primary residence (for example, a loan on your vacation home), you will owe tax on any deficiency.
- Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence but use it to take a vacation or send your child to college, you will owe tax on any deficiency.
The insolvency exception to tax liability. If you don’t qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief. If you can prove that you were legally insolvent at the time of the short sale, you won’t be liable for paying tax on the deficiency.
Legal insolvency occurs when your total debts are greater than the value of your total assets (your assets are the equity in your real estate and personal property). To use the insolvency exclusion, you will have to prove to the satisfaction of the IRS that your debts exceeded the value of your assets.
Bankruptcy to avoid tax liability.You can also get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn’t much point in doing the short sale or DIL of foreclosure because any benefit to your credit rating created by the short sale will be wiped out by the bankruptcy.
The above information is deemed reliable but not guaranteed and it is not meant to take the place of a tax accountant’s professional opinion. The above information does not qualify as expert advice. It is a holistic overview of DIL of foreclosure based on personal experiences.
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