Buying at the tail end of the housing bubble in early 2006, an old professor of mine bought more house than he should have. After a divorce and an expensive health issue, he just couldn’t make the loan payments anymore. In fact, he admitted that he was nearly insolvent.
He’d taken a second loan secured by his home, was facing a potential federal tax lien (he’d put off Uncle Sam for three years), and told me that he’d avoided his brother-in-law for three hours at Thanksgiving dinner because he’d signed as a guarantor on the professor’s first loan.
He seemed pretty even-keeled about the situation, and confident that he would be on financially strong footing again. He just wanted to know if a deed in lieu of foreclosure was a good option for him. What is it exactly? he asked. What happens if I do it? What are the alternatives?
Well, my only piece of advice was for him to call a friend of mine (and an ex-student of his) who practiced real estate law in the professor’s home state. But let’s walk through some of the issues he was concerned about, and see if we can’t get you a better understanding of a deed in lieu. We’ll consider:
- What is a deed in lieu of foreclosure?
- What is required for one, and what’s the process?
- What are its advantages and disadvantages for the borrower?
- How about the lender?
- How will it impact a borrower’s taxes or credit score?
- How is it different from a short sale or a foreclosure?
What is a Deed in Lieu of Foreclosure?
Let’s take a look at some basics of the deed in lieu of foreclosure. In this section we’ll go over the definition of deed in lieu, the requirements, and finally the process.
Definition of a Deed in Lieu of Foreclosure
Under a deed in lieu of foreclosure the borrower transfers by deed its interest in the secured property to the lender in exchange for the lender releasing its right to foreclose on the borrower’s property. A deed in lieu will prevent the filing of a foreclosure action or stop an existing one.
How does this work? When a person borrows money from a lender, the lender may take a security interest in the borrower’s real estate (either by a mortgage or a deed of trust) to protect itself in the event the borrower defaults on the loan. If the borrower (also known as the mortgagor because they grant the mortgage to the lender) defaults on the loan, the lender (the mortgagee, as they receive the mortgage lien) has several different options to make itself whole (or as close as possible). One of these methods is a deed in lieu of foreclosure.
As an aside, the lender’s security interest in real property is called either a deed in trust or a mortgage. While there are differences between the two (the primary one being that a mortgage requires judicial action to foreclose on property, while the deed of trust does not), for simplicity’s sake this article refers to both as a mortgage. And in case you were wondering, 15 states use mortgages only, 26 use deeds of trust only, and nine states permit both.
Before we dive in much further, it should be noted that the rules for a deed in lieu of foreclosure vary by state. Accordingly, though this article describes their general rules, one should contact a real estate attorney to determine the local laws.
Requirements of a Deed in Lieu of Foreclosure
The primary requirement for a deed in lieu is that both the lender and borrower enter into the transaction voluntarily. Typically the lender is in a greater position of power than the borrower, and thus may be able to extract terms more favorable to it. Of course, the borrower may accept these terms, but must do so voluntarily. In the event a court determines the deed in lieu was not voluntary, the transfer may be voided. Further, if a court determines the lender acted in bad faith or employed outrageous conduct, it may impose punitive damages against the lender.
To support that a transfer was voluntary, (1) the process typically begins with the borrower asking the lender to accept a deed in lieu, and (2) the settlement agreement prepared by the lender (this instrument sets out the rights and obligations the parties under the transfer) likely includes a statement that the borrower is acting voluntarily.
Additionally, the agreement must show that the value given to the borrower is at least equal to the property transferred. If sufficient consideration is not given, the transaction may be challenged by claims of duress, fraud, or unconscionable advantage.
Deed in Lieu of Foreclosure Process
Following the borrower’s initial contact, the lender forwards borrower an application for a deed in lieu of foreclosure, including requests for information such as:
- Financial statement, including monthly income and expenses
- Tax returns
- Bank statements
Additionally, the lender may require the borrower to try and sell their home before proceeding on the deed in lieu request (generally banks would rather not own property).
The parties then negotiate the terms for the transfer and memorialize them in the settlement agreement. Upon signing of the deed and agreement, the transaction is completed.
