Monday, May 30, 2011
Friday, March 25, 2011
You Inherited An IRA. Can Creditors Grab It?
Ashlea Ebeling, 03.17.10, 04:41 PM EDT
In what estate planners and bankruptcy lawyers are saying could be a significant case, a federal bankruptcy judge in Minnesota has allowed a bankrupt woman to keep a $63,000 individual retirement account inherited from her father.
IRAs inherited from someone other than your spouse have traditionally not been protected in bankruptcy under either federal or state laws, and thus have been available for creditors to grab. "It’s a huge deal if these IRAs are now protected," said Marc Soss, a tax lawyer in Sarasota, Fla.
The issue is significant not only because more families are facing creditor problems, but also because more of a typical family's wealth is now in retirement accounts. As of the third quarter of 2009, 9% of all household financial assets were in IRAs, up from 4% of assets two decades ago, according to the Investment Company Institute.
Moreover, more of this IRA wealth is likely to be left to children in the future because of a provision that took effect in 2010 allowing all taxpayers to convert traditional pre-tax IRAs into Roth IRAs. In a conversion, you take money out of a traditional IRA, pay ordinary taxes on it and then move it into a Roth, where all future growth and withdrawals are tax free. While retirees are required to begin taking annual distributions from pre-tax IRAs when they turn 70.5, no such requirement applies to Roth IRAs. That means affluent retirees can leave their large Roth IRAs growing untouched, for their children, who can stretch out withdrawals over their own project life spans. (For "10 Reasons To Convert To A Roth IRA," click here.)
In the Minnesota case, In re Nessa, the federal bankruptcy judge relied on new language in the 2005 federal bankruptcy law that protects $1 million in IRA assets from creditors. (The law also protects all assets rolled from an employer pension plan, such as a 401(k) or defined benefit plan, into an IRA, regardless of the amount.) The judge concluded that an inherited IRA is still a retirement account protected under that law, even though it has switched hands from the original owner to the beneficiary. Jean Hannig, the bankruptcy lawyer in Fargo, N.D., who represented debtor Nancy Nessa, hailed the decision as a resounding victory for debtors.
While the Minnesota decision was the first reported case to look at the application of the 2005 law to inherited IRAs, the judge there may not have the last word. The bankruptcy trustee has appealed the ruling to the U.S. Court of Appeals for the 8th Circuit. And earlier this month, a Texas judge in another bankruptcy case, In re Chilton, came to the opposite conclusion of the Minnesota judge.
More Americans will be handing down IRAs to their kids. A new decision suggests it might be a creditor proof inheritance. But nothing is certain yet.
In what estate planners and bankruptcy lawyers are saying could be a significant case, a federal bankruptcy judge in Minnesota has allowed a bankrupt woman to keep a $63,000 individual retirement account inherited from her father.
IRAs inherited from someone other than your spouse have traditionally not been protected in bankruptcy under either federal or state laws, and thus have been available for creditors to grab. "It’s a huge deal if these IRAs are now protected," said Marc Soss, a tax lawyer in Sarasota, Fla.
The issue is significant not only because more families are facing creditor problems, but also because more of a typical family's wealth is now in retirement accounts. As of the third quarter of 2009, 9% of all household financial assets were in IRAs, up from 4% of assets two decades ago, according to the Investment Company Institute.
Moreover, more of this IRA wealth is likely to be left to children in the future because of a provision that took effect in 2010 allowing all taxpayers to convert traditional pre-tax IRAs into Roth IRAs. In a conversion, you take money out of a traditional IRA, pay ordinary taxes on it and then move it into a Roth, where all future growth and withdrawals are tax free. While retirees are required to begin taking annual distributions from pre-tax IRAs when they turn 70.5, no such requirement applies to Roth IRAs. That means affluent retirees can leave their large Roth IRAs growing untouched, for their children, who can stretch out withdrawals over their own project life spans. (For "10 Reasons To Convert To A Roth IRA," click here.)
