Short Sales and Deeds in Lieu of Foreclosure in Oregon and Washington

Short Sales and Deeds in Lieu of Foreclosure

A short sale or deed in lieu may help avoid foreclosure or a deficiency.

Many homeowners facing foreclosure determine that they just can’t afford to stay in their home. If you plan to give up your home but want to avoid foreclosure (including the negative effects it will cause on your credit report), consider a short sale or a deed in lieu of foreclosure. These options allow you to sell or walk away from your home without incurring liability for a “deficiency.”

To learn about deficiencies, how short sales and deeds in lieu can help, and the advantages and disadvantages of each, read on.

Short Sale

In many states, lenders can sue homeowners even after the house is foreclosed on or sold, to recover for any remaining deficiency. A deficiency occurs when the amount you owe on the home loan is more than the proceeds from the sale (or auction) -- the difference between these two amounts is the amount of the deficiency.

In a “short sale” you get permission from the lender to sell your house for an amount that will not cover your loan (the sale price falls “short” of the amount you owe the lender). A short sale is beneficial if you live in a state that allows lenders to sue for a deficiency -- but only if you get your lender to agree (in writing) to let you off the hook.

If you live in a state that doesn’t allow a lender to sue you for a deficiency, you don’t need to arrange for a short sale. If the sale proceeds fall short of your loan, the lender can’t do anything about it.

How will a short sale help? The main benefit of a short sale is that you get out from under your mortgage without liability for the deficiency. You also avoid having a foreclosure or a bankruptcy on your credit record. The general thinking is that your credit won’t suffer as much as it would were you to let the foreclosure proceed or file for bankruptcy.

What are the drawbacks? You’ve got to have a bona fide offer from a buyer before you can find out whether or not the lender will go along with it. In a market where sales are hard to come by, this can be frustrating because you won’t know in advance what the lender is willing to settle for.

What if you have more than one loan? If you have a second or third mortgage (or home equity loan or line of credit), those lenders must also agree to the short sale. Unfortunately, this is often impossible since those lenders won’t stand to gain anything from the short sale.

Beware of tax consequences. A short sale may generate an unwelcome surprise: Taxable income based on the amount the sale proceeds are short of what you owe (again, called the “deficiency”). The IRS treats forgiven debt as taxable income, subject to regular income tax. The good news is that there are some exceptions for the years 2007 to 2009. To learn more, see “Income Tax Liability in Short Sales and Deeds in Lieu,” below.

Deed in Lieu of Foreclosure

With a deed in lieu of foreclosure, you give your home to the lender (the “deed”) in exchange for the lender canceling the loan. The lender promises not to initiate foreclosure proceedings, and to terminate any existing foreclosure proceedings. Be sure that the lender agrees, in writing, to forgive any deficiency (the amount of the loan that isn’t covered by the sale proceeds) that remains after the house is sold.

Before the lender will accept a deed in lieu of foreclosure, it will probably require you to put your home on the market for a period of time (three months is typical). Banks would rather have you sell the house than have to sell it themselves.

Benefits to a deed in lieu. Many believe that a deed in lieu of foreclosure looks better on your credit report than does a foreclosure or bankruptcy. In addition, unlike in the short sale situation, you do not necessarily have to take responsibility for selling your house (you may end up simply handing over title and then letting the lender sell the house).

Disadvantages to a deed in lieu. There are several downfalls to a deed in lieu. As with short sales, you probably cannot get a deed in lieu if you have second or third mortgages, home equity loans, or tax liens against your property.

In addition, getting a lender to accept a deed in lieu of foreclosure is difficult these days. Many lenders want cash, not real estate -- especially if they own hundreds of other foreclosed properties. On the other hand, the bank might think it better to accept a deed in lieu rather than incur foreclosure expenses.

Beware of tax consequences. As with short sales, a deed in lieu may generate unwelcome taxable income based on the amount of your “forgiven debt.”

Income Tax Liability in Short Sales and Deeds in Lieu

If your lender agrees to a short sale or to accept a deed in lieu, you might have to pay income tax on any resulting deficiency. In the case of a short sale, the deficiency would be in cash and in the case of a deed in lieu, in equity.

Here is the IRS’s theory on why you owe tax on the deficiency: When you first got the loan, you didn’t owe taxes on it because you were obligated to pay the loan back (it was not a “gift”). However, when you didn’t pay the loan back and the debt was forgiven, the amount that was forgiven became “income” on which you owe tax.

The IRS learns of the deficiency when the lender sends it an IRS Form 1099C, which reports the forgiven debt as income to you.

No tax liability for some loans secured by your primary home. In the past, homeowners using short sales or deeds in lieu were required to pay tax on the amount of the forgiven debt. However, the new Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) changes this for certain loans during the 2007, 2008, and 2009 tax years only.

The new law provides tax relief if your deficiency stems from the sale of your primary residence (the home that you live in). Here are the rules:

Loans for your primary residence. If the loan was secured by your primary residence and was used to buy or improve that house, you may generally exclude up to $2 million in forgiven debt. This means you don’t have to pay tax on the deficiency.

Loans on other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence (for example, a loan on your vacation home), you’ll owe tax on any deficiency.

Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence, but use it to take a vacation or send your child to college, you will owe tax on any deficiency.

The insolvency exception to tax liability. If you don’t qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief. If you can prove you were legally insolvent at the time of the short sale, you won’t be liable for paying tax on the deficiency.

