If you’ve struggled to pay your mortgage, you might have heard the term “deed in lieu of foreclosure” as a possible solution to your situation. A deed in lieu agreement means you will surrender the deed for your home to the bank instead of the bank taking action to foreclose on your home. However, if you owe more than the home is worth, the bank will forgive the remaining loan balance. Although tax consequences apply to many debt forgiveness arrangements, a tax forgiveness measure in 2016 may relieve those who successfully negotiate a deed in lieu.
This 2007 law waives the provision in which the IRS considers forgiven mortgage debt taxable income. Previously, homeowners who negotiated a deed in lieu of foreclosure would have to claim the forgiven amount as income and pay taxes accordingly. This act is in effect for mortgage debt forgiven from 2007 through 2018, provided the mortgage is on the owner’s primary home. Most states also forgo taxing this debt as income, though it is important to check the latest tax laws in your area.
Forgiven debt on mortgages for secondary homes and on home equity loans not used to improve a primary residence will be taxed as income.
When you enter a deed in lieu of foreclosure agreement with your lender, you will receive IRS Form 1099-C. This will indicate any negative loan balance that has been reported to the IRS. Although up to $2 million can be forgiven under the 2007 act, you must still report the forgiven amount on your tax return using Form 982.
If you owe more than your home is worth, and you can no longer afford the payments, you can request that the lender consider a deed in lieu of foreclosure agreement. If the mortgage company agrees, it will send you a settlement agreement that details the terms and conditions of the arrangement and indicates that both parties are entering the agreement voluntarily.
You will need to support your request with financial documents, including tax returns, bank statements, and financial statements that detail your monthly income and expenses. In some cases, you may need to prove you have tried to sell your home and were unable to do so for several months or longer.
You should avoid signing a deed in lieu of foreclosure agreement that does not forgive your negative loan balance. Although you cannot be taxed on the balance, the lender can sell it to a collection agency that can then attempt to sue you for the debt. Always get the waiver of your negative loan balance in writing before proceeding with the deed in lieu agreement.
If you can qualify for tax forgiveness, a deed in lieu of foreclosure carries some benefits if you are unable to repay your mortgage.
One major drawback of a deed in lieu of foreclosure? If you have a second mortgage on your home, your secondary lender is unlikely to agree to a deed in lieu. If they do agree, they are more likely to pursue you for the forgiven loan balance. If you want to avoid collections, you may need to go another route if you have more than one mortgage.
If your mortgage debt doesn’t qualify for forgiveness, you may be able to seek back tax assistance by claiming insolvency. This means you owe more in debt than your assets, such as real estate and property, are worth. If you can prove insolvency to the IRS, they may waive the tax on your forgiven debt.
Some homeowners whose mortgage debt is not forgiven file for bankruptcy. Chapter 7 bankruptcy wipes out unsecured debts, while Chapter 13 bankruptcy reorganizes debts under an affordable payment plan. This may be an option for you if you owe more in taxes and other types of debt than you can comfortably afford to repay.
If you can sell your home for less than it is worth, you may be able to get your lender to agree to a short sale. This also requires the lender to forgive the outstanding balance of your mortgage. Debt forgiven through a short sale is also tax-exempt through 2018 under the Mortgage Forgiveness Debt Relief Act. The main disadvantage to a short sale compared to a deed in lieu is the time it may take to find a buyer for your home, particularly in a slow market.
If you have high-interest debts that are putting your home at risk, Solvable can help. We match you with well-reviewed back tax assistance programs that specialize in assisting homeowners with credit card, tax, and student loan debt. Get in touch today to get on the path to financial recovery.