In the Minnesota case, In re Nessa, the federal bankruptcy judge relied on new language in the 2005 federal bankruptcy law that protects $1 million in IRA assets from creditors. (The law also protects all assets rolled from an employer pension plan, such as a 401(k) or defined benefit plan, into an IRA, regardless of the amount.) The judge concluded that an inherited IRA is still a retirement account protected under that law, even though it has switched hands from the original owner to the beneficiary. Jean Hannig, the bankruptcy lawyer in Fargo, N.D., who represented debtor Nancy Nessa, hailed the decision as a resounding victory for debtors.
While the Minnesota decision was the first reported case to look at the application of the 2005 law to inherited IRAs, the judge there may not have the last word. The bankruptcy trustee has appealed the ruling to the U.S. Court of Appeals for the 8th Circuit. And earlier this month, a Texas judge in another bankruptcy case, In re Chilton, came to the opposite conclusion of the Minnesota judge.
Spendthrift Trusts in Bankruptcy: It’s a Question of State Law
If you are the beneficiary of a trust, and are considering filing for bankruptcy, you might be wondering if you will lose your interest in the trust to your creditors. The answer to this question depends, first, on whether the trust is a “spendthrift trust” under the law of the state which governs the trust, and second, if the trust contains no valid spendthrift clause, on whether there is an exemption which can be used to protect your interest in the trust.
The law states that a trust becomes property of the bankruptcy estate, unless the trust contains a spendthrift clause enforceable under state law. If so, section 541(c)(2) of the bankruptcy law excludes the trust from the bankruptcy estate, and therefore it is protected. This means your bankruptcy lawyer will need to carefully examine the terms of the trust to see whether it contains a spendthrift clause.
Next, your lawyer will need to determine which state’s law governs the trust, and whether the trust’s spendthrift clause was properly drafted so as to be enforceable. This may a matter of interpreting complex trust law unique to the state involved. Your bankruptcy lawyer may need to seek an opinion from an experienced trust lawyer in order to answer this question.
If the trust contains a valid spendthrift clause, your worries are over, because your interest in the trust is excluded from the bankruptcy estate and you cannot lose it. However, if there is no spendthrift clause, or if the spendthrift clause is defective in some way so as to render it uneforceable under the law of the state involved, your interest in the trust will be lost unless you can claim it exempt.
The federal bankruptcy exemptions contain a “wild card” exemption in the amount of $11,200 which can be used to protect liquid cash assets such as a trust. If the value of your interest in the trust is less than this amount, the trust will be protected. Note that it is only your interest in the trust which needs to be exempted, rather than the entire amount in the trust, which may be subject to the interest of other persons who are beneficiaries of the trust.
If you elect to use the state law exemptions in your bankruptcy, it is possible, although unlikely, that an exemption law might be available to protect your interest in the trust. Some states have exemptions which protect various forms of income, and some states have “wildcard” exemptions which protect liquid cash assets such as trusts. However, such exemptions are usually quite limited, and due to the amounts involved in most trusts, it is not likely that a state exemption law of this nature would be sufficient to protect a trust.
The most favorable scenario is one in which your interest in a trust is subject to valid spendthrift clause, and therefore the trust does not even need to be claimed exempt, because it is excluded from the bankruptcy estate
The law states that a trust becomes property of the bankruptcy estate, unless the trust contains a spendthrift clause enforceable under state law. If so, section 541(c)(2) of the bankruptcy law excludes the trust from the bankruptcy estate, and therefore it is protected. This means your bankruptcy lawyer will need to carefully examine the terms of the trust to see whether it contains a spendthrift clause.
Next, your lawyer will need to determine which state’s law governs the trust, and whether the trust’s spendthrift clause was properly drafted so as to be enforceable. This may a matter of interpreting complex trust law unique to the state involved. Your bankruptcy lawyer may need to seek an opinion from an experienced trust lawyer in order to answer this question.
If the trust contains a valid spendthrift clause, your worries are over, because your interest in the trust is excluded from the bankruptcy estate and you cannot lose it. However, if there is no spendthrift clause, or if the spendthrift clause is defective in some way so as to render it uneforceable under the law of the state involved, your interest in the trust will be lost unless you can claim it exempt.
