Deed In Lieu of Foreclosure

A deed in lieu of foreclosure is an alternative way for a debtor to convey his or her property to a lender as opposed to a deed of trust sale or trustee sale.[1]  Even though this method of transferring property to a lender when a debtor is financially in trouble is still used, it has been less utilized because of its risk to lenders.[2]

General Concerns

It is critical that a deed in lieu of foreclosure is properly done to ensure a liability is extinguished in full so the debtor’s deficiency is reduced to $0. Sometimes the liability is not paid in full. For example, lenders can either intentionally or negligently have the debtor contract away statutory protections or create new note obligations in short sales, loan modifications, or more. In the situations where the liability is not paid in full, the “document or agreement between the parties should be clear enough to show that the parties intended the deeding of the property as payment in full.”[3]

A lawyer should know collection-bankruptcy and tax areas of law so that the client isn’t negatively impacted in one of the relevant. For example, a suggestion from a tax professional may ignore conveyance of property issues, whereas a real estate professional’s suggestion may create tax problems such as cancellation of indebtedness income (COD) collection debt. Lastly, a good title company should be recommended to handle the deed in lieu of foreclosure.

Advantages to a Lender

The deed in lieu of foreclosure is faster and less expensive than a traditional foreclosure.[4]

Advantages to a Borrower

The deed in lieu usually waives a debtor’s deficiency if done correctly. Further, a deed in lieu usually does less damage to a debtor’s credit score.[5]

Disadvantages to a Lender

A lender risks the results of a “merger of title”.[6] When property is transferred through a deed in lieu of foreclosure, the lesser title merges into the greater title.[7] Basically, the lender’s secured interest merges into its title ownership interest, the secured interest is dissolved, and any junior liens such as IRS liens gain priority and encumber the property. A trustee sale would wipe out these junior liens against a property, which is better for the lender.[8]

Disadvantages to a Borrower

The debtor would be better protected through Arizona’s anti-deficiency laws, namely A.R.S. § 33-814. Since this anti-deficiency statute typically only applies to a deed of trust sale, a debtor would not qualify for the statute’s anti-deficiency protection if he or she conveys his or her property through a deed in lieu of foreclosure.

The financially-troubled debtor is in a better position to remain on the property, stop paying the monthly payment, and let the property return to the lender through a deed of trust sale. In some cases, a debtor may save money to apply to a new residence through an agreement with the lender; the debtor will maintain the property and vacate soon after the deed of trust sale is completed, and the lender will pay the debtor an extra $1,000 to vacate the property. This agreement implicates the benefits of I.R.C. § 108(c)[9] if the entire mortgage forgiveness act have been met.