With a Deed In Lieu Of Foreclosure, aka cash for keys, you give your home to the lender (the "deed") in exchange for the lender canceling the loan. This is called deeding the home back to the lender.
The homeowner gives the lender a properly prepared and notarized deed, and the lender forgives the mortgage, effectively canceling any foreclosure action. In order for the Deed-in-Lieu of Foreclosure to work, you must provide a marketable title, free and clear of other mortgages, liens, or other encumbrances.
This legal transaction starts after a homeowner has fallen behind on his loan payments and is in foreclosure. Even if the foreclosure has not commenced, the lender can be approached and asked if they will accept a "deed in lieu of" continuing into the foreclosure process. Sometimes lenders require a homeowner to be behind on his/her payments before they will consider accepting the deed, usually 90 days in judicial foreclosure states and 30 days in non-judicial states.
Before the lender will accept a deed in lieu of foreclosure, it will probably require you to put your home on the market for a period of time (three months is typical). Banks would rather have you sell the house than have to sell it themselves. Just as with a short sale, you must negotiate with your lender to agree to agree forgive any deficiency (the amount of the loan that isn't covered by the sale proceeds) that remains after the house is sold or you can be held liable for the difference.
Benefits To A Deed In Lieu
Many believe that a deed in lieu of foreclosure looks better on your credit report than does a foreclosure or bankruptcy. In addition, unlike in the short sale situation, you do not necessarily have to take responsibility for selling your house (you may end up simply handing over title and then letting the lender sell the house).
Disadvantages To A Deed In Lieu
You probably cannot get a deed in lieu if you have second or third mortgages, home equity loans, or tax liens against your property.
In addition, getting a lender to accept a deed in lieu of foreclosure is difficult these days. Many lenders want cash, not real estate -- especially if they own hundreds of other foreclosed properties. On the other hand, the bank might think it better to accept a deed in lieu rather than incur foreclosure expenses.
Beware Of Tax Consequences
As with short sales, a deed in lieu may generate unwelcome taxable income based on the amount of your "forgiven debt." . The IRS may consider the difference between the value at which you deed your home to the bank and the mortgage balance as "income" on which you have to pay taxes if your lender forgives the debt. Money you'll have to come up with the cash to cover the taxes.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. However, there are specific qualifications that you have to meet. For example only, this provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately.)
Another possible tax exception is if you can prove that you were "insolvent" - that your debts were bigger than your assets- before your mortgage lender agreed to a short sale of your property. Only a tax professional will truly know if you are insolvent by IRS standards.
Regardless of the above, you may still have to report debt relief on your state return only a tax professional can advise you.