The federal bankruptcy exemptions contain a “wild card” exemption in the amount of $11,200 which can be used to protect liquid cash assets such as a trust. If the value of your interest in the trust is less than this amount, the trust will be protected. Note that it is only your interest in the trust which needs to be exempted, rather than the entire amount in the trust, which may be subject to the interest of other persons who are beneficiaries of the trust.
If you elect to use the state law exemptions in your bankruptcy, it is possible, although unlikely, that an exemption law might be available to protect your interest in the trust. Some states have exemptions which protect various forms of income, and some states have “wildcard” exemptions which protect liquid cash assets such as trusts. However, such exemptions are usually quite limited, and due to the amounts involved in most trusts, it is not likely that a state exemption law of this nature would be sufficient to protect a trust.
The most favorable scenario is one in which your interest in a trust is subject to valid spendthrift clause, and therefore the trust does not even need to be claimed exempt, because it is excluded from the bankruptcy estate
Sunday, February 20, 2011
The Government and Banks May Punish "Strategic Defaults"
September 14, 2010
Steve Elias, NOLO BANKRUPTCY AND FORECLOSURE BLOG
What Are Strategic Defaults?
A number of articles have recently appeared in leading newspapers and magazines reporting that more and more people are engaging in what they call "strategic defaults," defined as not paying your mortgage when you can afford to do so.
The typical story involves a family with a decent income who bought into the housing market when it was high and who now are upside down on their mortgage payments. Rather than continuing to the keep the mortgage current, this family decides to remain in the home without paying the mortgage and then moving when forced to do so (usually due to foreclosure).
This tactic is similar to the advice I give clients who would benefit from stopping their mortgage payments in order to save money to use when they must leave their homes. The difference is that most of the people I speak to really can't afford their mortgage anyway (so foreclosure is probably inevitable). By stopping their mortgage payments, these folks are just trying to cut losses and save some money which they'll need to find new housing at some point in the future.
Proposed Government Actions to Discourage Strategic Defaults
It is not against any law to stop paying your mortgage, whatever the reason. However, the banking industry is pressuring lawmakers and the government housing entities (Fannie Mae, Freddie Mac, and the Federal Housing Administration) to punish people who have engaged in strategic defaults.
Effective October 1, 2010, Fannie Mae will not purchase any mortgage made to a person who has engaged in a strategic default within the past seven years, and Freddie Mac is expected to follow suit. Since almost all mortgages are purchased Fannie or Freddie for securitization and resale, if this happens to you, you will probably be banned from the home mortgage market for seven years.
And it gets worse. The U.S. House of Representatives has passed a bill [H.R. 5072, FHA Reform Act of 2010] that would deny insurance under the Federal Housing Administration to anyone who has engaged in a strategic default. Since FHA insurance is a requirement for many mortgages, this law (if passed by the Senate) might prevent you from obtaining a new mortgage loan -- forever.
Distinguishing Between Strategic Defaulters and Truly Distressed Homeowners
But how will "strategic default" be defined by the law? The House bill leaves the definition of "strategic default" to the HUD Secretary. But figuring out what is and isn't a strategic default won't be an easy task. What if you obtained a modification "in good faith" but then purposely re-default? Do you need to show proof of unemployment or other hardship? If differentiating between strategic defaulters and truly distressed borrowers were an easy task, laws would be better able to distinguish between the two groups. But it's not an easy task, and the laws are unlikely to do a good job of distinguishing between the two groups.
Next up: Using the loan modification process to avoid a "strategic default" accusation.
A number of articles have recently appeared in leading newspapers and magazines reporting that more and more people are engaging in what they call "strategic defaults," defined as not paying your mortgage when you can afford to do so.
The typical story involves a family with a decent income who bought into the housing market when it was high and who now are upside down on their mortgage payments. Rather than continuing to the keep the mortgage current, this family decides to remain in the home without paying the mortgage and then moving when forced to do so (usually due to foreclosure).
This tactic is similar to the advice I give clients who would benefit from stopping their mortgage payments in order to save money to use when they must leave their homes. The difference is that most of the people I speak to really can't afford their mortgage anyway (so foreclosure is probably inevitable). By stopping their mortgage payments, these folks are just trying to cut losses and save some money which they'll need to find new housing at some point in the future.
