A deed in lieu of foreclosure may seem like a better alternative to foreclosure. You agree to move out of the home by a specified date and the lender agrees to cancel your mortgage. Lenders prefer a smooth move-out via deeds-in-lieu, and homeowners think it looks better on their credit. However, a deed-in-lieu leaves a black mark on your credit and keeps you from obtaining new credit for years to come. There are also financial consequences come tax time.
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Credit Scores and Deficiency Judgments
A deed-in-lieu affects your credit as much as foreclosure. According to Fair Isaac, the makers of the FICO scoring system, both events lower scores by 85 to 160 points, on average. A deed-in-lieu is a form of credit default, thus, posing the same amount of risk to future creditors. It also remains on your credit report for seven years. If the lender reports a negative balance, or deficiency, for the difference between the amount owed on the loan and the amount the lender recovers at the foreclosure auction, the impact on credit is worse. A deficiency judgment on your credit indicates you still owe the lender money after the home is sold.
Tax Liability on a Deed-In-Lieu
A deed-in-lieu is subject to federal taxation. The lender reports the deficiency as canceled debt to the IRS. This unpaid portion of the mortgage balance is treated as income from a sale and thus, taxable. It may also be treated as forgiven debt, which is also taxable. The manner in which the IRS treats it depends on whether the mortgage is a recourse or nonrecourse debt, which has to do with what assets a lender can go after following default. Criteria for recourse and nonrecourse loans varies by state. Consult a real estate attorney and tax professional to find out whether you face tax liability for a deed-in-lieu.
Moving Out to Move On
You may receive a deed-in-lieu after you've exhausted all other alternatives to foreclosure, such as a:
- deferment or loan modification that makes payments affordable
- short sale, in which you sell the home at a fraction of the mortgage balance owed
- refinance to pay off your current loan with a better mortgage
After analyzing your financial situation, the lender may offer you a deed-in-lieu, set a time frame for you to move out and even pay you to do so, an agreement known as cash-for-keys. You may have 30 to 60 days to vacate and must leave the home in broom-clean condition. Your lender or its agent provides move-out terms for a deed-in-lieu in writing.
Impact on Mortgage Borrowing
For seven years after a deed-in-lieu, mortgage lenders will know about your credit misstep through your credit report and your loan application. The Uniform Residential Loan Application, or Form 1003, used industry-wide for mortgages, requires you to declare whether you've had a deed-in-lieu of foreclosure. In general, you must wait four years after a deed-in-lieu to get a conventional mortgage. You may qualify for a Federal Housing Administration loan in as little as one or three years, depending on the circumstances surrounding the deed-in-lieu.