What Happens to a Marital Home with Negative Equity During Divorce?

What Negative Equity Means

Negative equity—sometimes called being "underwater" or "upside down"—occurs when the outstanding mortgage balance is greater than the current fair market value of the home. For example, if you owe $425,000 on your mortgage but the home is worth $390,000, you have negative equity of $35,000.

This situation can arise from:

• Declining home values in a softening or distressed market
• A recent purchase with a small down payment or high loan-to-value ratio
• Taking cash-out refinances or home equity loans that increased the mortgage balance
• Deferred maintenance or damage that reduced the home's market appeal
• Market timing, economic downturns, or neighborhood changes

Negative equity is not the same as low equity. Low equity means there is some value but not much. Negative equity means there is no cash available at closing—and in fact, the sellers would need to bring money to the table to satisfy the mortgage and close the sale.

Why Negative Equity Complicates Divorce

Divorce typically involves dividing assets and debts. A home with positive equity is an asset. A home with negative equity is effectively a debt—or at minimum, a shared liability with no immediate value to distribute.

Key complications include:

• No buyout is possible. One spouse cannot buy out the other's interest when there is no equity. Any payment between spouses would need to be part of a negotiated settlement unrelated to actual property value.
• Both remain liable. Until the mortgage is paid off, assumed by one party with lender consent, or the property is sold, both borrowers remain contractually obligated to the lender regardless of what the divorce decree says.
• Neither can refinance alone. Refinancing requires equity or the ability to bring cash to closing. If neither spouse qualifies or has the funds, removing one spouse from the mortgage is not feasible.
• Neither may want to keep it. Keeping a home with negative equity means accepting ongoing mortgage payments, maintenance, taxes, and insurance on a property worth less than what is owed.
• Selling may require cash. If the property must be sold, the spouses may need to bring money to closing to cover the shortfall between sale proceeds and the payoff amount, plus closing costs.

What Are Your Options?

Continue Joint Ownership Temporarily

Some couples agree to delay the sale and remain joint owners and joint borrowers until market conditions improve or equity is restored through principal paydown. This requires:

• Clear agreement on who lives in the home, if anyone
• Division of mortgage, tax, insurance, maintenance, and HOA responsibilities
• A plan for monitoring value and revisiting the sale decision
• Legal protections if one spouse stops contributing
• Understanding that both credit reports remain affected by payment history

This is rarely ideal, but it may be the least costly option in the short term.

One Spouse Keeps the Home and Assumes Full Responsibility

One spouse may agree to keep the home, continue making all payments, and accept responsibility for the mortgage—even though they cannot refinance. The other spouse is removed from the deed (quitclaim) but remains on the mortgage unless the lender agrees to release them.

This arrangement should include:

• Legal language clarifying responsibility and indemnification
• Clear consequences if the responsible spouse defaults
• Possible security (such as life insurance or a lien) protecting the non-occupant spouse
• Acknowledgment that the non-occupant spouse's credit and borrowing capacity remain affected
• A timeline or trigger for refinance or sale once equity is restored

Coordination with your attorney is essential. The non-occupant spouse should understand they remain at risk if payments are missed.

Pursue a Short Sale

A short sale allows the home to be sold for less than the mortgage balance, with the lender agreeing to accept the proceeds as full or partial satisfaction of the debt. Short sales require:

• Lender approval, which can be a lengthy process
• Demonstration of financial hardship
• Professional representation by a realtor experienced in short sales
• Coordination with the lender's loss mitigation or workout department
• Possible deficiency liability (the lender may pursue the borrowers for the unpaid balance)
• Tax consequences if forgiven debt is treated as taxable income (consult a CPA)
• Negative impact on both spouses' credit scores

Short sales can take months to negotiate and close. They are not guaranteed.

Request a Deed-in-Lieu of Foreclosure

In some cases, the lender may accept the property back in exchange for releasing the mortgage debt. This is called a deed-in-lieu. It is generally less damaging to credit than foreclosure, but:

• The lender must agree
• There can be no junior liens
• Deficiency and tax liability may still apply
• Both borrowers' credit will be negatively affected
• It is not a common or preferred solution in divorce

This is typically considered only when no other option is viable.

Let the Property Go to Foreclosure

This is the last resort and carries the most significant consequences:

• Severe damage to both spouses' credit
• Possible deficiency judgment allowing the lender to pursue both borrowers for the unpaid debt
• Potential tax liability on forgiven debt
• Legal and emotional costs
• Difficulty obtaining future mortgage financing

Foreclosure should be avoided whenever possible. Speak with your attorney about alternatives and protections.

What About Deficiency Liability and Taxes?

New Jersey is a recourse state in most situations, meaning lenders may pursue borrowers for deficiency balances after a short sale or foreclosure. Whether and how aggressively lenders pursue deficiencies varies. Your attorney can explain your rights and risks.

If a lender forgives part of the debt, the IRS may treat the forgiven amount as taxable income unless an exclusion applies. Some exclusions, such as the Mortgage Forgiveness Debt Relief Act, have expired or been limited. Consult a CPA before finalizing any short sale, deed-in-lieu, or settlement involving forgiven mortgage debt.

How Should Negative Equity Affect the Overall Settlement?

Negative equity is a shared marital liability. If one spouse agrees to remain fully responsible for the property and mortgage, that responsibility should be considered in the overall division of assets and debts.

For example:

• The spouse assuming the underwater home may receive a larger share of other marital assets
• The other spouse may assume a greater share of other marital debts
• Alimony or support terms may be adjusted to reflect the ongoing burden

Your attorney and financial advisor should work together to ensure the settlement reflects both the legal assignment of responsibility and the practical financial reality.

Who Should Be Involved?

Negative equity cases require careful coordination:

• Attorney: To draft enforceable settlement language, explain liability, and protect your rights
• Real estate professional: To provide a current market analysis, discuss timing, and evaluate short sale feasibility if applicable
• Mortgage professional: To assess refinance potential, explain loan terms, and clarify lender requirements and release options
• Financial advisor or CDFA®: To model cash flow, evaluate settlement options, and help assess long-term affordability and risk
• CPA or tax professional: To analyze tax consequences of forgiven debt, loss deductions, and settlement structures

Do not attempt to navigate negative equity and divorce without professional guidance. The decisions you make now affect your credit, finances, legal liability, and future housing options.

Is Waiting Always the Right Answer?

Waiting for the market to recover may be prudent, but it is not without cost or risk:

• Ongoing mortgage, tax, insurance, and maintenance expenses
• Continued joint liability and credit exposure
• Relationship tension and difficulty moving forward
• Uncertainty about when or whether equity will return
• Opportunity cost of capital or settlement funds tied up in the property

Work with your attorney and financial advisor to weigh the cost of waiting against the cost of other options.

Moving Forward

Negative equity does not mean you are trapped forever. It does mean you need to understand your liability, evaluate your realistic options, and make informed decisions with the help of qualified professionals.

Be honest about the financial reality. Do not assume the problem will resolve itself or that a divorce decree alone protects you. And do not make unilateral decisions that affect joint debt without legal guidance.

Negative equity is one of the most challenging housing scenarios in divorce, but with the right information, coordination, and professional support, it can be managed.