Advantages and Disadvantages of a Deed in Lieu
Next, let’s take a look at the pros and cons of using a deed in lieu of foreclosure from both the borrower’s perspective and the lender’s perspective.
From a Borrower’s Perspective
From the borrower’s perspective, there are many benefits to using a deed in lieu. First and foremost, it releases the borrower from its payment obligations under the loan documents. Secondly, when compared to other options, like foreclosure and short sales, a deed in lieu process is fairly quick and fairly inexpensive. It doesn’t require a trip to court, and it doesn’t require the borrower to take the time, effort and cost of finding a buyer for the property.
Borrowers may also find a deed in lieu attractive because it doesn’t negatively impact their credit report as much as a foreclosure. The deed in lieu appears on a credit report for about seven years as a “debt settled for less,” and borrowers will be able to finance another home within 2-3 years. The impact may be even smaller if the lender agrees to not file any negative reports with credit reporting agencies. In contrast, financing isn’t typically available for 5-7 years following a foreclosure.
One of the primary benefits to borrowers of a deed in lieu relates to the lender’s ability to pursue payment of a “deficiency.” The deficiency is the difference between the property’s value at the time of transfer and the amount of the debt outstanding. The lender has the right to pursue a deficiency under the loan document’s recourse clause. However, when a deed in lieu is used, the borrower is released from liability for any deficiency either because (1) their state’s laws prohibit deficiency judgments following a deed in lieu of foreclosure, or (2) the lender agrees under the settlement agreement to waive its right to the deficiency. Where the state doesn’t prohibit such deficiency actions, a borrower will want to make sure the lender waives its deficiency right in the settlement agreement. In contrast, in most states deficiency judgments can be obtained in foreclosure actions.
Other benefits include: (1) a lender may agree to give the borrower certain limited possessory interests in the property following transfer, e.g., borrower may lease the property from the lender (while this is possible, generally banks would prefer to hold all interest in the property in order to make it more saleable); (2) relocation money to borrowers where Fannie Mae and VA loans (and some conventional loans) are involved; (3) avoiding the notoriety of a pubic foreclosure action; and (4) negotiating more favorable terms with a lender than if a foreclosure action were used.
As an aside, because transferring the secured property to the lender will not always discharge a guarantor to a loan, a guarantor should ensure the settlement agreement provides the lender will not sue the guarantor.
Even though a deed in lieu can have significant benefits to borrowers, they’re not always the first choice of lenders. A deed in lieu will not extinguish any judgments against, or junior liens secured by, the property, e.g., a second mortgage or tax lien. Where such liens exist, the lender would become liable for them if they accepted a deed in lieu. Accordingly in such cases a lender is more likely to pursue foreclosure. In a foreclosure, liens are paid in order of their priority (meaning the holder of the first mortgage will be paid before junior liens), and all of the junior liens extinguished. It should be noted that some tax liens take priority over all other liens.
From a Lender’s Perspective
Like borrowers, lenders appreciate deeds in lieu because they can be completed faster and cheaper than a foreclosure action. The lender can quickly take fee title to the property and control its disposition. Additionally, because deed in lieu settlement agreements typically provide the property must be transferred to the lender in good condition, the deed in lieu option eliminates the risk of a borrower intentionally damaging the property (this may occur in foreclosure actions prior to eviction). Further, while lenders typically prefer to take property free and clear of all interests, where the property is generating rental income through leases, a lender may welcome taking ownership of this income stream (presumably, of course, only if it makes the property more marketable).
Additionally, lenders may prefer a deed in lieu because where (1) the property is worth less than the loan amount outstanding, and (2) the borrower is not insolvent at the time of transfer, the deed in lieu generally can’t be set aside in a later bankruptcy action. However, bankruptcy court may invalidate a deed in lieu if it finds the transfer was a “preferential transfer” or “fraudulent conveyance.” A preferential transfer occurs when the lender was an insider or knew that the borrower was insolvent at the time the transfer was made, and the transfer resulted in the lender receive more funds than it would have if a bankruptcy proceeding had liquidated the property. A fraudulent conveyance is one that is made to hinder, delay, or defraud a creditor, or, the borrower received less than the reasonably equivalent value for the property.
