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Stripping Junior Mortgage Liens In Chapter 13: A Brief Guide To Avoiding Second Mortgages

There are several reasons why some people choose Chapter 13 over Chapter 7. Some file Chapter 13 because their assets--perhaps a home, a business, life insurance cash value, or a vehicle--are so valuable that such assets would be vulnerable to liquidation by a trustee in a Chapter 7. Some file Chapter 13 in order prevent foreclosure of a home or rental property by twisting the arm of their mortgage lender behind their back and forcing them to agree to a five year period of time to bring the mortgage arrears current. Some file Chapter 13 in order to prevent the Internal Revenue Service or the state from garnishing wages, levying bank account or seizing assets by twisting the arm of the taxing agencies behind their back and forcing them to agree to a five year period of time to bring the tax arrears current. Some file Chapter 13 because their earnings are too high and they accordingly don't qualify for Chapter 7 relief. But another reason that many file Chapter 13, especially during a depressed real estate cycle such as the one we experienced between mid-2007 and 2013, is to avoid and remove junior mortgages, also frequently referred to as "home equity loans," from their residence and/or rental properties.

It is important to note that in a bankruptcy case, mortgage lenders have two separate and very distinct interests--mortgage lenders are owed a DEBT, and they have a LIEN against the collateral--the property--that allows them an advantage over other creditors that are not collateralized in the event you do not pay. Bankruptcy--whether it be Chapter 7, Chapter 13, or another chapter, discharges most debts but generally has no impact upon the validity or priority of liens, so if you fail to pay your mortgage during and after a bankruptcy, the mortgage company can and likely will foreclose upon its collateral and sell the property. In Chapter 13, one can not only the discharge the DEBT owed to a junior mortgage lender, i.e., a second, third or perhaps fourth position lender, but also in some cases avoid and permanently remove the mortgage lender's LIEN.

In order to avoid and remove a junior position mortgage lender's lien, the following conditions must be satisfied:

1. The chapter must be either 13 or 11. Stripping a junior mortgage lien is not permitted in Chapter 7, at least under existing law.

2. The judge must determine, after submission of competent evidence, such as a qualified appraisal, that the property's value is lower than the mortgage or mortgages senior in position to the one being avoided. In other words, if you owe your first position mortgage lender $200,000, a second position mortgage lender $50,000, and a third position lender $20,000 and you're hoping to avoid the third position lender's lien, the judge would have to be convinced that the value of the property is less than $250,000. Note that your mortgage lender has an opportunity to challenge your appraisal and submit one of its own.

3. You have to complete your Chapter 13 plan, meaning you need to make the court-ordered payments to your bankruptcy trustee for the entire thirty-six to sixty month period proposed in your plan. The lien is only officially avoided at the conclusion of the Chapter 13 case. So, if you fail to make your payments to the Chapter 13 trustee and the case is dismissed short of completion, the mortgage lender's lien is not avoided.

4. You must remain beneath the $383,175.00 unsecured debt limit. If you are successful in avoiding a mortgage lender's junior lien, the balance owed to that mortgage lender doesn't just disappear, it becomes an unsecured nonpriority debt, just like a credit card or a medical debt. In Chapter 13, one's unsecured debt must total less than $383,175.00. If adding the avoided junior mortgage lender's balance onto the already existing unsecured debt pushes your unsecured debt total above $383,175.00, lienstripping will not work.

5. Some judges--not most, but some--require that in order to avoid a junior mortgage lender's lien in a Chapter 13 case, you must be entitled to a discharge in that case. One is not entitled to a Chapter 13 discharge if one has received a Chapter 7 discharge within the four year period preceding the filing of a Chapter 13 case. One can still use Chapter 13 despite not being entitled to a discharge, which may make sense for the reasons noted above, but some judges will not permit the avoiding of a junior mortgage lender's lien in such cases.

Chapter 13 also permits a property owner to "cram down" certain secured debt. For example, say you own a commercial building worth $500,000, subject to a first position mortgage with a balance of $450,000 and a second position mortgage with a balance of $200,000. In Chapter 13, assuming you can convince your judge that the property is in fact worth $500,000, you can birfurcate or split the second position lender's claim into two parts--a secured portion for the $50,000 that its lien is worth, and a $150,000 unsecured portion. In Chapter 13, the $50,000 would then have to be repaid in full with interest over the thirty-six to sixty month life of the plan, and the $150,000 would have to be paid the same percentage on the dollar being paid to other unsecured nonpriority creditors, which could be anywhere between 0.0% and 100.0%. But note, that bifurcation is only permitted if the property is NOT your residence.

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