Bankruptcy v. Deed In Lieu of Foreclosure

Clients have frequently asked us what is the difference between a deed in lieu of foreclosure and a bankruptcy?

First, a deed in lieu of foreclosure (DLF) is when the homeowner signs over and transfers the deed to the home to the mortgage company without the legal process of a foreclosure. Most people believe this will look better on the credit report than a bankruptcy or a foreclosure. This is possible, however a DLF does not wipe out the pre-existing debt on the home as a bankruptcy would do. In other words, you as the homeowner would still owe the deficiency debt on the mortgage, the DLF just saved the mortgage company the time and expense of foreclosing. It does not eliminate the debt you owe them! This is the same on a “short sale”.

The mortgage company will eventually sell the home, usually at a loss, and demand you pay them the difference in money unless you have agreed in writing to wipe out the debt still owed. This debt is usually several thousands of dollars and possibly tens of thousands of dollars.  The difference in what you owe the mortgage company and the amount they sold the house for is called a “deficiency balance”.

If you do not pay the mortgage company the money they have demanded, they could sue you for the difference they lost from the sale of the home. The mortgage company will usually win the lawsuit because you do owe them the deficiency balance unless you have reached an agreement with them saying that you will not owe the deficiency balance.

In the alternative, the mortgage company could believe the debt is “uncollectable” from you and forgive the debt.  You may think, “that’s great!”  However, there’s a catch. The mortgage company will try to “write off” these thousands of dollars of loss on their taxes by filing a 1099(c) with the IRS eliminating your debt to them.  The drawback is the IRS will consider this “forgiven” debt to be gross income if it totals more than $600. In other words, you don’t have to pay back the full amount of the debt but the IRS will tax you on that forgiven debt as gross income. For example, the mortgage company losses $50,000 on the sale of your home.  The IRS will expect you to pay taxes on the $50,000.  If you are in the 25% tax rate, you would have to pay $12,500 in taxes to the IRS.  If you do not have the $12,500, the IRS could start assessing you penalties and interest. That could, in turn, lead to the garnishment of your paystubs!

In contrast, a bankruptcy will usually eliminate any deficiency balance you owe the mortgage company.  Therefore they cannot sue you or attempt to collect the deficiency balance you owe them. The IRS usually cannot tax you for the deficiency balance you owe the mortgage if you file the bankruptcy.  If you file bankruptcy, you are considered insolvent, and the IRS must waive the tax liability on the 1099 if you are deemed insolvent.

In conclusion, consider your options. However we believe surrendering the home in bankruptcy and wiping out any deficiency balance and eliminating your other unsecured debts, such as credit cards and medical bills, is usually a better alternative than a deed in lieu of foreclosure.