How to Deal With an Underwater Mortgage During Divorce

Going through a divorce is chaotic enough, but throw in a house with an underwater mortgage and things get particularly messy. Unfortunately, considering that about half of all marriages in the country end in a split, and over 20 percent of homes are currently underwater, this is a problem that rears its ugly head all too often.

So when it’s time for an unhappy couple to divide up property, possessions (maybe even kids) and go their separate ways, there are a few options for handling this complicated situation — however, like divorce, none of them are exactly simple or pleasant.

Why an Underwater Mortgage Is a Problem in Divorce

Generally, when a married couple divorces, assets are split among the two according to the divorce agreement. In the event the couple’s home is worth more than the price at which it was purchased — in what used to be a common scenario — any positive equity gained is included in the total value of the home. At the time of the split, the home is either sold and each spouse takes an equal share of the proceeds, or one spouse keeps the property with the positive equity counting toward his total share of assets.

However, in the case of an underwater mortgage, the home is worth less than the balance on the mortgage loan. This difference between a home’s original purchase price and its present value in called negative equity, and can be very tricky to address when it comes time to divvy assets. Who becomes responsible for this debt, and how can a couple ensure assets are split fairly despite it?

3 Ways to Handle an Underwater Mortgage During Divorce

Credit for Negative Equity

One option for dealing with an underwater mortgage in the midst of divorce is to provide a “credit” to the spouse who keeps the home. The drop in value between the purchase price and current home value is compensated for by providing that spouse a bigger portion of another asset.

For example, imagine a couple’s joint assets total $500,000, including a home worth $250,000. In a normal scenario, one spouse might keep the home while the other takes the remaining $250,000 as part of the divorce settlement. This would be an equal 50-50 split.

However, say the couple’s home is underwater by $50,000 (the mortgage balance is $300,000). Whomever keeps the home would be granted an additional $50,000 to compensate for that negative equity, and the other person would walk away with $200,000.

It makes sense on the surface, but this solution does present the possibility for an uneven distribution of assets. Home values are depressed now, but are certain to improve at some point in the future. If the home in question is to undergo a short sale or foreclosure, it makes sense to provide the homeowner a credit for the negative equity because there will be no opportunity to recoup the loss.

However, if the spouse who ends up with the home plans to keep it long term, it is likely to regain some, if not all, of the value lost over time. That means the homeowner will essentially double their money if they receive a credit while the home is underwater and then sell the property once values recover.

Zero It Out

In some cases, rather than make up for the property debt by allocating a larger portion of another asset to the spouse who chooses to keep the home, a divorce lawyer will simply “zero out” the debt instead. That means the negative equity is not considered when assets are split, and the person with the home is granted face value.

This is often a better option if one spouse decides to keep the home as a long-term investment and anticipates a lift in value down the line.

Zeroing out the debt is not always a possibility, however, depending on the state in which you’re getting divorced. Some states require that all assets and liabilities be divided at the time of the divorce, which includes negative equity.

Short Sale

Finally, if neither spouse can afford to handle the home on his own, one of the less desirable options for dealing with an underwater mortgage is to sell the property at a loss. This is known as a short sale, and is only possible if the homeowner is financially incapable of keeping current on mortgage payments and receives approval from the lender.

It’s important to note that a short sale can help you, your spouse and your lender avoid the lengthy headache of a foreclosure, but it can still be detrimental to your finances in several ways.

In addition to receiving less for the home than what was originally paid, which could amount to a loss of tens of thousands of dollars or more, a short sale also damages credit. This can make it difficult to acquire new loans and favorable interest rates in the future.

Additionally, your lender might still hold the mortgage holder responsible for the remaining balance on the loan. If you do decide to go through with a short sale, be sure the conditions of the agreement are crystal clear and the negative equity will not become you or your spouse’s responsibility following the sale.

Finally, a short sale might result in unexpected — and potentially significant — tax consequences.

If you’re going through a divorce and have an underwater mortgage to deal with, the number of options available to you might be dependent on your state’s divorce laws. Being aware of the options for dealing with an underwater mortgage during divorce can help you determine the best course of action, but it’s imperative you bring in a legal or financial professional to guide you through the process.

Photo source: Christmas Junkie