As we’ve already mentioned, bankruptcy law is complicated. However, with good legal advice, you can often use the intricacies of the system to combine different aspects of bankruptcy law, or even combine the filing of two different chapters of bankruptcy, to work to your best advantage. It really is worthwhile to obtain good legal advice here, from an attorney who specializes in bankruptcy. You want to make sure that you come up with the strategy that works best for your own unique financial situation, and you also want to make sure that what you are doing is entirely legal, and won’t be perceived by the court as a way to try to take advantage of the bankruptcy process.
Bankruptcy strategies include filing what is known as Chapter 20 bankruptcy (not a real bankruptcy chapter, but a way of combining Chapters 7 and 13). Other strategies include lien-stripping through Chapter 13, to remove liens on your home if your home has dropped in value, and what is known as a cramdown: a way of reducing the balance owing on a secured loan.
“Chapter 20” is not really a chapter under the bankruptcy code, but it is a term that is commonly used when filing Chapter 7, then converting to Chapter 13. This is a strategy that can help some debtors in certain circumstances, where either one of Chapter 7 or Chapter 13 alone does not adequately address their financial issues.
The advantages of Chapter 7 is that it is fast, and that it permanently discharges most or all of your unsecured debts. In addition, most debtors get to keep most of their property by exempting it. The disadvantages of Chapter 7, though, are that it will not discharge priority debts (such as child support and taxes) and most student loans, that it has no mechanism for you to catch up on missed payments for secured items you may want to keep, such as your home or your car, and that liens on secured items are not wiped out by the bankruptcy.
The advantage of Chapter 13 is that you come up with a repayment plan to repay all of your secured debts and some portion of your unsecured debts, which means that you don’t have to give up any property. The disadvantages of Chapter 13 are that you do have to repay all of your secured debts, not to mention that some people just cannot afford a repayment plan, so they cannot qualify.
The so-called Chapter 20 takes the benefits of both. It means filing Chapter 7, and receiving a discharge of all of your unsecured debts. Then you immediately file Chapter 13, listing only your secured debts and not the unsecured debts that were discharged in the Chapter 7.
The aims of doing a Chapter 20 are to get rid of the unsecured debts through the Chapter 7, then use the protection offered by Chapter 13 to allow yourself to catch up on payments on secured property that you want to keep, like your home and your car, through the repayment plan. The aim of the Chapter 13 is not to have your debts discharged (you will not be eligible for a discharge anyway, until four years have passed since receiving your Chapter 7 discharge). The aim of Chapter 13 is to bring your secured loans current over the course of the plan, while you benefit from the protection from creditors afforded by the automatic stay, so you can keep your property.
One thing to remember about doing a Chapter 20 is that, even though you are not required to give up non-exempt assets in Chapter 13, you will be required to give them up in the Chapter 7. So, if you have assets that you will not be able to exempt and that you want to keep, Chapter 20 may not be a good choice for you.
Lien-stripping of unsecured liens is allowed through Chapter 13, but not through Chapter 7. Lien-stripping works in the case of junior mortgages - for example, a second mortgage on a home - where the home’s value has dropped so much that it is less than the value of the first mortgage. This means that the second mortgage is considered to be “wholly unsecured.”
Here’s an example. Let’s say you purchased a home for $250,000 with an 80/20 mortgage. Your first mortgage was for $200,000, and your second mortgage was for $50,000. But what if your property value has dropped to just $180,000? You owe $70,000 more on your mortgages than what your home is now worth.
Remember that liens work in priority. (If you need a refresher on liens, refer to the section on how liens work in our article Decisions About Your Home and Mortgages in Bankruptcy). If a lender foreclosed on you, all of the sales proceeds would go to your first lender - and there will not even be enough to pay them back in full (you would be short by $20,000). This means that the first mortgage is undersecured. And there will be nothing at all left to pay towards the second mortgage: it is wholly unsecured.
Lien-stripping means that your attorney can argue to the court that, since that second mortgage is no longer secured by any value in the home, it should be treated as unsecured debt. The lien associated with that mortgage is stripped: it disappears. Yes, you still owe your lender that money. But that debt is now in the category of unsecured debt - the same category as credit card debt or medical bills - which means that it no longer needs to be repaid in full through your Chapter 13 repayment plan.
