Deed in Lieu of Foreclosure | Lizarraga Law Firm, PLLC

Practice Areas / Foreclosure Defense and Loan Modifications / Foreclosure Defense / Deed in Lieu of Foreclosure

Beware of tax consequences. As with short sales, a deed in lieu may generate taxable income based on the amount of your "forgiven debt."

If the bank agrees to a short sale or to accept a deed in lieu, you might need to pay income tax on any forgiven deficiency. To the IRS eyes, the amount of debt that is forgiven to you by the bank, constitutes income and you have to pay taxes on that income.

The bank will send you a Form 1099C and also a copy to the IRS. That is why the IRS knows that you experienced income on the forgiven debt.

However, you do not have to pay taxes for some loans secured by your primary home, under the new Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) that applies to loans during the 2007, 2008, and 2009 tax years only.

The new rule provides tax relief if your deficiency comes from the sale of your primary residence (the home that you live in). In other words:

• Loans for your primary residence. If the loan was secured by your primary residence and was used to buy or improve that primary residence, you may generally exclude up to $2 million in forgiven debt. Thus, you don't have to pay taxes on that deficiency.

• Loans on other real estate. If you default on a mortgage that's secured by property that is not your primary residence (for example, a loan on an investment property), you will owe taxes on that deficiency. However, if this is an investment property, you might wipe out the forgiven debt as a capital loss.

However, there is another twist. If you do not qualify for a relief under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief if you were legally insolvent at the time of the short sale, you. Legal insolvency means that your total debts are greater than the value of your total assets at the time the short sale occurred. Insolvency means that your debts exceeded the value of your assets.

Bankruptcy to avoid tax liability. You can also wipe out this tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes, in which case there is not too much benefit to do a short sale or deed in lieu since the potential benefit in your credit rating would be eliminated by filing for bankruptcy.