Proposed Government Actions to Discourage Strategic Defaults
It is not against any law to stop paying your mortgage, whatever the reason. However, the banking industry is pressuring lawmakers and the government housing entities (Fannie Mae, Freddie Mac, and the Federal Housing Administration) to punish people who have engaged in strategic defaults.
Effective October 1, 2010, Fannie Mae will not purchase any mortgage made to a person who has engaged in a strategic default within the past seven years, and Freddie Mac is expected to follow suit. Since almost all mortgages are purchased Fannie or Freddie for securitization and resale, if this happens to you, you will probably be banned from the home mortgage market for seven years.
And it gets worse. The U.S. House of Representatives has passed a bill [H.R. 5072, FHA Reform Act of 2010] that would deny insurance under the Federal Housing Administration to anyone who has engaged in a strategic default. Since FHA insurance is a requirement for many mortgages, this law (if passed by the Senate) might prevent you from obtaining a new mortgage loan -- forever.
Distinguishing Between Strategic Defaulters and Truly Distressed Homeowners
But how will "strategic default" be defined by the law? The House bill leaves the definition of "strategic default" to the HUD Secretary. But figuring out what is and isn't a strategic default won't be an easy task. What if you obtained a modification "in good faith" but then purposely re-default? Do you need to show proof of unemployment or other hardship? If differentiating between strategic defaulters and truly distressed borrowers were an easy task, laws would be better able to distinguish between the two groups. But it's not an easy task, and the laws are unlikely to do a good job of distinguishing between the two groups.
Next up: Using the loan modification process to avoid a "strategic default" accusation.
The Loan Modification Process Can Help Avoid a Charge of Strategic Default
October 18, 2010
Steve Elias, NOLO'S FORECLOSURE AND BANKRUPTCY BLOG
Banks are beginning to punish homeowners who engage in "strategic default," and pushing for legislation to do the same. A strategic default is defined as not paying your mortgage when you can afford to do so, thereby letting your home fall into foreclosure. (For a more comprehensive discussion of strategic defaults and the steps banks and legislatures are taking to punish homeowners, see my previous blog post The Government and Banks May Punish Strategic Defaults.)
An Ounce of Prevention: The Loan Modification Process
One way that homeowners can reduce the risk of a strategic default accusation is to use the loan modification process. (To learn about loan modifications, see Nolo's article Mortgage Modification and Refinancing Under the Homeowner Affordability and Stability Plan.) Here's how it might help:
Because nonpayment when you have the ability to do so is the key aspect of a strategic default, your best protection against having this label applied to you is to make a diligent effort to obtain a loan modification. Of course if you don't really need a modification, the mere attempt to obtain one probably won't immunize you from being considered a strategic defaulter. But few people are that well off.
If your first mortgage is 31% (or more) of your gross income, you have a non-affordable mortgage under the Making Home Affordable guidelines, and failing to pay it should not be considered a strategic default on your part. And you may have additional reasons why you cannot afford your mortgage at the time you defaulted (for example, student loan repayment obligations, a second or third mortgage, or erratic periods of employment).
Defaulting After a Obtaining a Loan Modification Might Hurt You
On the other hand, If you do obtain a modification and then immediately default without a change in circumstance, you may be considered a strategic defaulter almost by definition. (However, obtaining a loan modification is no easy feat. See my previous blog post More Money for Foreclosure Prevention: Will It Help?)
So, if your main goal in participating in a modification process is to avoid this label, success may be failure, and failure success. Such are the strange times we live in.
Document Everything
If you think that you might be considered a strategic defaulter, be sure to thoroughly document your modification efforts. Use email or the post to document all discussions with the bank or a HUD-approved housing counselor. If you receive a phone call from the bank or counselor, follow up with a confirmation letter and record the names and titles of everyone you talk with. Your goal is to be able to provide a ton of paperwork showing that you diligently sought a modification and your default was not made for "strategic" purposes.
