One of the great tools bankruptcy provides is the ability to avoid undersecured and wholly unsecured liens (often referred to as “stripping down” a lien or “stripping off” a lien). If you owned investment properties that are currently underwater, what if I told you there might be a way to reduce the outstanding mortgages on those properties to the value of the property? A claim, like a mortgage, is undersecured when the balance owing on the loan is more than the value of the property (so that there isn’t enough security to cover the mortgage balance in case of foreclosure). A claim is wholly unsecured when the value of the property doesn’t even provide any value to the lien in the case of foreclosure. This was common in the case of real property with two mortgages, and the value of the property was less than the balance of the first mortgage, so there is absolutely no security for the second mortgage.
In the wake of the depression in residential home values, many homeowners utilized the bankruptcy code, particularly chapter 13, to strip off these wholly unsecured loans. Whether fortunately or unfortunately, however, the bankruptcy code prohibits debtors from stripping down undersecured loans to their principal residence. That is, if your home has two mortgages, you can strip off a second mortgage if it’s wholly unsecured, but you can’t strip it down if there’s any value to pay it off. Further, you can’t do anything to modify the first mortgage because, presumably, there will always be at least one dollar of value to secure that first loan.
Things get interesting with investment properties, however, since there is no prohibition on stripping down or stripping off liens on investment properties. When it comes to investment properties, a debtor in bankruptcy can strip down liens to the value of the property, whether the lien is a first mortgage, second mortgage or so on. This versatility is very helpful to someone who may have purchased a second or even third property during the housing bubble, and the values remain so depressed that it will take years to recover. Accomplishing a strip down of liens for investment property isn’t without its difficulties. In a chapter 13 case, if you strip down a lien to the value of the property, the debtor must pay the new secured claim in its entirety in no more than five years. As an example, if an investment property has an outstanding mortgage of $500,000.00, but it’s only worth $250,000.00 today, you could strip down that mortgage to a new secured claim of $250,000.00 (the value of the property), but that secured claim would have to be paid in full over the course of a chapter 13 plan, no more than five years. This is impractical, if not impossible, for many debtors, unless you have access to lots of capital.
Chapter 11 doesn’t have this five year limitation, so bankruptcy under chapter 11 may be a little more useful. Unfortunately, however, chapter 11 cases are generally very expensive, requiring large sums of money upfront just for the legal work to be done, which many debtors may not have available. Moreover, in a chapter 11 case, a creditor may elect to forego the unsecured claim (the part of the loan that was stripped off) to retain a secured claim for the entire amount, in which case, surrender of the property is likely to occur. Notwithstanding, if you’re someone that may have some investment property that remains undersecured due to the housing market collapse, you should think about contacting a bankruptcy attorney. It might be worth the cost of a chapter 11 case to attempt to strip down the lien(s), especially if the property generates rental income and as real estate prices continue to rise.