When a borrower defaults on a mortgage or deed of trust, or fails to fulfill some other part of the contract, the lender can initiate foreclosure, which is a legal procedure that allows the lender to sell the property used as security to pay off the debt. If the property is sold, any amount of money left over after paying off the loan and the costs of selling are returned to the borrower. Title is transferred to either the lender or to a 3rd party who purchases the property in a foreclosure sale. The property is then free of all liens, including junior liens on the property.
Types of Foreclosure
There are 3 methods of foreclosure. Which method is available depends upon the contract and the state.
A judicial foreclosure is a sale approved by the court, and is used when a mortgage is the underlying debt instrument for the property. The holder of the mortgage, called the mortgagee, gives notice to the borrower, called the mortgagor, who also has the title of the property, of the deficiency, or other breach of contract. If the borrower does not respond satisfactorily, then the lender will accelerate the loan, which entitles the lender to the full amount of the loan plus costs immediately. If the borrower fails to pay the accelerated amount, then the lender goes to court to get approval for the sale of the property, then advertises the sale in local media, so that it can be sold in an auction.
Some states use a dead of trust as a way to protect the lender of money for property, instead of a mortgage. In this case, the title is held by a 3rd party—the trustee. The deed of trust has a power-of-sale-clause, that allows the sale of the property without going to court in the event of a default. Statutory foreclosure is carried out according to state law and the contract for the purchase of the property. Generally, if the borrower defaults, then the lender notifies the trustee of the default. The trustee may have to record a notice of default at the county recorder’s office as a way to give notice to the public about the impending auction. The auction is also advertised in the local media, listing, among other things, the total amount due on the property.
After the property is sold, an affidavit of foreclosure may have to be filed.
In some states, a lender may get title to the foreclosed property without any sale through strict foreclosure. When the borrower defaults, the lender asks the court to order the borrower to pay off the loan. The court sets a specific date by which the borrower must comply. If the borrower fails to pay, then the court simply awards full title of the property to the lender.
If the foreclosure sale does not pay off the loan, including accrued interest and costs of sale, then the lender may also get a deficiency judgment for the difference. A deficiency judgment can also be obtained against any guarantors of the debt, or against any owners who assumed the debt by contract.
However, any amount above the loan amount plus costs is returned to the borrower.
Deed in Lieu of Foreclosure
A borrower may be able to prevent foreclosure by simply giving the lender the title of the property. If the lender accepts, the borrower can transfer the title to the lender, eliminating the need of foreclosure—thus, it is called a deed in lieu of foreclosure (aka friendly foreclosure, deed-in-lieu), because it is agreed to by the lender and borrower. The borrower is released from the debt and does not have to worry about a deficiency judgment. Another advantage to the borrower is that a deed in lieu of foreclosure is less damaging to his credit score than a regular foreclosure. The advantages to the lender are the savings in the time and expense of a foreclosure, and the lender is more likely to receive the property in better condition.
While expedient, a deed in lieu of foreclosure has disadvantages for both borrower and lender. The main disadvantage for the borrower is that it is listed as a negative item in his credit report. The main disadvantage to the lender is that the property still has all junior liens attached, whereas in a regular foreclosure, all junior liens are eliminated. The lender will also lose any rights under FHA and VA guarantees, and will not receive any payment from any mortgage insurance that the borrower may have had.
A borrower may still be able to keep his property after a default through the process of redemption.
Most states give the borrower an equitable right of redemption, which must occur before the foreclosure sale. If the borrower pays all arrearages plus costs, then the loan will be reinstated. In some states, however, the borrower may have to pay the entire accelerated amount. If the entire amount is due and the borrower is unable to pay it, then another person may redeem the property, in which case, the borrower becomes liable to the redeemer of the property.
A few states allow the borrower to redeem the property after the foreclosure sale within a certain time, usually no more than 1 year following the sale. A court will generally appoint a receiver to manage the property until the redemption period ends. This statutory right of redemption gives the borrower clear title by paying the court for the amount of the debt before the statutory redemption period ends.
Title Conveyance in a Foreclosure Sale
If the borrow cannot or does not redeem the property, then the deed is conveyed to the highest bidder of the property by the sheriff or master-in-chancery free of liens. However, the deed has no warranties, and conveys whatever title the borrower had.
Mortgage Debt Forgiveness Act of 2007
A new law has been passed that for any renegotiated mortgage or for a foreclosure, any forgiven debt will not be taxable. The law applies to transactions that take place from January 1, 2007 to December 31, 2009. This law applies only to recourse loans—there is no forgiven debt for nonrecourse loans, because the lender must settle for what the property sells for, and cannot go after the borrower for any deficiency.
