One of the most powerful features of Chapter 13 Bankruptcy is lien stripping. A “lien” includes any charge against or interest in property to secure payment of a debt or performance of an obligation. This articles focuses on the stripping of mortgage liens in Chapter 13 Bankruptcy.
Many people who file Chapter 13 Bankruptcy do so in an effort to save their home from foreclosure. In most instances the value of the debtor’s residence has decreased so much that the property is worth less than the amount owed on the mortgage. The property in such circumstances is sometimes referred to as being “underwater”. Where the debtor has more than one mortgage, lien stripping may be used to remove junior mortgage liens from the property.
There are two important things to remember when it comes to lien stripping in Chapter 13. The first is the difference between “stripping off” a lien, and “stripping down” a lien. “Stripping off” a lien occurs when the entire lien is removed from the property or “collateral”; “stripping down” occurs when only the unsecured portion of the lien is removed from the collateral.
The second important thing to remember is that lien stripping is prohibited in Chapter 13 where the lien is secured in whole or in part by property which the debtor occupies as her principal residence. The Bankruptcy Code prohibits modification of such creditor’s rights. So, if the lien is even partially secured by the property, it cannot be stripped. The debtor may, however, be able to “strip off” a junior mortgage lien that is completely unsecured based on the current value of the property.
Lets use a hypothetical to illustrate how lien stripping works. Suppose the debtor purchased her residence 5 years ago for $500,000 by putting $50,000 down and obtaining a mortgage for $450,000. A year later the property has increased in value to $600,000, and debtor believing the property will continue to increase in value borrows $50,000 secured by a 2nd mortgage against the property. Fast forward 4 years and suppose the housing market has crashed and the fair market value of the property is now $400,000.
Lien stripping in Chapter 13 Bankruptcy is effectuated by valuing the collateral securing the lien, and then bifurcating the creditor’s single claim into two parts “secured” and “unsecured”. In the above-example, the 1st mortgage is only partially secured because the value of the property is $400,000, and the amount owed on the 1st mortgage is $450,000. Here, the 1st mortgage is said to be “under-secured” in the amount of $50,000. The 2nd mortgage, however, is completely unsecured because no portion of the 2nd mortgage is secured by the property based on its value.
So, can the debtor “strip off” the 2nd mortgage if she files Chapter 13 Bankruptcy? Yes! Because the 2nd mortgage is completely unsecured by the property, Chapter 13 allow her to “strip off” the 2nd mortgage and treat the debt as “unsecured” debt under her repayment plan. (Unlike secured debts, unsecured debts do not have to be paid in full in Chapter 13.) But, again, if the 2nd mortgage was even partially secured by the property it could not be stripped off.
Can the debtor “strip down” the 1st mortgage? No! The debtor cannot strip down the 1st mortgage because it is partially secured by property that the debtor occupies as her principal residence. Even though the value of the property is $50,000 less than the amount owed on the 1st mortgage, the bankruptcy court is powerless to “strip down” the first mortgage due to the anti-modification provisions contained in the Bankruptcy Code.
So, you ask, what if this was a rental property, and not the debtor’s principal residence. Could the 1st mortgage then be “stripped down”? Yes. The court could “strip down” the value of the 1st mortgage ($450,000) to the current value of the property ($400,000), a savings of $50,000 to the debtor. Here’s the catch, the debtor must pay off the entire amount of the secured portion of the “stripped down” claim under their Chapter 13 plan, which cannot exceed 60 months. That means the debtor would have to pay off the entire $400,000 balance of the “stripped down” 1st mortgage during the plan period. Most debtors do not have the financial resources to do so and, thus, as a practical matter, “strip down” of a 1st mortgage is often of little use to Chapter 13 debtors.
As mentioned, once a lien is “stripped off” the debtor may treat the debt a “unsecured debt” under her Chapter 13 Plan. Again, unlike secured debts, unsecured debts do not have to be paid in full (or anything for that matter) in Chapter 13 Bankruptcy. If the debtor completes her Plan, the balance of the stripped off lien is discharged along with the debtor’s other debts. If, however, the debtor does not complete her Plan, the lien is automatically reinstated to the position it was in prior to the bankruptcy.