Deed in Lieu of Foreclosure

The “deed in lieu of foreclosure” is the foreclosure alternative in which the property owner turns over the property to the lender and avoids the formal foreclosure process. As in a true short sale, the borrower’s goal in a “deed in lieu” resolution is to avoid liability for the deficiency that results if the property is worth less than what the borrower owes on the debt. The general idea is that the borrower saves the lender the expense of foreclosing by giving the lender the deed to property. In exchange the lender waives the deficiency.

Most lenders in the states where I practice law, Connecticut and New York, require the borrower to list the property for sale for a certain time period (usually at least 90 days) before they will consider a taking a deed in lieu of foreclosing. Whether the lender actually accepts the deed, or waives the deficiency, after the time period expires is an open question. I have not been involved with any deed in lieu transaction in Connecticut or New York nor have I heard of any completed deed in lieu transaction in Connecticut or New York. I think this is largely for three reasons. First, the bank would much prefer that the borrower sell the property rather than the bank have to add the property to its inventory of unsold, “bank-owned” properties. The bank has carrying costs on the properties it owns and there is no reason to increase those costs in a terrible real estate market. Plus, real estate agents will tell you that it is generally easier to sell a property that is occupied than it is to sell a property that is vacant. If the bank takes the deed, the property will be vacant.

Second, Connecticut and New York are judicial foreclosure states. By the time the borrower starts considering a deed in lieu in transaction, the bank has already commenced the foreclosure lawsuit. For residential foreclosures, the parties will spend time in Connecticut’s Foreclosure Mediation program or New York’s Foreclosure Settlement Conference program trying to agree to a mortgage modification. If the programs fail to achieve a modification, most banks believe completing the foreclosure is a foregone conclusion. The bank has less incentive to consider a deed in lieu because it has already initiated and, in its view, can expeditiously complete, the foreclosure without having to waive the deficiency. Contrast this with a nonjudicial foreclosure state where a deed in lieu can avoid commencement of the foreclosure process.

Finally, banks don’t like to waive deficiencies. In a judicial foreclosure state, where the foreclosure lawsuit has already commenced, the borrower gets no real benefit from a deed in lieu if the bank will not waive the deficiency. This is essentially the flip-side of the bank’s viewpoint discussed above: the bank has little incentive to consider a deed in lieu when the foreclosure action is pending and neither does the borrower.

That being said, if a borrower is resigned to losing the property, it cannot hurt to explore the deed in lieu possibility with the bank. At the least, it might provide the borrower with some flexibility in vacating the property.