Declining property values and the travel and business shut-downs during the pandemic have played havoc with the balance sheets of many real estate investors.
When faced with red ink, some individuals opt to liquidate their assets, while others prefer to negotiate with their creditors. One way to negotiate a debt obligation is with a workout agreement.
A workout agreement (also called a settlement agreement) is a contract made between you and a creditor that allows you to “work out” or renegotiate the terms of a loan. A real estate workout is not a repayment of a real estate secured loan nor a resolution achieved by way of a foreclosure. Instead, it is a negotiated settlement that establishes a new agreement between the two parties.
This article will explain the benefits of a workout agreement and what you need to know before entering into one.
The idea behind a workout agreement is that it should be mutually beneficial to both parties. A borrower who is in default avoids foreclosure, and a lender gains a greater chance of recouping the loan principal and interest without having to foreclose. The lender also avoids the expenses of any debt recovery efforts.
Not every lender will agree to a workout agreement, and those who do can vary widely in the terms they accept. Typical workout agreements involve extending the terms of the loan or rescheduling the payments.
The right solution depends on the following factors:
Workout agreements can be used for any type of loan, with the exception of government-backed student loans. Here are some of the different types of real estate workout agreements.
Modification – Changing the terms of an existing mortgage (usually temporarily).
Deed change – Granting the deed to the creditor instead of a foreclosure
“Friendly” foreclosure – Selling the property back to the debtor (or another party) with a clean title after foreclosure.
Short sale –Selling the property to a third party in exchange for debt forgiveness.
Short refinance – Refinancing the property for a loan amount less than the original amount.
Repayment plan – Making a down-payment on the balance and promising to pay the balance over time.
Repurchase after foreclosure – Buying back the property after foreclosure.
Forbearance –Discontinuing legal action in exchange for the borrower’s promise to take action (such as listing the property with a real estate agent).
Conversion – Changing an amortizing loan to an interest-only loan
Both the borrower and the lender should carefully consider the terms of the agreement before signing a new loan document. Here are some factors to consider:
Notification – The borrower should give the lender as much advance notice as possible of an inability to meet debt obligations. Most of the time, lenders are more likely to agree to a workout agreement if they have been notified of a possible default on the loan. Giving advance notice shows that the borrower is someone the lender can trust.
Honesty – A lender is not obligated to amend the terms of a loan, so the borrower helps their case by being as flexible as possible in accepting terms set by the lender. However, it is in the lender’s best interest to help the borrower as much as possible.
Tax implications – Although a workout agreement won’t damage a borrower’s credit score as much as a foreclosure, it will have a negative impact. Also, the IRS views any loan reduction or loan cancellation as taxable income. That means the borrower could end up owing more taxes for the year the workout agreement is signed.
Due diligence – Both parties must perform due diligence on issues surrounding the troubled loan. A pre-workout agreement is an important step for discussing specific problems with the loan, the goals of a workout agreement, and the terms of the contract.
When a loan is in arrears, it’s a bad situation for both the borrower and the lender. Just as both parties have something to lose in a foreclosure, both have something to gain with a workout agreement. Working together on a mutually beneficial solution beats the alternative every time.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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