Alternative to Foreclosure - Deed in Lieu of Foreclosure & Short Sales

Update 10-11-2011:  According to this FICO study, there's is little difference between foreclosure and short sale when it comes to a hit on your credit score, but shorter refresh period with short sales (about 3 years) than foreclosure (about 7 years).  Source:  http://massrealestatenews.com/credit-scoring-impacts-short-sale-vs-foreclosure/

It was sad to see a young couple with two children down the street from me that weren't able to sell their house on a short sale, so they wound up taking this action: Deed in Lieu of Foreclosure.

A Deed in lieu of foreclosure is a special deed that the homeowner/borrower uses to transfer ownership in a residential property (e.g., primary residence) to the mortgagee/lender to eliminate a loan that is in default (i.e., behind on payments) and thereby avoids a foreclosure.

Some reported advantages are: see wikipedia discussion here.

It immediately releases borrower from some portion (which means a possible deficiency judgment) or the entire mortgage and may be less impact as a foreclosure.

NOTE: I am trying to noodle this out and I'm not sure how this deficiency plays out, but I would recommend somewhere in the documentation that you sign in the DIL process would need to have the lender's agreement to "waive" their pursuit of a deficiency judgment.

Your lender is required to report a deficiency from a foreclosure or short sale to the IRS for tax purposes - so I assume this would be true if the lender also forgave a small portion of the loan under Deed in Lieu action. The lender sends you 1099A Form which reflects that the deficiency has "not" been forgiven/cancelled and the lender "can" come after you in future to collect the debt.

If the lender forgives the debt, you'll receive a Form 1099C. It suggests that the remainder of the debt has been cancelled and the lender will not come after you to collect the debt.

For income tax purposes in 2010, in both cases of the 1099A and 1099C Forms, I believe the "forgiveness" of these debts will need to be reported as income, but will subsequently be exempted from Income Taxes (per HR 3648 - the Mortgage Forgiveness Debt Relief Act, 2007).

Other benefits may include:

• Avoids the public (published in newspaper of record) notice of foreclosure situation;

• The borrower may get more generous terms than he/she would in a formal foreclosure.

• It probably will hurt the borrower's credit score and future ability to obtain credit (possibly more or less than a foreclosure);

• Advantages to a lender include a reduction in the time and cost of a repossession, lower risk of borrower revenge (theft and vandalism of the property before sheriff eviction), and additional advantages if the borrower subsequently files for bankruptcy.
I would think some disadvantages would be:

• It may not apply if you have more than one loan on the property.

• Negative impact on your credit score - perhaps worse than 120-150 points that foreclosures and short sales impact your credit score and maybe less than the 300-350 point drop in your credit score from a Bankruptcy.  (See this article for impact - http://www.ehow.com/about_7446137_effect-foreclosure-credit-rating.html)

• Losing a property in which you may have some equity but just couldn't afford to continue the payment.

• You may first be required to try to sell the property (as a short sale) for 60-90 days which often wastes your time, but delays the inevitable, since you may not receive an offer high enough to pay off the loan balance(s).

See a summary of advantages and disadvantages of Deeds in Lieu of Foreclosure at http://www.nolo.com/

or

Here at the HUD (Housing & Urban Development) website

Both the borrower (by voluntary action) and the lender have to agree on all terms. If possible, the written agreement must have total consideration (appraisal/fair market value of the property plus potential cash payment by borrower, if cash is available) at least equal to the loan balance. Otherwise, there will be loan forgiveness involved.

Before considering this action, please consult with a real estate attorney about the process and consequences.

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