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July 2010- Several years ago, a “deed in lieu of foreclosure" (deed-in-lieu) was a common way for financially strapped borrowers to convey their real property interest to their lender without having to go through a foreclosure or trustee sale. The deed-in-lieu offered benefits to both parties: For the lender, it was quicker and cheaper than foreclosure; for the borrower, it often inflicted less damage to his or her credit rating and generally waived any deficiency.
Eventually, however, lenders largely abandoned the deed-in-lieu option, due prominently to the risk to the lender resulting from the doctrine of “merger of title." The merger doctrine essentially holds that a “lesser title" merges into the “greater title"; upon a transfer of ownership interest to the lender via a deed-in-lieu:
the lender’s secured interest merges up into its title ownership interest;
the lender’s secured interest is dissolved; and
any junior liens - such as IRS liens, judgment liens or mechanics’ liens - move up in priority while still encumbering the property, offering these lien holders equity against which to foreclose.
In contrast, a formal foreclosure or trustee sale wipes out any junior liens against the property, and the trustee’s deed conveys free of those liens. Clearly, this scenario is far more advantageous to the lender.
Statutory developments have made deeds-in-lieu less attractive to borrowers as well. The use of a deed-in-lieu potentially eliminates anti-deficiency protection under A.R.S. § 33-814, which requires the conducting of a trustee sale in order to be effective.
Comeback. Notwithstanding these impediments, deeds-in-lieu seem to be making a resurgence among some lenders, under certain circumstances. On June 27, 2010, the Los Angeles Times reported that Bank of America had mailed out 100,000 deed-in-lieu solicitations in the previous 60 days, and that other lenders were receiving positive borrower responses to similar solicitations.
Whether a deed-in-lieu is a favorable option varies from one situation to the next. Any borrower considering a deed in lieu of foreclosure should thoroughly review all relevant documentation associated with the loan and the lender’s offer, and they should carefully consider the legal concepts at work as described above.
Even if a deed-in-lieu appears to be a sound legal option, financial considerations – such as the cost of lender-required title insurance and reports – should be factored into the decision as well. (Lenders would insist on title reports and title insurance to protect them against potential liens.) Responsibility for any such costs should be fully disclosed and understood before conveying.
Finally, borrowers should be certain that any potential deficiency is waived or released in writing by the lender. Even with a written waiver/release, there is still the potential for the lender to issue a Form 1099 to the IRS. This could lead to tax liability stemming from cancellation-of-debt income, depending on numerous factors that require analysis outside the scope of this article.