Understanding "Deed in Lieu of Foreclosure" Process

In this tumultuous mortgage market, a lender and borrower may decide to enter a “deed in lieu of foreclosure” agreement. This agreement requires the borrower to relinquish his or her rights in a property to the lender in exchange for being released from liabilities specifically named in the loan documents. In effect, the lender becomes the new owner. Such agreements are a common form of mortgage contract settlement.

A central requirement for this arrangement is that the appraised market value of the property must be less than the outstanding debt from the original agreement. Generally the property must not be subject to any 3rd party creditor claims or liens. A lender should perform a thorough title search. Unlike a foreclosure, other liens are not eliminated if proceeds from a sale come up short.

The borrower is freed from having a foreclosure, and the associated notoriety, on his or her credit history, and generally, the terms are more generous than a formal foreclosure proceeding. From the borrower’s perspective, this usually occurs when mortgage payments cannot be met and selling the property at market value has been unsuccessful.

Advantages to the lender include:
1. Takes title sooner, often by months, than a foreclosure.
2. Considerable savings on legal fees and court costs
3. Savings on other costs associated with the foreclosure
4. Allows lender to resell property sooner

A preferred alternative to the deed in lieu of foreclosure is a short sale. A short sale occurs when the borrower lists the home for less than market value and the lender agrees to accept proceeds less than the loan amount. This method allows the homeowner to avoid the credit impact and the lender can clear a non-performing loan without the associated costs of foreclosure, eviction and property rehabilitation.

A borrower should be aware that there may be tax consequences related to the amount of forgiven debt. The IRS learns of the deficiency generated by the deed in lieu of foreclosure transaction when the lender sends it an IRS Form 1099C. Some relief, however, was recently given as part of the Mortgage Forgiveness Debt Relief Act of 2007. Consult your local CPA to discuss your individual situation.