"Short Sale" and "Deed in Lieu" as Alternatives to Bankruptcy and Foreclosure

The slumping economy and real estate market have forced people to scramble to find a quick, inexpensive way to avoid going through a bankruptcy and/or foreclosure. A "short sale" and a "deed in lieu of foreclosure" agreement are two options many borrowers may not be familiar with.

A "short sale" occurs when an owner/borrower sells their property for less than the outstanding balance of the loan upon approval of the lender, who agrees to accept less than the total balance in full satisfaction. From the owner's perspective, a short sale allows relatively quick relief from the debt and avoids the negative impact of a foreclosure on their credit report (though the short sale itself may be reported to the credit bureau). From the lender's perspective, a short sale can cut losses because the lender may lose less money than they would if they had to foreclose.

Before lenders will approve a short sale, they typically want to see that a solid buyer is in place, a Notice of Default has been recorded and the owner has a real "sob story" as to why he is having financial difficulties and should be forgiven part of the debt. If the situation is right, the lender may approve a short sale but not agree to forgive a part of the debt. In this case, the lender will condition approval of the sale upon the borrower signing an acknowledgment of the obligation to pay all or part of the remaining balance.

A "deed in lieu of foreclosure" agreement is another way to avoid bankruptcy and a foreclosure while reducing the negative impact on a credit report. In this situation, the borrower simply gives the lender the deed to the property in exchange for the lender forgiving the debt. Like a short sale, the lender must agree and the closer the property value and the balance of the loan are to each other, the more encouraged the lender will be. Also, the lender will typically require that theirs be the only loan against the property since accepting a deed in lieu may not extinguish junior liens (whereas a foreclosure usually does).

A potential trap in either case is that the lender's agreement to forgive a certain amount of debt may be treated as income to the borrower for federal or state income tax purposes (although insolvency rules and the Mortgage Forgiveness Debt Relief Act of 2007 may alleviate this trap for many).