How Does a Deed in Lieu of Foreclosure Work?

A deed in lieu of foreclosure is sometimes referred to as simply a "deed in lieu." It transfers a home's title from the owner to the bank that holds the mortgage. The action is taken in lieu of having the lender foreclose on the property.

Homeowners who find themselves with mortgage payments that they can no longer afford are not always able to sell their homes for enough money to cover the balance they still owe. One solution is to sign the home over to the lender if it is willing to agree to such an arrangement. This process is referred to as a "deed in lieu of foreclosure." The lender accepts the deed, transferring ownership of the property rather than going through the time and expense of a foreclosure process.

People often make this choice after the bank has either denied a loan modification or a short sale offer. It can often be a better option for homeowners than waiting for the bank to foreclose. That's because the arrangement can free you from financial liability in a way that can be a bit less damaging than foreclosure if you've fallen behind with your mortgage and have no way of catching up and otherwise rectifying the situation.

Homeowners in distress like this can reach out to their lenders to find out whether a deed in lieu is an option. It involves submitting an application, along with proof of your financial situation. Each lender's rules for the process can vary. Some lenders might require that a home be listed for sale first so there's a chance for a short sale before they accept a deed in lieu.

Each party must sign the title-transferring document when both parties agree to the deed in lieu. It must be notarized. It becomes part of the public record, just like other property transfers.

Example of a Deed in Lieu of Foreclosure

Banks sometimes offer homeowners the option of a deed in lieu rather than approving a short sale. It can also be less expensive and a faster option than foreclosure for lenders.

Foreclosure means going through a court process in many states.2 A short sale involves selling the property for less money than what is still owed on the mortgage. Sellers can get out from under a mortgage that way if the lender allows the sale and agrees to waive the deficiency.3

For example, let's say you bought a house for $500,000. A year later, you were laid off from your job and could no longer afford to make your mortgage payments. You skipped paying your monthly mortgage for a while and now are scared that the bank will foreclose on your house. You reach out to the bank that manages your mortgage and ask if there are other options. The bank agrees to a deed in lieu and you begin the process of transferring ownership and the title to the bank. You no longer own the home. You get a new job and move to an apartment that you can afford.

What Does It Mean for the Bank?

Encumbrances, judgments, or tax liens that have been filed against a home can prevent a deed in lieu of foreclosure. These actions remain attached to the property if they're not released prior to the agreement for a deed in lieu. They would become the lender's responsibility after the transfer. Banks are more likely to accept a deed in lieu on a property that has only the original loan against it.

It's also possible that an existing pooling and servicing agreement (PSA) might ask the borrower to make a financial contribution in exchange for acceptance of a deed in lieu. A PSA is a contract in place when a mortgage-backed security is the owner of the mortgage.4

Borrowers who are unable or unwilling to meet this demand will often be refused a request for a deed in lieu.

Pros and Cons of a Deed in Lieu of Foreclosure

Pros Explained

• Debt can be eliminated without foreclosure: Make sure that the deed in lieu releases you from any liability to repay all loans against the property. There's little point in handing over the title if you'll be pursued for a deficiency balance, but this is often negotiable. Get any waiver in writing.1
• Lenders may offer money to assist with moving: They may agree to a "cash for keys" deal, which would provide you with money to assist with moving expenses in exchange for handing over the property quickly and in good condition.5

Cons Explained

• A deed in lieu will damage your credit: It will show up on your credit report even if the effect is often less than the credit damage you would experience with foreclosure.
• Getting another mortgage will be hard for a while: Unless you had clear extenuating circumstances, such as divorce, a death in the family, or serious illness, and that's why you had to ask for a deed in lieu, it may be difficult to get a mortgage for another house for a while.6

Do You Need To Pay Taxes on the Canceled Debt?

Ask your accountant whether the canceled debt from your home loan could result in a tax liability. It may be taxable, but you may be exempt, again depending on the circumstances.7

Frequently Asked Questions (FAQs)