A deed in lieu of foreclosure is a document that transfers a home's title from the homeowner to the bank that holds the mortgage.
The action is taken in lieu of having the lender foreclose on the property. When handled properly, it can free the homeowner from financial liability in a way that is less damaging than a foreclosure.
What Is a Deed in Lieu of Foreclosure?
Homeowners who find themselves with mortgage payments they cannot afford are not always able to sell their homes for enough money to cover the outstanding balance. A potential solution is to sign over the home to the lender—if the lender is willing to agree to such an arrangement.
People sometimes face this decision after the bank has either denied a loan modification or rejected a short sale offer. This often can be a better option for homeowners than waiting for the bank to foreclose on the property.
How a Deed in Lieu of Foreclosure Works
Banks sometimes offer homeowners the option of a deed in lieu of foreclosure rather than approve a short sale as a means of loss mitigation. For lenders, it's sometimes a less expensive and faster option than foreclosure, which requires litigation in many states. A short sale involves selling a property for less money than what is owed on the mortgage, and sellers can get out from under a mortgage this way if the bank allows the sale and agrees to waive the deficiency.
Always seek professional advice before agreeing to a deed in lieu of foreclosure. Contact the Consumer Financial Protection Bureau at (855) 411-CFPB to be connected with a Housing and Urban Development-approved counselor.
Homeowners in distress can approach their lenders to find out if a deed in lieu of foreclosure is an option. This typically involves submitting an application along with documented proof of your financial situation. Each lender and each situation is different. Some banks might require that a home be listed for sale, allowing for the potential of a short sale before they'll entertain the idea of accepting a deed in lieu.
If both parties agree to a deed in lieu of foreclosure, each signs the title-transferring document which needs to be notarized. It becomes part of the public record like most other property transfers.
Why Banks Reject Deeds in Lieu
Banks are under no obligation to accept deeds in lieu, and encumbrances, judgments, or tax liens filed against a property often can be an impediment. Such actions remain with a property if they're not released prior to the agreement for a deed in lieu of foreclosure. They would become the lender's responsibility, so banks are more likely to accept a deed in lieu on a property with only the original loan against it.
Foreclosure typically eliminates junior liens, so this often is an easier solution for lenders when any are in place. Junior liens are any that are recorded after the first mortgage.
It's also possible that an existing pooling and servicing agreement (PSA) might ask the borrower to make a financial contribution in exchange for acceptance of a deed in lieu. A PSA is a contract in place when a mortgage-backed security is the owner of the mortgage. Borrowers unable or unwilling to meet this demand likely will be refused a request for a deed in lieu of foreclosure.
Pros and Cons of a Deed in Lieu of Foreclosure
Debt can be eliminated without foreclosure.
Lenders may offer money to assist with moving and expediting the transfer.
It damages your credit report.
Getting another mortgage will be more difficult.
- Debt can be eliminated without foreclosure: Make sure that the deed in lieu specifically releases you from liability to repay all loans against the property. There's little point in handing over title if you'll be pursued you for a deficiency, but this is typically negotiable. Just make sure you get any waiver in writing.
- Lenders may offer money to assist with moving and expediting the transfer: In some circumstances, lenders may agree to a "cash for keys" agreement. This provides you with cash to assist with moving expenses in exchange for handing over the property quickly and in good condition.
- It damages your credit report: A deed in lieu will show up on your credit report even if the effect is usually less than the hit you would take for a foreclosure.
- Getting another mortgage will be more difficult: Fannie Mae and Freddie Mac won't buy a mortgage in the secondary market when it's made by a borrower who signed a deed in lieu without extenuating circumstances in the last four years. This drops to two years with extenuating circumstances.
Do I Need to Pay Taxes on Canceled Debt?
Ask your accountant whether the canceled debt from your home loan could result in a tax liability. In some instances, the canceled debt is taxable, but in others, the taxpayer may be exempt depending on specific circumstances.
- Deeds in lieu of foreclosure help lessen the negative impact of losing one's home in certain circumstances.
- Lenders sometimes prefer deeds in lieu of foreclosure because they can be less costly than foreclosure.
- Before agreeing to a deal, make sure the lender agrees to waive your financial obligation in exchange for signing the deed.
- Consult a tax professional to determine if your canceled debt is taxable.