February 23, 2015
Deeds in Lieu of Foreclosure
By Alan Doran, General Counsel, OneTitle National Guaranty Company
Many homeowners facing foreclosure who determine that they cannot afford to stay in their home turn to a Deed in Lieu of Foreclosure (“DIL”). This option allows the owner to avoid foreclosure and sell or walk away from his home, and may help him avoid liability for a deficiency (responsibility for the difference between the balance of the loan and the fair market value of the property). DILs are well-accepted loss mitigation alternatives to foreclosure and have been incorporated into most servicing standards.
A DIL is an instrument in which the mortgagor conveys to the lender a deed to the mortgaged property in full or partial satisfaction of the mortgage debt. While the lender is expected to pursue home retention loss mitigation options with a delinquent borrower who wants to stay in the home, a DIL can be advantageous to the borrower in certain circumstances compared to a loan modification. For example, a DIL may be beneficial for the borrower where the amount owed under the mortgage exceeds the current market value of the mortgaged property—potentially making the borrower legally liable for the deficiency—or where the borrower’s circumstances have changed and he is no longer able to afford payments of principal, interest, taxes and insurance even after a modification, or the loan does not qualify for a modification under available programs. Often, in return for saving the mortgagee the time and effort to foreclose on the property, the mortgagee will agree to waive any deficiency judgment and may contribute to the borrower’s moving costs. A DIL also stops the accrual of interest and penalties on the debt, avoids the high legal costs associated with foreclosure and may be less damaging to the homeowner’s credit than a foreclosure.
As noted above, with a deed in lieu of foreclosure, the deficiency amount is the difference between the fair market value of the property and the total debt. Usually, a deed in lieu of foreclosure is deemed to fully satisfy the debt. However, lenders frequently look for new ways to recoup their losses. New York law does not automatically preclude a lender from obtaining deficiency judgment following a deed in lieu of foreclosure. This means that a lender may try to hold the borrower liable for a deficiency following a deed in lieu of foreclosure. To avoid a deficiency judgment with a deed in lieu of foreclosure, the agreement must expressly state that the transaction is in full satisfaction of the debt. If the deed in lieu of foreclosure agreement does not contain this provision, the lender may file a lawsuit to obtain a deficiency judgment.
Furthermore, before the lender will accept a DIL, it may require the owner to put the home on the market for a period of time. Banks would often rather have the owner sell the house than have to sell it themselves or add it to their Real Estate Owned (“REO”) portfolio.
Unlike in a short sale, the owner does not necessarily have to take responsibility for selling his house. To the contrary, in many DIL transactions, the owner simply hands over the title and the lender sells the house. The principal advantage to the borrower is that it usually immediately releases him from most or all of the personal indebtedness associated with the defaulted loan. The borrower also avoids the public notoriety of a foreclosure proceeding and may receive more generous terms than he would in a formal foreclosure. Some credit counselors believe that a DIL looks better that a foreclosure or bankruptcy on the owner’s credit report. Advantages to a lender include a reduction in the time and cost of a repossession compared to a foreclosure action, lower risk of borrower revenge (e.g. theft and vandalism of the property before a sheriff-guided eviction) and additional advantages if the borrower subsequently files for bankruptcy.
As with short sales, the owner generally cannot arrange a DIL if he has second or third mortgage, home equity loan, or tax liens against the property since the lender will likely not want to assume liability for the junior liens from the owner. In this case, the lender will generally prefer to foreclose in order to clear the title.
The credit benefits relative to a foreclosure may also be limited. According to the consumer division of Fair Isaac (the company that invented the FICO score), short sales, foreclosures, and deeds-in-lieu of foreclosure are all “not paid as agreed” accounts and are considered the same for purposes of a consumer’s FICO score. Therefore, a DIL will generally have the same negative impact on the scores used to calculate eligibility and rate for many future loans as a foreclosure. Nevertheless, there may be benefits in other contexts, such as employment, where decisions are based on an overall read of the credit report rather than simply a credit score. A DIL may also generate unwelcome taxable income based on the amount of the owner’s “forgiven debt.” Finally, getting a lender to accept a deed in lieu of foreclosure can be difficult due to lenders’ strong preference for cash over real estate—a preference that is magnified if the lender already holds a large REO portfolio.
Because of the requirement that the instrument be voluntary, lenders will often not initiate a DIL. Instead, these lenders will wait to receive a written offer from the borrower that specifically states that an offer to enter into DIL negotiations is being made voluntarily. Lenders are cautious of subsequent claims that the lender acted in bad faith or pressured the borrower into the settlement. Neither the borrower nor the lender is obliged to proceed with the DIL until a final agreement is reached.
In New York, the Home Equity Theft Prevention Act (“HETPA,” NY Real Property Law, Section 265-a) has created some confusion regarding DILs. The state legislature’s intent in drafting the Act was to protect homeowners in financial distress from being victims of scams and unintentionally losing their homes. Nevertheless, it is unclear whether HETPA applies to deeds in lieu of foreclosure since there is no clear exclusion. The primary concern relates to the two-year right of rescission, creating a risk with which some banks or title insurers are uncomfortable. However, the New York State Department of Financial Services has expressed a view that these interpretations are misguided and that the legislative intent of HETPA was not to cover a purchaser of a DIL, but rather that the legislation’s drafters contemplated that § 265-a would apply only to the scammers and unscrupulous entities who stole a homeowner’s equity and to bona fide purchasers who might buy the property from them.