One of the major benefits of a chapter 13 bankruptcy is the ability of a homeowner to “strip” second and subsequent “consensual” liens – like deeds of trust – from a residence under certain conditions. This type of lien strip, sometimes more useful than the type that can only remove non-consensual liens like judgment liens, is so beneficial that it is reserved for debtors who file and complete one of the “reorganization” bankruptcies (under chapters 11, 12 or 13 of the US Bankruptcy Code; chapter 13 is the most common for individual debtors). So debtors will sometimes choose to file a Chapter 13 even if they also qualify to file a Chapter 7, which is normally the preferred form of bankruptcy due to cost, length of the proceedings, and timing of discharge.
The rules for this sort of lien strip, provided in 11 USC 506 and applicable case law, are as follows:
- The property must be the residence of the debtor, not a rental or other commercial property.
- The value of the property must be less than the first mortgage; even a few dollars over will make the lien strip unavailable.
- The debtor must complete the plan of reorganization in the bankruptcy before the lien strip will be effective.
Suppose a residence at one time worth $350,000 or $400,000 is now valued at $300,000. The property is secured by two deeds of trust; a first lien on which $310,000 is currently owed, and a second lien on which $30,000 is owed. (This scenario would likely have resulted from market conditions which caused the value of the property to decrease faster than the first lien note is paid down.)
Under this scenario, a chapter 13 debtor could strip the second lien upon completion of either a three- or five-year plan. So upon discharge, the $30,000 second deed of trust becomes completely unsecured, allowing the debtor to then sell the property without paying that deed of trust from closing.
There are a few situations where this type of lien strip doesn’t work. They include the following:
- If the property in the above example is worth $315,000 rather than $300,000, then since the value exceeds the first lien, the second lien will continue to attach to the property. No lien strip is allowed even though most of the second lien is technically unprotected by any equity in the property.
- If the property is worth $200,000 rather than $300,000, then even though the debtor could remove the second lien, why bother? The debtor would have to continue to pay throughout the plan on a first lien that well exceeds the value of the property, which makes no economic sense. (It is sometimes difficult for debtors to see the wisdom of letting a property go, particularly a family home to which they have an emotional attachment. This is where objective legal counsel can help.)
- If the debtor’s financial circumstances have changed so drastically – through an extended period of unemployment, for example – that he can no longer afford to maintain the payments on the first lien, then it is impossible to propose a feasible plan which could be confirmed. Without confirmation there is no discharge; without discharge there is no lien strip.
This lien strip provision has been successfully utilized often since the severe economic downturn in 2008, which caused the value of numerous properties to fall below the amount owed on first liens. As the market continues to improve, however, and values of homes once again rise, it will be less available as a tool to relieve debtors of excessive junior lien debt on their residences. Consumers who believe they may qualify to take advantage of this provision in the bankruptcy code should consult with an experienced bankruptcy attorney, to determine if it might help save their homes.