June 2010: Real Estate

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 Even though the word “foreclosure” has lost much of its stigma in recent years, thanks to Wall Street recklessness and subsequent bailouts, it’s still a state most homeowners would prefer to avoid. Not only does foreclosure wreck a homeowner’s credit score for years to come, but the very word conjures up feelings of failure. (Banks’ smoke-and-mirror lending practices have fueled untold foreclosures in the first place, but that’s another story.) 

 

There is another way out from under a monster mortgage. It’s called a deed in lieu, which is a deed instrument in which the borrower gives the property back to the lender. Borrowers forfeit all equity they’ve earned in the home in exchange for the cancellation of the outstanding debt. They simply walk away from the property as if they were renters returning keys to a landlord. The lender, meanwhile, avoids hefty legal costs related to a foreclosure.  

There are several advantages to this arrangement. The most obvious is that it releases the borrower from future payments, and the lender promises to stop all foreclosure proceedings. It also makes less of a dent in the borrower’s credit score. And it just sounds better than “foreclosure.” 

The disadvantages, however, aren’t insignificant. Walking away from equity can be like walking away from an IRA or a 401(k): The lost investment can be in the tens of thousands of dollars, if not more, depending on how long the borrower has lived there and improvements made to the property. Also, the borrower can expect her credit score to drop by 150 to 250 points. That’s not as low as it would drop through foreclosure, but the hit stays on one’s credit report for around seven years (borrowers have to request to have it removed after that amount of time), which can make applying for a new mortgage before then difficult. Experts say two to three years is the average amount of time to wait before applying for a new mortgage. Also, a borrower cannot get a deed in lieu if there are second or third mortgages, home equity loans or tax liens against the property because the primary lender does not want the complication of multiple lenders attached to the property.

Another drawback: Borrowers can’t force this type of deed on lenders. Typically, lenders require proof that the borrower has been actively trying to sell the property for at least two to four months before they’ll be convinced the delinquency was due to “unavoidable hardship.” That’s three to four more months of late or missed payments, which can make a borrower’s distressed financial situation ever more precarious. Even then, there’s no guarantee the lender will enter into this type of agreement since lenders, especially these days, prefer cash over real estate. They might already be saddled with multiple homes in a similar state. In fact, most lenders won’t agree to a deed in lieu unless it’s the only way to avoid hefty foreclosure expenses or they determine they can turn around and sell the house for a profit. 

The borrower might also have to pay income tax on any resulting equity that went toward anything other than the home itself. The new Mortgage Forgiveness Debt Relief Act of 2007 allows homeowners to exclude up to $2 million in forgiven debt if the loan was used to buy or improve the house. But if equity was put toward the renovation of a second home or buying a new car or saving for a child’s college fund, the homeowner will owe income tax on it, which can run into the tens of thousands of dollars. The only way to get around this is to file for bankruptcy—always the last resort. 

To learn more about a deed in lieu, refer to the U.S. Department of Housing and Urban Development’s “Deed in Lieu of Foreclosure Option.”

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