A “cramdown” is another strategy that is available in Chapter 13 to reduce the amount you will have to repay on certain loans.
Cramming down is allowed on certain secured debts. It is a way of reducing the amount of principal you owe on that debt, provided that the current value of the security (the collateral) is less than the balance owing. Since cars tend to depreciate quickly, cramming down is often used on car loans. It may also be used on mortgages on investment property, or any other secured items you have purchased on credit, such as appliances. Cramming down may not be used on mortgages on your principal residence.
A cramdown means reducing the principal balance owing on a loan to the current value of the asset securing the loan. It is only worth doing if that asset is worth less than what you owe on the loan. For example, if you owe $15,000 on your car loan, but your car is only worth $10,000 today, you can cram down your loan to $10,000 on your Chapter 13 repayment plan. The remaining $5,000 owing will get moved over to your unsecured debts, which means that you will only have to repay a portion of that $5,000.
There are some important restrictions about using a cramdown:
- If you want to cram down a car loan, you must have owned that car for at least 910 days (around two and a half years) before filing bankruptcy. This keeps people from abusing the rule by buying a new car and cramming down their loan shortly after.
- If you want to cram down loans on other secured items of personal property, you must have owned those items for at least one year.
- If you want to cram down a mortgage loan on an investment property, you must be able to pay out the entire mortgage, in full, by the end of your repayment plan period. For most people, this makes cramming down of mortgages on investment property impossible. (Don’t forget, you may not cram down mortgages on your principal residence at all).
Combining with a short sale
A short sale is a way of being able to sell a home that is worth less than what you owe on its mortgage(s). You need to negotiate with your bank to get permission to do this. Even though it means that the bank will receive less money from you than you owe on your loan(s) and therefore take a loss, they often will approve a short sale because they would lose even more if the foreclosed on you.
Bankruptcy and short sales can work hand in hand. Bankruptcy can be undertaken before, during, or after a short sale. The evaluation processes for a short sale and for bankruptcy are very similar, so it is wise to consider both options before coming up with a final plan. Advice from experienced professionals in coming up with an appropriate plan may save you thousands of dollars or more.Declaring bankruptcy before initiating the short sale process
If you have chosen to ride through a bankruptcy, you can stay in the home as long as you continue to make your mortgage payments. You still have title to the home - but, if you decide that you want to move, you are stuck. You can’t sell the home. But as soon as you stop making the mortgage payments, your lender will foreclose on you.
One option, to avoid the black mark of a foreclosure on your credit report, is to work with your lender to negotiate a short sale. This way you and your lender can mutually agree to terminate the mortgage, and you can exit with little additional damage to your credit score.Declaring bankruptcy and doing a short sale together
In Chapter 13 bankruptcy you can try to work with your lender to negotiate a loan modification or repayment plan. However, you do also have the option of trying to negotiate a short sale. Your lender will usually give you six or so months to negotiate the short sale while in Chapter 13 bankruptcy.
Title to the property remains in the borrower’s name until the short sale is closed. The lender(s) must then waive the deficiency balance and, since that debt was discharged through bankruptcy, the borrower is exempt from having to pay any income tax on the forgiven debt.Declaring bankruptcy after a short sale
Declaring Chapter 7 bankruptcy immediately following a short sale makes sense if your lender has refused to waive a large deficiency balance. Before the short sale, the mortgage was secured by the home, but after the short sale, with no home as collateral, the deficiency is now an unsecured debt, which can be completely shed through Chapter 7 bankruptcy.
Theoretically, you could wait a number of years to declare Chapter 7 bankruptcy in order to have the deficiency judgment shed. However, there are income limits for being able to declare Chapter 7. If you think your income may be higher in the future than it is now (e.g., if your financial distress was caused by unemployment or under-employment, but you think you might be back to regular work in a few years) you would be better off to declare Chapter 7 bankruptcy right away after the short sale, while you are still eligible for it.
Read on for our next article in this series: Life After Bankruptcy