What Is a Deed in Lieu of Foreclosure?
Pros and Cons to a Deed in Lieu of Foreclosure
A deed in lieu of foreclosure is a title-transferring document that's signed by a homeowner, notarized by a notary public, then recorded in public records. It transfers a home's title from the homeowner to the bank that holds the mortgage.
As the name suggests, the action is taken in lieu of or instead of having the lender foreclose. Most people face this decision after the bank has either denied a loan modification or rejected a short sale offer.
Why Banks Offer Deeds in Lieu
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. And it's generally a less expensive and faster option than foreclosure, which requires litigation in many states.
A deed in lieu can favor the bank more than it favors the homeowner.
Of course, you would want to sell the home before considering a deed in lieu if you have equity, but some homeowners don't because their mortgage is underwater.
Requesting a Deed in Lieu
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.
Some banks require that the home must be listed for sale, allowing for a potential of a short sale, before they'll entertain the idea of accepting a deed in lieu. You could be required to submit a copy of the listing agreement to prove that you've indeed listed the property for sale.
A common misconception about deeds in lieu is that the property must already be in foreclosure. In fact, the lender might or might not have filed a notice of default or started judicial proceedings to foreclose. It might still be open to discussing a deed in lieu.
Banks are often reluctant to accept deeds in lieu of foreclosure when homeowners are current with their mortgage payments, but being current doesn't necessarily mean that the bank will automatically refuse.
Why Banks Reject Deeds in Lieu
Banks are under no obligation to accept deeds in lieu, and they might reject one for a few couple of reasons.
There Are Junior Encumbrances
Any encumbrances, judgments, or tax liens filed against the property will stay with the property if they're not released prior to the agreement for a deed in lieu of foreclosure. They become the lender's responsibility—the lender effectively inherits them. A property with only the original loan against it is typically the best candidate.
Foreclosure typically eliminates junior liens, so this could be an easier solution for the lender when any are in place. Junior liens are any that are recorded after the first mortgage.
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.
The Terms Are Unacceptable
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. The borrower might refuse either due to principle or lack of principal.
Pros and Cons to a Deed in Lieu
Always seek legal advice before jumping to give your bank a deed in lieu of foreclosure. Remember, it's in the bank's best interest to obtain the deed from you. It might not be in your best interest to comply. You could be adversely affected in a few ways:
- A deed in lieu will show up on your credit report, but the effect is usually less than the hit you would take for a foreclosure.
- You won't be able to buy another home for a while. Fannie Mae and Freddie Mac won't buy a mortgage in the second 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. Compare the wait to buying after a foreclosure, which is seven years without extenuating circumstances, five with, and you've essentially picked up a three-year gain.
- Make sure that the deed in lieu specifically releases you from liability to repay all loans against the property. Otherwise, you could be liable for any loan deficiency even after turning the property over to the lender—the difference between the home's value and the balance of your mortgage loan. 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.
- You could be required to give the lender cash in addition to title to make up some of the difference if your loan balance is significantly more than the home's fair market value.
Potential Tax Effects
Ask your accountant whether the canceled debt from your home loan could result in a tax liability. The 2007 Mortgage Forgiveness Debt Relief Act offered protection from this through December 2017, and that legislation was renewed under the terms of the Further Consolidated Appropriations Act of 2020—but only through December 2020.
Insolvency might be another exemption available if this legislation is eventually allowed to expire.
Cornell Law School Legal Information Institute. "Deed in Lieu of Foreclosure." Accessed March 10, 2020.
Southwest Riverside County Association of Realtors. "Risks and Benefits of a Deed in Lieu of Foreclosure." Accessed March 10, 2020.
Homeownership.org. "Deed-in-Lieu of Foreclosure." Accessed March 10, 2020.
Consumer Financial Protection Bureau. "What Is a Deed-in-Lieu of Foreclosure?" Accessed March 10, 2020.
Congress.gov. "H.R.1865 - Further Consolidated Appropriations Act, 2020." Accessed March 9, 2020.