An Ounce of Prevention: The Loan Modification Process
One way that homeowners can reduce the risk of a strategic default accusation is to use the loan modification process. (To learn about loan modifications, see Nolo's article Mortgage Modification and Refinancing Under the Homeowner Affordability and Stability Plan.) Here's how it might help:
Because nonpayment when you have the ability to do so is the key aspect of a strategic default, your best protection against having this label applied to you is to make a diligent effort to obtain a loan modification. Of course if you don't really need a modification, the mere attempt to obtain one probably won't immunize you from being considered a strategic defaulter. But few people are that well off.
If your first mortgage is 31% (or more) of your gross income, you have a non-affordable mortgage under the Making Home Affordable guidelines, and failing to pay it should not be considered a strategic default on your part. And you may have additional reasons why you cannot afford your mortgage at the time you defaulted (for example, student loan repayment obligations, a second or third mortgage, or erratic periods of employment).
Defaulting After a Obtaining a Loan Modification Might Hurt You
On the other hand, If you do obtain a modification and then immediately default without a change in circumstance, you may be considered a strategic defaulter almost by definition. (However, obtaining a loan modification is no easy feat. See my previous blog post More Money for Foreclosure Prevention: Will It Help?)
So, if your main goal in participating in a modification process is to avoid this label, success may be failure, and failure success. Such are the strange times we live in.
Document Everything
If you think that you might be considered a strategic defaulter, be sure to thoroughly document your modification efforts. Use email or the post to document all discussions with the bank or a HUD-approved housing counselor. If you receive a phone call from the bank or counselor, follow up with a confirmation letter and record the names and titles of everyone you talk with. Your goal is to be able to provide a ton of paperwork showing that you diligently sought a modification and your default was not made for "strategic" purposes.
Lawsuits Allege Banks Broke Promises to Homeowners Facing Foreclosure
February 7, 2011
Steve Elias, NOLO'S BANKRUPTCY AND FORECLOSURE BLOG:
Steve Elias, NOLO'S BANKRUPTCY AND FORECLOSURE BLOG:
Two recent lawsuits, in Washington and California, use "promissory estoppel" (a legal theory in contract cases) to get monetary damages from banks that broke their promises to homeowners facing foreclosure.
The Washington Case: Promissory Estoppel as a Cause of Action
Abuses by mortgage banks and servicers committed while dealing with homeowners seeking foreclosure relief or mortgage modifications have been well documented. They are especially and eloquently detailed in a class action lawsuit filed on January 10, 2011 in the State of Washington. Reading the Introduction to the complaint (if not the whole document) will be well worth your while.
Among the claims contained in the class action complaint is a type of breach of contract known as promissory estoppel. Promissory estoppel may seem like an impossible-to-understand example of legal jargon but i'ts actually relatively simple. It means that a party making a promise is prevented (estopped) from reneging on the promise. You can sue for promissory estoppel if 1) someone makes you a promise that is clear and unambiguous, 2) your reliance on the promise is reasonable and foreseeable, and 3) you suffered damages as a result of your reliance.
You can't hold someone to a naked promise just by itself. In other words forget about suing your parents who failed to deliver on their promise to send you to Harvard. But if you go through all the motions of enrolling, signing a lease for your housing, and buying textbooks, and your parents had good reason to believe that you would act on their promise, you may have a winning case to recover, at the very least, your out-of-pocket expenses, and possibly even for other liabilities you incurred.
In the class action complaint the promissory estoppel claim deals with a common practice in the mortgage industry. There the bank promised the named plaintiff a permanent mortgage modification if she completed a trial period during which the modified payments were to be paid to the bank. The plaintiff did, in fact, complete the trial period but the bank refused to give her the modification as promised. Here, the requirements for promissory estoppel were clearly met. The bank promised a permanent modification in exchange for three (or more) trial payments. The homeowner reasonably and foreseeably relied on the promise and made the payments. The bank reneged on the promise, and the homeowner suffered damages in that the trial payments would not have been made absent the promise.
You might wonder why this isn't a common-variety breach of contract case. For a contract to be enforceable both sides have to receive something of value (called consideration) in exchange for their agreement to perform the terms of the contract. Also, there has to be an offer and an acceptance. In the situation where the bank makes a promise to modify, it's arguable that only the homeowner is receiving consideration and so a valid contract has not been made. But the law, through the doctrine of promissory estoppel, eliminates the need for mutual consideration and will, under the appropriate circumstances, enforce the promise or award damages if it is not carried out.
