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Mortgage Assistance for a Property that is "Under Water"

One expression that emerged after the real estate market collapsed in 2008 is "strategic default" or "strategic walkout".  Some property owners, faced with a house that has plummeted in value to a point below the balance of the mortgage, simply abandon the property even though some of them can afford the monthly payment.  They think that by giving the property back to the bank and walking away, they are off the hook.  There has been a lot of discussion in the media about the morality of such practices, but few address its legal ramifications.

Most property owners remember signing a stack of legal documents at the closing for the purchase or refinancing of the property.  Two of the most important documents are a note and a mortgage.  The note says the borrower is personally liable for the loan that was extended for the purchase/refinance of the property.  A borrow who defaults on this note can be sued in court and a monetary judgment can be awarded by the court.  This can result in wages being garnished, banks accounts being frozen and/or seizure of other assets in satisfaction of the debt.

The mortgage says that the loan the bank extends for the purchase/refinance o the property is secured by the property.  In other words, the property serves as the collateral for the loan.  If the borrower does not pay the loan, the lender can foreclose on the property in an effort to collect the money owed to them.  Most foreclosure sales are short sales, meaning that the sale proceeds are insufficient to pay off the note.  After they sell the property in foreclosure, the bank can pursue the borrower for the balance owed on the loan, or the deficiency balance.  A borrower cannot avoid personal liability on the note by simply giving the property back to the lender and walking away.

There are several ways to effectively deal with mortgage debt on a property that is underwater:

Deed in lieu of foreclosure:  This is a procedure by which a property owner transfers the property to the lender by mutual consent, typically in exchange for the lender writing off the balance owed.  While it may be a relatively gracious way of getting out of a bad housing B deal, there are several things that a borrower should keep in mind.  First, the lender is not required to accept a deed in lieu of foreclosure and they often will not.  Second, the lender is not likely to accept a deed in lieu of foreclosure if there is a second mortgage on the property.  Third, if the property is not the borrower's residence, there are often severe tax implications that result from the lender writing off the debt.

Short Sale:  In a short sale, the property owner sells the property for less than what is owed with the consent of the lender, who will often agree to write off the difference (the deficiency).  Again, the lender is not required to accept a short sale, nor are they required to write off the deficiency.  Additionally, if the property is not the borrower's residence, the deficiency that is written off could be considered as taxable "debt forgiveness" income by the IRS and result in severe tax implications.

Bankruptcy:  Bankruptcy is a proceeding governed by federal law where the debt owed by an individual or business is either legally forgiven, or discharged, or adjusted.  There are several types of bankruptcy, the most common being Chapter 7 Liquidation.  A Chapter 7 allows the person filing for bankruptcy protection, called the debtor, to keep some assets while wiping out most debts.  This includes the personal liability on the note, so the debtor can surrender the property in foreclosure without worrying about the lender pursuing a deficiency against them.  Additionally, bankruptcy is a non-taxable event, so there are not the severe tax implications of the other options.  The lender will still take the property through foreclosure, but the debtor is free of the note.

If you have a property that is underwater and you are considering walking away from it, be sure to consult with an experienced bankruptcy and consumer rights attorney before taking any action.  You will have options, but the consequences of choosing the wrong option are significant, so you need to seek good counsel in order to choose wisely.

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