Deeds in Lieu of Foreclosure

Introduction

In the traditional sense, a deed in lieu of foreclosure is a specialized instrument designed to transfer property to a lender in satisfaction of a lien on real property and in exchange for a full and complete release. DILs often contain a clause similar to the following:

This Deed is executed and delivered by Grantor and accepted by Grantee in lieu of Grantee demanding and collecting the Indebtedness and in lieu of the necessity for Grantee to give notice of default, notice of intent to accelerate, notice of acceleration, notice of posting for foreclosure, and conduct of a foreclosure sale of the Property.

The customary DIL occurs when both parties expressly consent to the mutual benefits of the arrangement. Morission v. Christie, 266 S.W.3d 89 (Tex.App.—Ft. Worth 2008, no pet.).

DIL Versus Foreclosure

A DIL can be useful for a borrower if it avoids the negative consequences of foreclosure, including: adverse credit impact for seven or more years; the potential for a deficiency lawsuit by the lender; and the prospect that the IRS will deem the deficiency amount to be ordinary income taxable to the borrower. That could be a large number and the borrower must take that amount as ordinary income all in one year (unless the property is homestead). For a real estate investor, the IRS consequences of foreclosure may be the worst aspect of the foreclosure process.

A DIL, unlike a foreclosure, does not wipe out subordinate liens or intervening interests. These remain attached to the property even if the lender accepts a DIL. Flag-Redfern Oil Co. v. Humble Exploration Co., Inc. 744 S.W.2d 6 (Tex. 1987).

Drafting the DIL

A DIL is usually accomplished by means of a special warranty deed, but a deed without warranties may also be used. The instrument should contain specific statements and recitals if it is to have the desired effect. A simple warranty deed to the lender will not do the job. From the borrower’s perspective, the DIL should convey the property “as is” and include the following:

(1) agreement by the lender not to post the property for foreclosure or conduct a foreclosure sale;

(2) agreement that the indebtedness is fully paid, without forgiveness of debt and without deficiency, and the borrower is fully released;

(3) the liens (i.e., the vendor’s lien and the deed of trust lien) are canceled;

(4) the lender waives any claims and causes of action against borrower going forward;

(5) the lender agrees not to take any action that will damage the borrower’s credit; and

(6) the lender agrees not to report to the IRS that the borrower has received income as a consequence of the DIL agreement. Finally (again, in the optimal circumstance) a separate release of lien(s) should also be recorded.

From the lender’s perspective, a DIL should recite that the lender’s acceptance of the instrument does not result in merger of title—i.e., the lender’s lien is not extinguished by the DIL.

Limitations on DILs

Few institutional lenders today will accept a DIL as a means of avoiding foreclosure. The reason is that the foreclosure process itself is usually advantageous to the lender since it cleans up title by eliminating junior liens and intervening interests. A foreclosure also clearly establishes a deficiency amount (the difference between the price at foreclosure and the balance on the note) for which the lender may then sue the borrower.

Lender Rejection of DILs

It is desirable for the borrower to obtain the lienholder’s express acceptance to a DIL, if at all possible. Executing a unilateral DIL runs the risk of lender rejection by means of an affidavit recorded with four years as permitted by Property Code Section 51.006(c).

Query: What happens if a borrower executes a unilateral DIL that recites that it is executed and delivered in satisfaction of the debt, and the lender never files a contradicting affidavit? Can the borrower then argue that there was an implied agreement to waive the deficiency in exchange for the DIL?