2 ways to avoid foreclosure, both painful

Dear Debt Adviser,
I am in a financial situation where I can no longer afford my mortgage loan. I am familiar with the basic foreclosure process. However, the bank mentioned two other options:

  1. A short sale, in which they may accept less than the full amount owed.
  2. A deed in lieu of foreclosure, whereby you deed the property to your mortgage lender in exchange for forgiveness of all or a portion of the loan.

Which of these two options would be the least damaging?
— Renee

Dear Renee,
I’m glad you said “least damaging” as either a short sale or deed in lieu of foreclosure is going to do substantial damage to your credit and credit score. There is also the possibility of damage to your tax liability that I want you to consider. I’m also glad that you asked a very timely question that many readers may benefit from directly or may pass on to others in a similar situation.

From your letter, it sounds as if you have done your research as far as what options are available, but I’d encourage you to explore them all, including a mortgage modification, before you make a final decision. If you haven’t tried the HOPE Now hotline at (888)995-HOPE as part of your search for alternatives, then I’d strongly recommend it.

Keeping the lender’s loss to a minimum may be in your best interest and should be a factor in choosing a short sale or deed in lieu of foreclosure. There is some good news with these two options. You may not suffer any tax consequences for the amount due on your mortgage loan that is forgiven. The Mortgage Forgiveness Debt Relief Act of 2007 allows you to exclude up to $2 million, or $1 million if you’re married and filing separately, in qualifying forgiven mortgage debt from your income. Without this protection, you would have to pay income taxes on the amount of the bank’s loss on your property. For more information, I suggest you check out the IRS website.

While many of you may have heard about this exclusion that applies to loans for home improvement, home purchase or refinancing of debt related to your home purchase or improvement, fewer know that any part of the loan used for nonresidential purposes is not excluded. In other words, if part of your mortgage debt was used to pay off consumer debt and/or to pay for a car, that portion of your mortgage debt would not qualify for the Mortgage Forgiveness Debt Relief Act protection and would become taxable income for you. This also applies to any previous home equity loans used for nonhousing expenses that may have been refinanced into your current mortgage.

When a debt of more than $600 is forgiven by a lender, you are sent a Form 1099 at the end of the year for the amount forgiven. This makes the forgiven debt ordinary income for you with taxes due and payable. So, although the lender may forgive you, the IRS may not be as forgiving!

Asking which of the two options — short sale or deed in lieu of foreclosure — is the least damaging to your credit is a great question. The damage from a deed in lieu of foreclosure could be greater as the loss would probably be greater. How much damage depends on the size of the bank’s loss. In theory, the smaller the loss, the smaller the harm to your credit score. If you do the short sale, ask the lender how it intends to report the partial charge-off. There may be room for negotiation here based on the lender’s policies and your relationship.

Good luck!

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