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What Does Deed in Lieu of Foreclosure Mean?

A financial crisis creates a lot of serious problems for anyone, whether it's from a divorce, job loss or major medical expense. But homeowners with major money troubles also face the threat of foreclosure. One possible solution is something called deed in lieu of foreclosure.

Strip away the legalese, and what that phrase describes is the situation where a homeowner agrees to turn over their property to the lender to avoid foreclosure. Handled properly, this option can help a stressed homeowner get out of a difficult situation and out from under hundreds of thousands of dollars in debt. But handled without attention to the details, a deed in lieu of foreclosure can leave a homeowner no better off than losing the home to foreclosure.

What Happens When You're Facing Foreclosure

Deed in lieu of foreclosure is one of several options if you are a homeowner facing foreclosure. The others are:

  • Short sale. This is when the homeowner accepts an offer from the lender for less than they owe on the house.
  • Mortgage modification. Any change to the original loan in cases of financial hardship is called a modification.
  • Chapter 13 bankruptcy filing. This allows homeowners to repay the loan as approved when their petition is granted.

Simply walking away from the home or allowing the foreclosure and eviction process to run its course can leave you with ruined credit, reduced resources, and a substantial amount of debt that can increase over time from the unpaid mortgage balance. In many states, borrowers can continue to be liable for the amount of the home loan on which they default, plus substantial interest.

A deed in lieu offers you the chance to negotiate with your lender to reduce or eliminate any outstanding mortgage balance, and even offers the potential of getting you some cash to find a new place to live.

Although it doesn't feel like it when you're in a desperate financial situation, a homeowner in possession of their property still has some leverage with the lender. In many states, the foreclosure process can be lengthy and expensive for the lender, who must hire attorneys, pay for legal advertisements, or go to court to prove that the homeowner is in default and claim the property. In addition, the lender also may need to go through a separate legal process to finally evict the homeowner, even after a successful foreclosure.

Finally, lenders worry that a distressed, angry homeowner might damage the property or strip it of valuable items, such as appliances, cabinets, fixtures and more. Offering a deed in lieu of foreclosure means the lender can get the property sooner, in good shape and at less cost. That allows the lender to resell the home as soon as possible at the best current price.

It's risky to pursue a deed in lieu by yourself, since it involves what can be complicated legal contracts. If you're facing foreclosure, you should talk to an approved Housing and Urban Development (HUD) housing counselor and a bankruptcy or foreclosure defense attorney to determine the best options. Even if you do pursue negotiating a deed in lieu on your own, at least have the final agreement reviewed by an attorney to protect yourself.

Advantages of a Deed in Lieu of Foreclosure

A deed in lieu arrangement offers several advantages to the homeowner:

  • It allows you to avoid or minimize any deficiency on your mortgage. That's the loss the lender takes on the difference between the current, fair market value for your home and the balance of your home loan. In many states, the law allows lenders to pursue borrowers for any deficiency. In some cases, that balance continues to charge interest at the penalty rate stated in the original mortgage, which is often several percentage points higher than the stated mortgage rate. Under a deed in lieu arrangement, homeowners have the ability to negotiate the deficiency and even eliminate it. If you get this kind of deficiency waiver, make sure it's in writing and notarized, and keep copies with your long-term financial records to protect yourself.
  • It may give you help moving. In a "cash for keys" arrangement, the lender offers money to help you with moving and finding a new place to live to ensure that the property is turned over quickly and in good condition.
  • It could reduce the hit to your credit. Plummeting credit scores come with a formal foreclosure, depending on your circumstances. Although settling the mortgage for less than the full balance owed will still hurt your credit, the damage may not be quite as bad. And while a deed in lieu arrangement will hamper your ability to get another home loan for up to four years, that's better than the seven-year wait that applies to most foreclosures.

Downsides of Deeds in Lieu of Foreclosure

Understand that your lender is under no obligation to offer a deed in lieu of foreclosure and that some mortgages under certain servicing agreements may not be eligible for such an arrangement. If there's a significant shortfall between the amount owed on the loan and the value of the property, the lender may require you to pay additional money to reduce its loss.

Obviously, the better shape the home is in, the more likely it is that you'll be able to arrange a deed in lieu. And if there is a second or even a third mortgage on the home, including a home equity loan or home equity line of credit, the other, subordinate lenders will need to release their liens and sign off on the arrangement. If the primary mortgage lender is eager to take possession of the property, the lender may offer to pay the other lien holders to arrange a deal. But those additional loans against the home will complicate getting a deed in lieu.

One downside to a deed in lieu is that you may face taxes on the amount of your forgiven debt, which the IRS considers income. The taxable amount is the total debt at the time it was forgiven minus the fair market value of the home at that time. For example, if the outstanding mortgage debt at the time of the deed in lieu arrangement was $180,000 and the market value of the property was $150,000, the homeowner could owe tax on $30,000.

Where to Go for Help

To find out whether you might qualify for a deed in lieu of foreclosure, contact your lender or mortgage loan servicer, which is the company that collects your mortgage payments. Also contact a HUD-certified housing counselor and the Consumer Finance Protection Bureau for help in exploring your options at (855) 411-CFPB (2372). A counselor may be able to help you arrange a deal at no cost with the servicer.

You also can contact a bankruptcy attorney, legal clinic or foreclosure defense attorney, but you will have to pay for their help. There are many foreclosure scams that dupe homeowners into paying money upfront and getting no help at all, so avoid dealing with anyone promising to wipe out your foreclosure in exchange for a fee.

Keep detailed records of all your communications with lenders, servicers and counselors, including full names, phone numbers and email addresses of everyone with whom you talk. Once you've arranged a deed in lieu, keep all your records on file in case any questions come up.

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