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Deed in lieu tax consequences to borrower

A borrower may be able to avoid foreclosure through a deed in lieu whereby the homeowner agrees to transfer the title of the property to the lender. In return, the lender will release the borrower from all obligations from the mortgage. This is beneficial to the borrower because the negative effect of the deed in lieu on his credit score is much less than that of a foreclosure. Meanwhile, the lender benefits because he is able to forgo the expenses and the effort that are usually needed for a formal foreclosure.

However, a borrower who is able to get a deed in lieu will be liable for taxation on the cancellation of indebtedness or COD income. The tax results would be based on whether the loan is classified as a non-recourse loan or a recourse loan. This classification is specified in the loan documents that were originally signed by the lender and borrower. Basically, if the only option of the lender is to get back the property when the borrower defaults, then it is a non-recourse loan. However, if the lender can go after the borrower to collect any shortfall when the property is sold, then it is a recourse loan. A lender has to submit a Form 1099-C to the IRS in the case of a shortfall in a recourse loan where a deed in lieu has been granted. This is known as the borrower’s COD income.

In the case of a non-recourse loan, the IRS will consider the tax consequences of the deed in lieu as if the borrower had sold the property. It the current market value of the property is less than what is owed, the borrower will have a personal loss but this is not tax deductible. On the other hand, if the value of the property is greater than the outstanding loan, the borrower will have a gain that may not be taxed if he is able to comply with IRC Sec. 121 two-year residency requirement. In the case of a recourse loan, the situation is similar to the non-recourse loan except that the borrower will also be taxed for COD income if the value of the property is less than what is owed. Ordinary income rates will be applied for the COD income.


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4 Responses to Deed in lieu tax consequences to borrower

  1. David Smith says:

    Hi Moe:

    Thanks for all of the information that you provide. I do have 2 questions for you…I live in Michigan and lenders do have deficiency rights. If a DIL is done, you said in the article above that the lender will “release the borrower from all obligations from the mortgage”. Is the lender always required to release the borrower from any deficiency when a DIL is done? Secondly, you say that the borrower would be liable for taxes on the COD amount. Doesn’t the Mortgage Forgiveness Debt Relief Act eliminate the tax liability?

    Thanks in advance for your assistance and keep up the good work!

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  2. japama says:

    Thanks for all of the information that you provide. I do have 2 questions for you…I live in Iowa and lenders I imagine do have deficiency rights. If a DIL is done, you said in the article above that the lender will “release the borrower from all obligations from the mortgage”. Is the lender always required to release the borrower from any deficiency when a DIL is done? Secondly, you say that the borrower would be liable for taxes on the COD amount. Doesn’t the Mortgage Forgiveness Debt Relief Act eliminate the tax liability?

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  3. Tim says:

    Where on the original loan documents is it staed whether my loan is non-recourse or recourse?

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  4. Allyson says:

    The lender does not necessarily have to ALWAYS release you completely from all obligations, but all of the cases I’ve heard of, they typically do release you so long as you vacate by your vacate date they give you and abide by the specifics they ask of you, such as leaving the home in broom swept condition and leaving all items attached to the home, such as the stove, dishwasher, ceiling fans, etc…

    A non-recourse loan is one in which the lender releases you from all financial obligations upon the deed-in-lieu, and a recourse loan is one in which the lender does not release you from all obligations. A recourse loan is one in which the lender can seek a deficiency balance from you if your home sells below what you previously owed on your mortgage. The bank will most likely explain to you which type will apply to you with your paper work stating your approval or denial of the deed-in-lieu.

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