Promissory Estoppel in a Recent California Foreclosure Case
The doctrine of promissory estoppel was recently applied to a mortgage workout situation in a California appellate court case titled Claudio Aceves v U.S. Bank (Court of Appeal, Second Appellate District, Div One (1/27/11)). Here Ms. Aceves fell behind on her mortgage and filed for Chapter 7 bankruptcy after the bank served a Notice of Default, a required step in the California foreclosure process. She decided to convert the case to chapter 13 bankruptcy and raise the necessary money to reinstate the loan and pay off the arrearage over the course of the chapter 13 plan. The bank told her they would work with her and that she needn't pursue her Chapter 13 remedy. Relying on this representation, Ms Aceves did not file Chapter 13 and also did not object when the bank filed a motion in her Chapter 7 case to lift the automatic stay (which legally enabled the bank to continue with its foreclosure remedy).
In fact the bank failed to enter into good faith negotiations and instead completed the foreclosure. Ms. Aceves sued the bank alleging a cause of action for promissory estoppel, among others. She argued that 1) the bank's promise to work with her in reinstating and modifying the loan was clear and unambiguous, 2) the bank in fact failed to negotiate the modification, 3) she relied on the bank's promise by forgoing bankruptcy protection under chapter 13 and failing to oppose the motion to lift the stay, 4) her reliance was reasonable and foreseeable, and 5) she suffered damages in the form of losing her house.
The lower court dismissed the action but the court of appeals ruled that in fact Ms. Aceves had stated a claim for promissory estoppel and should be allowed to proceed with her lawsuit in the trial court. In making its ruling the court specifically found that "U.S. Bank never intended to work with Aceves to reinstate and modify the loan. The bank so promised only to convince Aceves to forgo further bankruptcy proceedings, thereby permitting the bank to lift the automatic stay and foreclose on the property."
As long as this case remains published (and isn't ordered de-published by the California Supreme Court) it provides great precedent if you decide to sue your mortgage lender or servicer for breaking its promises. If you can't find an affordable lawyer, you might consider doing your own state court lawsuit with the help of Nolo resources such as Represent Yourself in Court, by Paul Bergman and Sara Berman-Barrett, and Everybody's Guide to Small Claims Court, by Ralph Warner.
While you may be invited to join a class action, those types of cases usually are much more beneficial to the lawyers bringing them than they are to the plaintiffs. If possible, you should consider going your own way. However, sometimes a class action is the only way to find a lawyer without parting with an arm or a leg and if that is your situation, and self-help is not an option, by all means sign up as a class action plaintiff. .
Bankruptcy and Second-Mortgage Liens
February 15, 201
Steve Elias, NOLO's BANKRUPTCY AND FORECLOSURE BLOG:
If you file for Chapter 7 or Chapter 13 bankruptcy, what happens to second or third mortgages and liens on your home? The real estate crash, and the resulting depreciation in home values, may mean that as a practical matter, many people won't have to worry about those liens. Here's why.
The Real Estate Crash Has Resulted in Many Unsecured Second and Third Mortgages
Because of the real estate crash, many people have second and third mortgages on their homes that are no longer secured by the home's value. For instance if your home is now worth $200,000 and you owe $200,000 on your first mortgage and $50,000 on your second mortgage, your home's value secures the first mortgage, but after that, there is no equity left to secure the second mortgage.
What Happens to Those Mortgages if You File for Bankruptcy?
In Chapter 7 bankruptcy, your bankruptcy discharge will eliminate your personal liability on the second mortgage but will not eliminate the lien. In Chapter 13 bankruptcy, you can eliminate both your personal liability and the lien in a procedure called lien stripping. The basic lien stripping rule is: You can eliminate a lien that has no security in the home, but you can't eliminate the lien if part of it is secured by the home's value.
Here's an example. Say your home is worth $210,000, your first mortgage is $205,000, and your second mortgage is $25,000. You can't strip off the second lien because it is secured by at least $5,000 of your home's value.
