What Is a Deed in Lieu of Foreclosure?

Pros and Cons to a Deed in Lieu of Foreclosure

Foreclosure sign on house figurine
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If you've heard about banks offering homeowners the option for a deed in lieu of foreclosure over a short sale, you might ask yourself why anybody would want to give a bank a deed to their home instead of going through the short sale process. Essentially, if the bank rejects your short sale, the bank is telling you to go pound sand. Under those circumstances, why would you want to help the bank?

In some cases a deed in lieu can favor a bank more than it favors a homeowner. Most people face the deed in lieu decision after the bank has either denied a loan modification or rejected a short sale. Of course, if you have equity, you would sell the home before considering a deed in lieu, but some sellers facing this decision do not have any equity because their mortgage is underwater.

Definition of a Deed in Lieu of Foreclosure

A deed in lieu of foreclosure is a title-transferring document signed by the homeowner, notarized by a notary public and eventually recorded in the public records. It transfers the home's title from the homeowner to the bank that holds the mortgage.

Rejected Deed in Lieu of Foreclosure

A common misconception about deeds in lieu is that the property must be in foreclosure. The lender may or may not have filed a notice of default or started judicial proceedings to foreclose but may still be open to discussing a deed in lieu. However, banks are often reluctant to accept a deed in lieu of foreclosure if the homeowner is current, but being current doesn't mean the bank will refuse. Banks are under no obligation to accept a deed in lieu of foreclosure. Here are a few reasons why a bank might refuse a deed in lieu:

  • Such action is not profitable for the bank. If a bank believes it can make more money through foreclosure, either because the property has equity or the federal government is providing financial incentives to the bank to foreclose, the bank might reject a homeowner's offer to deliver the deed in lieu of foreclosure.
  • Junior encumbrances, judgments, or tax liens. Any subsequent lien filed against the property will stay with the property and become the lender's responsibility if not released prior to the agreement for a deed in lieu of foreclosure. Typically, a property with only one loan is the best candidate. Or, a second lender might accept a deed in lieu if the first loan is current and the property is worth more than the sum of its encumbrances.
  • Servicing guidelines prohibit deeds in lieu. Many loans are serviced by PSAs, and the guidelines in those PSAs might prohibit a deed in lieu of foreclosure. PSAs are required to follow guidelines and those terms cannot be altered.
  • Unacceptable terms. It is also possible that the PSA might ask the borrower to make a financial contribution in exchange for acceptance of the deed in lieu, and the borrower might refuse either due to principle or lack of principal.

Drawbacks to a Deed in Lieu of Foreclosure

Always seek legal advice before jumping at the bit to give the bank a deed in lieu of foreclosure. Remember, it is in the bank's interest to obtain the deed from you. It might not be in your best interest to comply. In some ways, it can be argued that giving a bank a deed in lieu of foreclosure is just a step above walking away from your mortgage. Following are a few ways you could be affected with a deed in lieu of foreclosure:

  • It will affect your credit. A deed in lieu will show up on your credit report. Some sources say the affect on credit is identical to that of a full-blown foreclosure. Each individual's situation is different. When in doubt, call a credit bureau and ask.
  • Ability to buy another home.There is no such thing as giving a deed in lieu and turning around to immediately buy another home. The mortgage giants, Fannie Mae and Freddie Mac, that buy loans in the second market will not buy a mortgage made by a borrower who signed a deed in lieu for four years without extenuating circumstances, two years with extenuating circumstances. They continually make changes to guidelines.
  • Compare the wait to buy after a foreclosure, which is seven years without extenuating circumstances, five with, and what you have picked up is essentially a three-year gain. Looking at it another way, a short sale may qualify you to buy a home within two years, in which case you may have lost two years if you are forced to wait four years after a deed in lieu.
  • Release of liability. Make sure that the deed in lieu specifically releases you from liability to repay the loan. Moreover, there is little point in handing over title if you have a second lender that will pursue you for a deficiency.

    Potential Tax Effects

    Be sure to ask your accountant whether the canceled debt from your home loan could result in a tax liability. Temporarily, the 2007 Mortgage Forgiveness Debt Relief Act continues to offer protection due to an extension provided by the Bipartisan Budget Act of 2018, and that legislation gets renewed annually. Insolvency may be another exemption available.