However, any forgiven debt, also known as cancellation of debt income, will reduce the homeowner’s basis in the property, which will add to any gain by the amount that is forgiven, when the home is sold. The borrower will still have to pay taxes on this capital gain, but it will be at the lower capital gains rate of 5% or 15%, depending on the borrower’s income rather than the usually higher ordinary tax rate on ordinary income that applied to cancelled debt.
There are some limitations to the tax forgiveness. There is a $2 million dollar limit of COD income that can be forgiven, and the law applies only to a principal residence—not vacation homes or investment properties. The exclusion also does not apply if the homeowner refinanced the mortgage, but the money was not used to improve the property.
Taxes on a Foreclosure
Although a homeowner does not receive any money when a lender forecloses on the home, the IRS still treats it as a sale for tax purposes, and the homeowner must pay a capital gains tax on this so-called phantom income, if the sale price is greater than the homeowner's basis in the property. However, if the homeowner lived at least 2 years in the previous 5 years in the home, then he will be eligible for the home sale exclusion rule that exempts the 1st $250,000 of gains ($500,000 for a joint filers) from taxes, which also applies to the phantom income of a foreclosure. A borrower can also avoid paying taxes on the gain if he is insolvent—unable to pay his bills, which generally applies to most people whose homes are foreclosed.
Example—Taxes on a Nonrecourse and Recourse Mortgage
A borrower has a mortgage of $120,000, an adjusted basis in the property of $40,000, and an income that qualifies him for the 5% capital gains rate. Later, on January 3, 2007, the property is foreclosed by the lender. The fair market value of the home is $100,000.
Scenario 1 - Nonrecourse Loan
The lender sells the property for $100,000. Because it is a nonrecourse loan, the lender is only entitled to the sale price. The lender has no legal right to get the deficiency of $20,000 from the borrower. But the borrower must pay a capital gains tax of 5% on the $60,000 profit—the difference between the fair market value of the home and the borrower's basis—which equals $3,000, even though the borrower does not receive any of the money.
Scenario 2 - Recourse Loan
With a recourse loan, the lender is entitled to the $20,000 deficiency from the borrower, but decides to forgive the debt, since the borrower has no assets to pay off the deficiency. Previously, the borrower would have had to pay ordinary income tax on this cancellation of debt income of $20,000 in addition to the capital gains of the foreclosure, even though the borrower does not receive any of the income. With the Mortgage Debt Forgiveness Act, he won't have to pay any tax on the forgiven $20,000 debt, but will still have to pay the capital gains tax on the $60,000 of phantom income.
Scenario 3 - Insolvency and the Home Sale Exclusion Rule
If the borrower can show that he was insolvent—unable to pay his bills—or that he lived in the home as his principal residence for at least 2 of the previous 5 years, then he will not owe taxes on the capital gain, even in a foreclosure, and whether the loan was a recourse or nonrecourse loan. Note that, without the Mortgage Debt Forgiveness Act, taxes would apply to any forgiven debt, even when the capital gains would be excluded by the Home Sale Exclusion Rule. However, the borrower could still avoid paying the tax if he can show that he is insolvent.
How Foreclosure Affects Credit Scores
According to this article at MyFICO.com, which is maintained by Fair Isaacs Company, the same company that developed the algorithm for calculating the FICO credit score which is used by most lenders, the following negative credit events will lower scores by the following amounts (format: initial credit score > score range after negative credit event):
- Settling a mortgage for a reduced amount:
- 680 > 615 - 635
- 780 > 655 - 675
- 680 > 575 - 595
- 780 > 620 - 640
- 680 > 530 - 550
- 780 > 540 - 560
Note that the higher your credit score was initially, the more it will fall after a negative credit event. What the actual resulting score will be will depend on the rest of the information in your credit report.
- Foreclosure stripping. Many owners of properties being foreclosed, especially in Arizona, Florida, and the Las Vegas area, have stripped their properties of fixtures, such as kitchen cabinets and whirlpools and even carpeting, to sell on Craigslist before the foreclosure. Source: Nice Home. Where’s the Rest of It?
- Foreclosure stripping is currently only a criminal offense in Arizona, but it is rarely prosecuted because of the difficulty of proving that the previous owner of the property stripped it, since many foreclosed properties are abandoned and may have been stripped by non-owners, either to use in their own residence or to sell on Craigslist.
- In other states, such as Nevada, stripping by the owner is not a criminal offense, so only civil remedies are available to the owner of the foreclosed property. Although banks can sue for civil damages, it is usually not worth the cost.
