Mortgaged homeowners who are struggling with their mortgage payments may decide to abandon their home to the bank. Known as foreclosure abandonment, the action involves walking away from the home before the lender legally forecloses it through a foreclosure sale. Abandonment is risky, as the lender may not foreclose on the home, leaving the homeowner liable for the mortgage payment, utility bills and other expenses related to the property even though he no longer lives there.
Foreclosure Abandonment Basics
Homeowners who owe more on their mortgage than their home is worth sometimes cannot sell their home or renegotiate or modify the terms of their mortgage. In this scenario, homeowners in financial difficulty may choose to avoid the financial loss of paying down a mortgage that exceeds their home value by simply abandoning the home and allowing the bank to foreclose. Foreclosure abandonment is sometimes called strategic default because it's a choice to default that is motivated by financial strategy rather than the inability to pay.
Risks for the Homeowner
Under the mortgage contract, the borrower agrees to pay back the loan with interest and offers the deed of his house as collateral to secure the loan. A lender may pursue in court any homeowner who fails to uphold his end of the bargain. The homeowner is also responsible for all expenses related to the property including taxes, insurance and utilities. Regardless of whether the homeowner lives at the property, he is still responsible for the mortgage costs and the property expenses until the new property owner or the bank gets back the title at a foreclosure sale. If the bank chooses not to foreclose, the borrower may be on the hook for significant expenses related to a property that he believes he has abandoned.
State laws often establish additional rules for foreclosure abandonment. In some states, like California and Arizona, it is legal for a homeowner to abandon a foreclosure without recourse or the threat of their lender pursuing them for the entirety of their loan. These state laws protect homeowners from some of the potential legal consequences of abandonment. This doesn't mean, though, that a strategic default is without consequences even in these non-recourse states. Defaulting homeowners will still take a huge hit on their credit rating and may find themselves denied for future loans.
Tax Law Consequences
Other regulations governing foreclosure abandonment are tax-related. In some cases, there are serious tax consequences to abandoning a home loan obligation. The IRS considers an abandoned debt obligation that exceeds home value to be a type of income. In other words, if the abandonment and subsequent foreclosure result in some or all of the outstanding debt being written off, you pay income tax on the forgiven amount in some cases. Note that this rule usually does not apply in the case of non-recourse loans, according to the IRS.