What if a Lien Remains on Your Home After Chapter 7 Bankruptcy?
Although you can't lien strip in a Chapter 7 bankruptcy, the lien may have very little effect on your future financial affairs. The Chapter 7 bankruptcy will discharge your personal liability for the second mortgage (meaning you can't be sued for money owed on it). And, absent value in the house securing the second mortgage, the holder wouldn't benefit from a foreclosure (since all the value of the home would go to the first mortgage holder in a foreclosure sale).
This means there won't be negative consequence from the lien remaining on the home after your bankruptcy -- unless of course your home's value comes back to a point that would allow you to sell the home or support a foreclosure action by the second mortgage lender. This is clearly less likely when your home is way underwater (50% is common) than when you are just a tad underwater.
The bottom line? Even though you might have a better result in Chapter 13 -- where you can lien strip -- from a practical standpoint, people with severely underwater second mortgages may do just as well in a Chapter 7 bankruptcy.
In some cases it needn't be one choice or the other. It used to be that you could file a Chapter 7 bankruptcy, discharge your personal liabilities and then immediately file a Chapter 13 bankruptcy to strip off the lien. This was called a "Chapter 20" bankruptcy. Now it's not quite that simple. You are still entitled to file a Chapter 13 bankruptcy right after your Chapter 7 discharge but you won't qualify for a Chapter 13 discharge. Still, at least one bankruptcy court said that you don't need a discharge to strip off a second lien in a Chapter 13 case filed on top of a Chapter 7 case, as long as you filed the Chapter 13 in good faith.
The Real Estate Crash Has Resulted in Many Unsecured Second and Third Mortgages
Because of the real estate crash, many people have second and third mortgages on their homes that are no longer secured by the home's value. For instance if your home is now worth $200,000 and you owe $200,000 on your first mortgage and $50,000 on your second mortgage, your home's value secures the first mortgage, but after that, there is no equity left to secure the second mortgage.
What Happens to Those Mortgages if You File for Bankruptcy?
In Chapter 7 bankruptcy, your bankruptcy discharge will eliminate your personal liability on the second mortgage but will not eliminate the lien. In Chapter 13 bankruptcy, you can eliminate both your personal liability and the lien in a procedure called lien stripping. The basic lien stripping rule is: You can eliminate a lien that has no security in the home, but you can't eliminate the lien if part of it is secured by the home's value.
Here's an example. Say your home is worth $210,000, your first mortgage is $205,000, and your second mortgage is $25,000. You can't strip off the second lien because it is secured by at least $5,000 of your home's value.
What if a Lien Remains on Your Home After Chapter 7 Bankruptcy?
Although you can't lien strip in a Chapter 7 bankruptcy, the lien may have very little effect on your future financial affairs. The Chapter 7 bankruptcy will discharge your personal liability for the second mortgage (meaning you can't be sued for money owed on it). And, absent value in the house securing the second mortgage, the holder wouldn't benefit from a foreclosure (since all the value of the home would go to the first mortgage holder in a foreclosure sale).
This means there won't be negative consequence from the lien remaining on the home after your bankruptcy -- unless of course your home's value comes back to a point that would allow you to sell the home or support a foreclosure action by the second mortgage lender. This is clearly less likely when your home is way underwater (50% is common) than when you are just a tad underwater.
The bottom line? Even though you might have a better result in Chapter 13 -- where you can lien strip -- from a practical standpoint, people with severely underwater second mortgages may do just as well in a Chapter 7 bankruptcy.
In some cases it needn't be one choice or the other. It used to be that you could file a Chapter 7 bankruptcy, discharge your personal liabilities and then immediately file a Chapter 13 bankruptcy to strip off the lien. This was called a "Chapter 20" bankruptcy. Now it's not quite that simple. You are still entitled to file a Chapter 13 bankruptcy right after your Chapter 7 discharge but you won't qualify for a Chapter 13 discharge. Still, at least one bankruptcy court said that you don't need a discharge to strip off a second lien in a Chapter 13 case filed on top of a Chapter 7 case, as long as you filed the Chapter 13 in good faith.
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