Legal insolvency occurs when your total debts are greater than the value of your total assets (your assets are the equity in your real estate and personal property). To use the insolvency exclusion, you’ll have to prove to the satisfaction of the IRS that your debts exceeded the value of your assets.

Bankruptcy to avoid tax liability. You can also get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn’t much point in doing the short sale or deed in lieu of, because any benefit to your credit rating created by the short sale will be wiped out by the bankruptcy.

How can a Deed in Lieu of Foreclosure Create Debt Relief?

A Deed in Lieu of Foreclosure is an option for some homeowners who have fallen behind on their mortgage payments. In essence, this option will cancel the loan on the home for the home buyer, as he or she will give the deed (ownership) of the home back to the lender. It's different from a foreclosure because it's a straight-up deal -- an effort to avoid foreclosure is beneficial to the consumer and the lender because they both get something out of it -- the consumer gives up his home to avoid foreclosure, the lender accepts the deal to avoid losing profits on a property.

In most instances a deed in lieu of foreclosure is easier on consumer credit history and has a distinguished advantage above short sale in that the homeowner is not the responsible party for finding a new home buyer.

While it may not be easy to just walk away from an investment, it may be easier to walk away than enter a short sale, which is very damaging to credit history, or accepting foreclosure, which is also harms credit substantially.

If you can successfully offer your lender a deed in lieu of foreclosure, you'll have to walk away from your property completely, but it will in many instances be your best choice. You may still have to file for bankruptcy in certain circumstances, for example, if the home was what you used to collateralize debt with another lender, or if you are still left behind on other payments on car loans or credits cards.

It might be up to you to prove to your lender that the deed in lieu of foreclosure is good for them too -- they're not in the habit these days of wanting to hang on to more real property, but by the same token, they're not big on paying for all of the paperwork and rigmarole of foreclosure either.

If you think this is a viable option for you, discuss it with your bankruptcy attorney first to be sure there are not other choices that won't work better for you.

Should I Sue an Abusive Debt Collector?

Sometimes debt collectors get out of control with phone calls to your home or office, and even in some instances, calls to your relatives and other people who you live with or have lived with in the past.

There is a fine line between what consumers may consider abusive and what the law considers abusive. There is a time and there are certain circumstances that would make it appropriate to sue a collector, but you need to know exactly what circumstances these are so you don't waste valuable time.

First of all, you have to have documented proof that a collector has broken the law. For example, did they call you after 9PM? Did they call you repeatedly after 9PM? Was the person or people you interacted with from the collector rude or use harsh or profane language? If they did, and especially if they did so repeatedly and you can prove it, then suing a debt collector might be the right thing to do.

Unfortunately, if you just feel inconvenienced by debt collectors and feel it isn't fair that they are contacting you, you won't have grounds to sue. That said, if you can prove your case in court that a debt collector has harassed you or treated you in a manner outside of what is considered appropriate, you may be entitled to certain monetary losses, such as those associated with a psychologist, or money you paid out to change your phone number in an attempt to discontinue excessive or abusive collector phone calls.

Is Bankruptcy Harder on My Credit Score than Foreclosure?

This is a great question that many clients I have ask when considering filing for bankruptcy in Portland or Vancouver.

The truth of the matter is that it depends, but oftentimes, people fear bankruptcy because they think it will be the worst of "two evils." It can often be the case that bankruptcy is easier on your credit score than a foreclosure.

To be 100% truthful, whether you opt for bankruptcy or foreclosure, there will be a negative impact on your credit. That said, foreclosure does damage without providing any positive results, namely, helping to restore your credit as a Chapter 7 or Chapter 13 bankruptcy will. In addition, a foreclosure does not wipe debt you owe to creditors and typically has a longer lasting negative impact on your credit score. As if that weren't enough, having a foreclosure on a property on your credit history will make it a great deal harder for you to purchase a new home in the future.

When you file for bankruptcy it will start your credit history from the ground up and allow you (in most instances) to have a fresh start for your financial health. In some cases, people who file for bankruptcy can bounce back within 24 months or so, as they make a strong effort to stay on top of bills and apply for any credit lines they can -- ensuring, of course, that they make their payments on time, even if it's with a secured credit card.

Regardless of what the general "rules" are, you need to consult with a bankruptcy attorney to know whether bankruptcy is the right choice for your financial future.

Is a Short Sale Better Than a Foreclosure for My Bankruptcy?

This is a common question among those facing bankruptcy, especially bankruptcy brought on by falling behind on mortgage payments. So what's the right answer?

When dealing with the bank that you have to pay your mortgage to, if you opt for a short sale and they agree, this allows you to sell the house for a value lesser than what you initially paid. If the bank accepts this agreement with you, you will no longer be held responsible for any more mortgage payments on the home (as it is no longer yours as of the date it is sold to the new owner.)

This allows you some breathing room, and while you will no longer own the home, you will have the money that you would have had to use to pay the mortgage to pay for other outstanding bills and/or for rent elsewhere.

The disadvantage is that it's pretty much up to you to find a new buyer for the home, and the bank that you have the loan with will have to agree on the new price of the home. If you're not quite sure what the bank will go for in terms of the price of the home, it can be an uphill battle. That said, most banks will work with you to some degree because getting a mortgage of some kind from someone is better than having the home go into foreclosure, which leaves it up to them to price and sell themselves.

Make sure that you discuss all of your options with your bankruptcy attorney -- short sales are not always the best answer for every consumer, especially given the state that the home is located in. It's always best to know which option best suits you and your chances at a better financial future.