A short sale or deed in lieu may help prevent foreclosure or a shortage.

Many house owners facing foreclosure figure out that they simply can't afford to remain in their home. If you prepare to give up your home however desire to avoid foreclosure (including the negative acne it will trigger on your credit report), consider a short sale or a deed in lieu of foreclosure. These alternatives permit you to offer or leave your home without sustaining liability for a "deficiency."

To learn more about shortages, how short sales and deeds in lieu can help, and the advantages and downsides of each, continue reading. (To learn more about foreclosure, consisting of other options to avoid it, see Nolo's Foreclosure area.)

Short Sale

In numerous states, lenders can sue property owners even after the home is foreclosed on or sold, to recuperate for any staying shortage. A deficiency happens when the quantity you owe on the mortgage is more than the proceeds from the sale (or auction) the distinction between these two amounts is the amount of the shortage.

In a "brief sale" you get approval from the lending institution to sell your home for a quantity that will not cover your loan (the sale rate falls "short" of the amount you owe the loan provider). A brief sale is advantageous if you live in a state that enables lenders to sue for a shortage however only if you get your loan provider to agree (in writing) to let you off the hook.

If you live in a state that does not permit a lender to sue you for a deficiency, you don't need to arrange for a short sale. If the sale proceeds fall brief of your loan, the lender can't do anything about it.

How will a brief sale assist? The primary advantage of a brief sale is that you get out from under your mortgage without liability for the deficiency. You likewise prevent having a foreclosure or a personal bankruptcy on your credit record. The basic thinking is that your credit won't suffer as much as it would were you to let the foreclosure proceed or apply for personal bankruptcy.

What are the drawbacks? You've got to have an authentic deal from a purchaser before you can discover whether or not the lender will support it. In a market where sales are tough to come by, this can be discouraging because you won't understand in advance what the lending institution is willing to opt for.

What if you have more than one loan? If you have a 2nd or 3rd mortgage (or home equity loan or line of credit), those loan providers must also consent to the short sale. Unfortunately, this is often difficult because those lending institutions will not stand to gain anything from the brief sale.

Beware of tax consequences. A brief sale may generate an unwelcome surprise: Gross income based upon the quantity the sale profits lack what you owe (again, called the "deficiency"). The IRS treats forgiven financial obligation as gross income, based on routine income tax. The bright side is that thanks to the Mortgage Forgiveness Debt Relief Act of 2007, there are some exceptions for the years 2007 to 2012. To read more about this Act and your tax liability, see Nolo's post Canceled Mortgage Debt: What Happens at Tax Time?

Deed in Lieu of Foreclosure

With a deed in lieu of foreclosure, you offer your home to the loan provider (the "deed") in exchange for the loan provider canceling the loan. The lender assures not to initiate foreclosure proceedings, and to end any existing foreclosure proceedings. Be sure that the lender concurs, in writing, to forgive any shortage (the amount of the loan that isn't covered by the sale profits) that remains after the home is sold.

Before the loan provider will accept a deed in lieu of foreclosure, it will probably require you to put your home on the market for an amount of time (3 months is common). Banks would rather have you offer your home than need to offer 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 insolvency. In addition, unlike in the short sale scenario, you do not always have to take responsibility for selling your house (you may end up simply turning over title and then letting the lender sell your house).

Disadvantages to a deed in lieu. There are numerous downfalls to a deed in lieu. Similar to short sales, you most likely can not get a deed in lieu if you have second or third mortgages, home equity loans, or tax liens against your residential or commercial property.

In addition, getting a lending institution to accept a deed in lieu of foreclosure is difficult nowadays. Many lenders desire money, not real estate especially if they own hundreds of other foreclosed residential or commercial properties. On the other hand, the bank may believe it much better to accept a deed in lieu rather than sustain foreclosure expenditures.

Beware of tax effects. Similar to short sales, a deed in lieu may create unwanted taxable earnings based upon the quantity of your "forgiven financial obligation." To read more, see Nolo's post Canceled Mortgage Debt: What Happens at Tax Time?

If your lender concurs to a brief sale or to accept a deed in lieu, you may have to pay income tax on any resulting shortage. When it comes to a brief sale, the shortage would be in money and in the case of a deed in lieu, in equity.

Here is the IRS's theory on why you owe tax on the shortage: When you first got the loan, you didn't owe taxes on it due to the fact that you were obliged to pay the loan back (it was not a "gift"). However, when you didn't pay the loan back and the financial obligation was forgiven, the amount that was forgiven became "income" on which you owe tax.

The IRS finds out of the shortage when the lending institution sends it an IRS Form 1099C, which reports the forgiven debt as earnings to you. (To find out more about IRS Form 1099C, read Nolo's post Tax Consequences When a Lender Crosses Out or Settles a Debt.)

No tax liability for some loans protected by your main home. In the past, property owners using short sales or deeds in lieu were needed to pay tax on the quantity of the forgiven debt. However, the new Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) changes this for specific loans throughout the 2007, 2008, and 2009 tax years only.

The new law supplies tax relief if your shortage originates from the sale of your main house (the home that you reside in). Here are the guidelines:

Loans for your primary house. If the loan was protected by your main home and was used to buy or enhance that house, you may usually omit up to $2 million in forgiven debt. This suggests you do not need to pay tax on the shortage.

Loans on other realty. If you default on a mortgage that's protected by residential or commercial property that isn't your main residence (for example, a loan on your trip home), you'll owe tax on any deficiency.

Loans protected by however not utilized to improve main residence. If you get a loan, secured by your main house, however utilize it to take a getaway 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 show you were legally insolvent at the time of the short sale, you will not be liable for paying tax on the shortage.

Legal insolvency takes place when your total debts are greater than the worth of your overall possessions (your properties are the equity in your realty and individual residential or commercial property). To use the insolvency exemption, you'll need to prove to the satisfaction of the IRS that your financial obligations went beyond the value of your assets. (To learn more about utilizing the insolvency exception, checked out Nolo's article Tax Consequences When a Creditor Writes Off or Settles a Financial Obligation.)

Bankruptcy to avoid tax liability. You can also get rid of this type of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you submit before escrow closes. Of course, if you are going to apply for personal bankruptcy anyway, there isn't much point in doing the short sale or deed in lieu of, due to the fact that any advantage to your credit ranking produced by the brief sale will be eliminated by the bankruptcy. (To find out more about utilizing insolvency when in foreclosure, checked out Nolo's article How Bankruptcy Can Aid With Foreclosure.)

Additional Resources

To find out more about brief sales and deeds in lieu, consisting of when these alternatives might be ideal for you, see Nolo's Bankruptcy and Foreclosure Blog or the bestselling Foreclosure Survival Guide, now offered online at no charge. Both are written by practicing attorney Stephen R. Elias, president of the National Bankruptcy Law Project.