Notwithstanding these benefits, as explained in the section above, lenders may be reluctant to accept a deed in lieu because (1) they don’t like to own property, and (2) they may not be able to sue the borrower for a deficiency. Nevertheless, a lender may agree to a deed in lieu if it determines the deficiency it will forgo is less than the costs it would incur in a foreclosure action. As part of this determination, the lender will have to consider whether it’s likely they’ll be able to collect funds from the borrower even if they win a deficiency judgment.
Tax Consequences of a Deed in Lieu
A deed in lieu is exchanged for the lender canceling the borrower’s debt. Generally the IRS treats canceled debt as taxable ordinary income. However, under the Mortgage Forgiveness Debt Relief Act of 2007, for loans between 2007 and 2016, a borrower will not be taxed on up to $2M of forgiven-debt on its primary residence’s mortgage. Additionally, this tax relief may be available if the borrower can establish it was insolvent at the time the deed in lieu was made.
Alternatives to Deed in Lieu
When a borrower is having difficulty making its loan payments, the lender and borrower have a number of different options. They may negotiate so-called “loan work-outs” such as modifying the loan, a partial claim loan, forbearance and others. But where these aren’t satisfactory, two common alternatives to a deed in lieu are a short sale and foreclosure.
Short Sale
A short sale is when a borrower in default gets the permission of its lender to sell the secured property for less than the outstanding debt, and forward the sale proceeds to the lender in exchange for release of borrower’s debt obligation.
Short sales include many of the same advantages and disadvantages as a deed in lieu: (1) the lender may be precluded from recovering a deficiency if (a) state law prohibits deficiencies in short sales or (b) the bank waives its right to deficiency in the sale agreement; (2) deficiencies from short sales of primary residences can enjoy tax relief under the Mortgage Forgiveness Debt Relief Act of 2007; (3) their negative impact on credit reports is less severe than foreclosure actions; and (4) lenders will generally not agree to them where junior liens exist (this is so because the other lien holders must also agree to the short sale, and given that they wouldn’t receive any payment from the sale proceeds, getting such agreements is a practical impossibility).
As to differences, borrowers may prefer a deed in lieu because a short sale requires that they incur the time and cost of marketing and obtaining a bona fide offer for the property. If the real estate market is stagnant, this may not be an easy task. Even when a borrower secures an offer and presents it to the bank, the lender may reject it as too low and require the borrower to find a higher offer. If a sale price can be agreed on, a lender may prefer the short sale to a deed in lieu because banks prefer cash (from the short sale) rather than real property (from a deed in lieu foreclosure).
Foreclosure
A foreclosure is a process by which a lender, in response to a borrower defaulting on a loan from the lender, forces the sale of property securing the loan in order to recover the loan’s unpaid balance. There are two types of foreclosures, judicial and non-judicial. Only the judicial process requires a court’s involvement, but in both cases the proceeds from the sale are used to satisfy liens against the property in order of priority (generally the order in which they were created).
Often lenders and borrowers prefer to avoid foreclosure actions given that they take more time, and cost more, than a deed in lieu or short sale. Further, as noted above, foreclosures have a greater negative impact on credit reports than a short sale or deed in lieu. Nonetheless, there can be advantages to both borrower and lender. For example, most states provide that a lender can recover a deficiency in a foreclosure action. Accordingly, if a deficiency is large enough, and if the property is located in a state that prohibits deficiency judgments after a deed in lieu or short sale, then the lender may incur the additional foreclosure costs for the right to recover the deficiency. Interestingly, because some states don’t allow a deficiency after a foreclosure, in such a state a borrower might actually prefer a foreclosure rather than a short sale or deed in lieu if the lender won’t agree to waive the deficiency.
Conclusion
So what did my professor do? I don’t know. He never told me. But, his lawyer must have given him some good advice because last year the professor sent me a Christmas card showing him and his smiling new bride standing on the front lawn of their beautiful (but not too big) new home. Because this article is only for informational purposes, and not to give legal advice, if you have any particular deed in lieu of foreclosure, short sale or foreclosure issues, please do like the professor and consult a licensed attorney.
Do you have any questions? Thoughts? Second-marriage advice I can pass on to the professor? Let us know in the comments below!