Millions of American homeowners are now upside-down on their home mortgage and they are looking for a way out. In some areas like the Inland Empire of California, local homeowners have seen values drop 30-50% and many are making a “business” decision to walk away without ever exploring ways to save their home. If you have decided to walk away from your home and think you have no other option but to bail on your upside-down house, you may want to read this.
Wouldn’t it be much easier to save your home if you only had a first mortgage and no other payments? What if you could effectively wipe out $50,000, $100,000 or $200,000 of what you owe on your mortgage? Also, if the market turns around, think of all the equity you could build back up years from now? For homeowners who have taken out a second mortgage on their home, facing financial difficulties can be particularly challenging. In most cases, a second mortgage reduces your home equity to a very small margin leaving you vulnerable to the whims of your lenders. In cases where real estate values have declined, as we are seeing in most markets today, there are strategies that you can use to protect yourself from excessive debt. Current bankruptcy law allows judges to approve the loan modifications of the terms of certain debts, namely auto and student loans and second-home mortgages. In the case of second mortgages, if the value of the property falls below the loan amount, debtors potentially could reduce the balance of the loan to equal the current value of the property.
Stripping the Lien, Cram Down or Strip Down
When a judge removes the second mortgage during bankruptcy proceedings it is referred to as “stripping” the lien, a“cram down” or “strip down.” This can happen if the loan is secured by other collateral that is part of the bankruptcy filing or if the home is not your principal residence or even if the payment structure on the second mortgage falls heavily during the bankruptcy filing period itself.
Here is a Lien Stripping Example:
- Home is worth $200,000.
- The first mortgage is $200,000.
- A second mortgage (or in certain states, a deed of trust) for $100,000.
- Lenders are only secured up to the value of the property. In this case the first lender is secured by the property value.
- The second lender has nothing securing their lien. They are unsecured because the property has no value left over from the first lien. In a Chapter 13, you can lien strip the second lender.
- The second lien is treated as an unsecured creditor.
- Most likely the second lender will not be able to collect on the mortgage after the bankruptcy discharge and the homeowners (debtors) still get to keep the house.
- The homeowner would not even have to pay the lien when they sell the house.
- Now, THIS IS A POWERFUL tool for homeowners who are underwater!
Additional liens on your home beyond your initial mortgage, whether you have taken a second mortgage or just another related lien, could be negated in the case of a Chapter 13 personal bankruptcy filing.
Liens can be stripped off of the debtor’s assets in Chapter 11 or Chapter 13 when there is not enough equity in the asset, after deducting senior liens from the property’s current market value, to secure the unsecured in whole or in part, where the lien exceeds the value of the debtor’s property. Section 506 of the Bankruptcy Code acknowledges that a lien is only a secured claim to the extent there is value in the asset to which it attaches. To the extent that the claim exceeds the value of the collateral, that portion of the claim is unsecured. In Chapter 11 or Chapter 13, even voluntary liens, such as mortgages and security interests, can be stripped down to the value of the collateral, with the exception of voluntary liens secured only by the debtor’s residence. Congress is currently considering changes to bankruptcy law allowing the modification of home mortgages.
Despite the general rule, two exceptions may apply so as to allow lien stripping of a mortgage on a personal residence: loans based on a home plus other collateral. Lien stripping is prevented only when the lien is secured “solely” by a personal residence. Court decisions have made it clear that when the debtor has given other collateral (in addition to the personal residence; e.g., office equipment) as security for the mortgage, lien stripping will be allowed. Thus, if you will be taking out a second mortgage or refinancing your home, you should consider offering additional collateral, such as furniture, as security for the loan. This can be done under the guise of seeking better terms from the lender, such as a lower interest rate.
Many (but not all) bankruptcy courts follow a rule that makes a second mortgage totally unsecured if the first mortgage balance equals or exceeds the value of the personal residence. This exception will not apply in the case of a refinancing of a mortgage, since in a refinancing the new mortgage pays off the first mortgage. The exception is predicated on there being two distinct mortgages (a first and a second mortgage). For this reason, if you have the option of financing your business through a second mortgage or refinancing your first mortgage, the second mortgage may be the better choice, especially where the amount of the first mortgage is close to the value of the home.
In addition, remember that the general rule applies only to a lien secured solely by a personal residence. Thus, lien stripping will be not allowed for a mortgage on a building used in a business.
While there is no assurance of what the courts will decide, depending on the terms of the original loans as well as the details of your filing, there are options for home owners with multiple liens on their home. This is because most additionally mortgages are unsecured, especially in the modern context of depressed home values. While inflated home appraisals may have allowed you to take out an additional mortgage, it’s possible that your original home loan is now upside-down. When the real estate market was much more active, lenders often side stepped the 20% down payment rule by allowing the borrower to get private mortgage insurance. As a further side step this rule of thumb, many borrowers took out a second mortgage to cover the 20% payment which led to the additional lien on the home. Given current market conditions, many buyers ended up with net negative financing, or negative equity, before they even made their first payment (and often did not have to provide any collateral).
Within Chapter 13 Bankruptcy law, section 11 USC 1322, can potentially allow you to forgo your second mortgage, under certain circumstances. If your second lien on the whole is unsecured, then when the value of your home drops below the first mortgage deed of trust, the second becomes wholly under secured. This second loan can be negated through a Chapter 13 filing.
The lien stripping program is available for individuals desiring to reorganize their debt using Federal Laws under Title 11 of the United States Code. The mortgage removal program can only be used in the context of reorganization, often referred to as Chapter 13(see below).
If you own a home with more than one mortgage, you may be able to completely remove or “avoid” the second and subsequent junior mortgages from your home and county records, thus leaving only the first original mortgage!
To qualify for this defense, the court will generally require objective evidence that the home is appraised for less than the value of the initial mortgage, which can be obtained through a county property appraisal or through a third party certified appraisal that is accepted by the court. In an environment where home prices in most markets have fallen at least 30%, many borrowers may qualify.
Attorney Pernell Agdeppa has much to say about this bankruptcy defense for homeowners: “Homeowners can file a Chapter 13 bankruptcy and can pay the various filing charges/fees (to strip a lien we must file a complaint against the second or junior lien holder(s)).In my opinion, the most critical aspect of this process is to carefully qualify each potential client to determine whether bankruptcy is their best alternative and make them aware of its lasting credit impacts.”
“While removing junior debt from their properties will help them financially, clients must also be capable of staying within their financial plan to fulfill their obligations of their Chapter 13 filing.”
Tax liens can also be stripped off in reorganization proceedings (Chapters 11 and 13) to the extent that the lien does not attach to equity in property. Tax liens can’t be avoided in Chapter 7 on the grounds that they impair exemptions; if the tax is dischargeable in the Chapter 7 filing, the bankruptcy court can determine the amount of the lien that is secured at the time of the filing. Payment of that sum entitles the debtor to the release of the lien.
Ultimately, working with a qualified tax and real estate attorney or experienced real estate bankruptcy lawyer will help you present your case to the Federal Bankruptcy Court, so it’s important to get qualified legal advice in advance regarding any filings.
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