Jan 11, 2008

How Bankruptcy Can Be Used to Deal With Foreclosure

The media is full of stories about the skyrocketing rates of foreclosure. Often, people believe they can save their home and they scramble to find the best possible way to prevent their home from being taken away. Not uncommonly, however, the handwriting is on the wall--the home will be lost--and the homeowner's chief concern is how to move on without causing further harm to his or her economic status. In either situation--keep the home or move out--bankruptcy can be an incredibly useful tool in dealing with foreclosure.

What is foreclosure? In California and most other states, a foreclosure starts when you fall behind on your payments for several months. Your lender sends you a Notice of Default giving you a period of time to cure the default--typically three months. If you haven't caught up by the end of the default period, you are notified that the property will be sold at public auction--on a date scheduled roughly 20 to 30 days later. If you still haven't adequately dealt with the problem by that date, the property is sold and you can't get it back unless your state laws provide a redemption period--one last grace period for you to recover the house by paying off the loan being foreclosed on.

Some people facing foreclosure on their home manage to work out a settlement with their lender under which the payments they've missed get tacked on to the end of the loan period. Others get their lenders to agree to a short sale--that is, you sell the property for whatever you can get for it and the lender writes off the difference between what you owe and the sale proceeds. If the loans being written off were used to acquire or improve the home, there is no income tax liability. If the loan was used for other purposes (for example, a home equity loan used to fund a vacation) then the amount written off can be considered as taxable income. See New Tax Break for People Who Default on Their Mortgages.

Bankruptcy may provide some relief. At the point you are faced with the forced sale of your property, you will undoubtedly start thinking about bankruptcy if you haven't before. Bankruptcy may help you keep your home or, if that's not in the cards, at least get you out from under your mortgage without liabliity for the deficiency (the difference between what you owe and what the property is ultimately sold for). And bankruptcy also eliminates any tax liability you might have for loans taken out against the property for purposes other than property improvement. By delaying the foreclosure process, it can also help you save some money to deal with the aftermath of your bankruptcy.

When you file bankruptcy, the foreclosure process comes to a halt (called the "automatic stay") and remains that way until your bankruptcy case comes to an end or the lender obtains court permission to proceed (called "lifting the stay").

There are two types of bankruptcy--Chapter 7 and Chapter 13.

Chapter 7 bankruptcy. Chapter 7 is the most popular type for getting rid of debts. However, a Chapter 7 bankruptcy typically lasts for only four months--after which the foreclosure can resume. And if the court grants the lender permission to continue the foreclosure while your bankruptcy case is pending, you have even less time. In short, Chapter 7 won't prevent an ultimate foreclosure--although for the time the process is delayed you can live in your home for free and amass a savings that can help you find a new dwelling.

In addition to getting rid of unsecured debt, such as credit card and medical debts, Chapter 7 bankruptcy will also get rid of your mortgage debt (and exempt you from tax liability for the loss incurred by the lender in the foreclosure sale in case the loss involved a loan that wasn't used to acquire or improve the property. As mentioned, write offs on loans used to acquire or improve a principal residence no longer generate income tax liability).

Chapter 13 bankruptcy. Chapter 13 bankruptcy is a different animal altogether. You can actually defeat the foreclosure by proposing a plan to pay off mortgage arrears over time. For example, assume you are $10,000 behind on your mortgage. You file a Chapter 13 bankruptcy and propose a plan under which you will make current paymnts on your mortgage and additionally pay off the $10,000 arrears at a rate of $277 per month over three years, thereby keeping your home and avoiding the foreclosure sale.

While Chapter 13 bankruptcy may seem like an ideal solution, you may not be able to propose or afford a plan that the court will approve. This is because certain debts such as child support and back taxes must be paid in full during the life of the plan, and you must have enough steady income to meet your daily expenses as well as the arrears and other debts you are required to pay off under your plan.

Since a repayment plan under Chapter 13 plan isn't always practical, and since Chapter 7 will only provide a temporary delay from the foreclosure sale, how should you proceed? If you come to terms with the fact that you'll have to move--a bitter result to be sure but sometimes unavoidable--you can at least view bankruptcy as the best way to get out from under your mortgage debt (and any tax liability you might have) as well as a way to save some money that will help you weather the psychological and economic shocks that lie ahead.

To read further, check out my latest article in the Nolopedia, Nolo's free encyclopedia of legal information.

1 Comments

I’ve heard that about 1% of properties in preforeclosure typically go into foreclosure. Does anybody have data showing what the actual percentages were for the LA area in say 1988, 1991, 1995 and 2000?