- A FICO score can drop by as much as 160 points on a foreclosure. Source: Debtor's Dilemma: Pay the Mortgage or Walk Away
Banks Walking Away from Some Foreclosures
Banks are starting to walk away from foreclosures rather than taking possession of low-end properties because the costs of legal fees, repair and maintenance exceeds the value of the property. Oftentimes, when a property sits unoccupied for awhile, vandals do more damage to the property, thereby lowering its value even more. Many municipalities are making the original owners liable for the property, who usually don't know that their bank had canceled the foreclosure process or simply failed to schedule a sheriff's sale until months afterward. Because the original homeowners have already abandoned the properties, and usually don't have the money to maintain the property anyway, some cities have tried to hold the mortgage holders liable, but it is often difficult to find the mortgage holders, since the mortgages were securitized and sold to investors. Nonetheless, the city of Buffalo, New York, for instance, had sued 37 banks in 2008 in an attempt to hold them liable for the property's deterioration.
Source: In Homeowners’ Latest Woe, Banks Are Skipping Foreclosures - NYTimes.com
Related LinksForeclosure and Bankruptcy - This article explains how bankruptcy affects foreclosure.
Taxation of Canceled Debt - Taxes may be due on the canceled debt in a foreclosure. This article explains what is taxable, and how to avoid it.
- HOMFDEF: Home Foreclosures D Summary - Bloomberg - Provides graphs of the foreclosure rate over various selected periods.
- Research looks at how mortgage delinquencies affect scores - Banking Analytics Blog - This blog entry, posted on FICO's website, shows the impact of late payments on mortgages for 3 typical borrowers with initial credit score of 680, 720, and 780. It also points out that a short sale, deed in lieu of foreclosure or other settlement, or a foreclosure will have the same impact on one's credit score, lowering the credit score to around 605 to 675. However, if there was a deficiency balance, then the credit score can drop as low as 570. The post also lists the amount of time it will take to recover to the previous score, where an initial 680 score will take 9 months to recover after being either 30 days or 90 days late on a mortgage payment, whereas someone with an initial score of 780 will take 3 years to recover after a 30-day late payment and 7 years to recover after a 90-day late payment, which is the length of time that the credit event can be listed in the credit reports on which the score is based. Bankruptcy lowers the credit score to about 525 to 560 for all borrowers. However, a 680 score can recover in about 5 years, while the 720 and 780 scores will take 7 years to recover, while a chapter 7 bankrupt will take 10 years to recover, which is the amount of time that the bankruptcy can be listed on the credit report. The time it takes to recover from a short sale, deed in lieu of foreclosure, or a foreclosure is the same as it is for a bankruptcy.
- Banks Ignored Signs of Trouble in Foreclosures - NYTimes.com
- Foreclosures Slow as Document Flaws Emerge - NYTimes.com (10/1/2010)
- Avoid foreclosure and get the help you need : Fannie Mae
- Walking Away From Million-Dollar Mortgages - NYTimes.com - According to this article, 1 out 7 homeowners with mortgages over $1,000,000 are walking away from their mortgages compared to 1 of 12 who do so with a mortgage of less than a million.
- For Some Homeowners in Foreclosure, a Rent-Free Approach - NYTimes.com - Because it takes more than 250 days to evict homeowners who have simply stopped paying their mortgage, the homeowners can save money for a new start or to simply survive during the lengthy foreclosure process. Legal challenges and the mounting number of foreclosures have lengthened the average time to eviction to 438 days, especially for states that allow only a judicial foreclosure proceeding.
- Articles about the government's new Home Affordable Foreclosure Alternatives (HAFA) program that facilitates short sales and deeds in lieu of foreclosure. The program starts on April 5, 2010 and ends on December 31, 2012.
- Before You Walk Away From Your Mortgage, Read This - WSJ.com - 8 things to consider before deciding on a strategic default or foreclosure.
- Return of the Predators - If you are having trouble paying your mortgage, avoid loan modification companies, which usually charge large upfront fees and may not even be able to modify your loan. Either use a reputable credit counselor, many of which are available for free, or deal with the lender yourself.
- Mortgages - Another Foreclosure Alternative - NYTimes.com - An article about deeds in lieu of foreclosure.
- Mortgages - Even High-Score Borrowers at Risk of Mortgage Default - NYTimes.com
- Economic View - Will More Borrowers Walk Away From Their Mortgages? - NYTimes.com - An article about strategic defaults, where borrowers simply walk away from their mortgages because their property is worth less than the remaining debt, simply because it is financially prudent to do so, especially in those states, such as Arizona and California, where the mortgages are nonrecourse loans.
- After Foreclosure, a Big Tax Bill From the I.R.S.