Tuesday, September 13, 2011

Lien Stripping In Chapter 13 Bankruptcy - Primary vs. Non-Primary Residence

The following excerpt in a recent article on the lien stripping process in a Chapter 13 bankruptcy proceeding highlights the unique rules applicable to a primary residence and the distinction between how the rules apply to a primary residence vs. a non-primary residence:

  • Lien Stripping in Chapter 13 Bankruptcy

    In a process called lien stripping, a secured debt like a second mortgage or car loan may be reduced to the value of the collateral backing the loan and divided into portions of secured and unsecured debt.

    Under sections 506(a) and 506(d) of the U.S. Bankruptcy Code, through Chapter 13 lien stripping, a loan is secured up to the amount of the fair market value of the collateral, and the remaining balance of the loan is classified as unsecured debt. For example, if a car loan was for $10,000 but the current fair market value of the vehicle is only $7,000, through lien stripping the car loan will remain as secured debt for only $7,000 and the remaining $3,000 of debt will be converted into unsecured debt.

    Unique Rules for Primary Residences

    Importantly, different rules apply for loans secured by primary residences. A second mortgage on a home can be stripped only if the current fair market value of the home does not exceed the value of the first mortgage.

    For example, assume the current value of a primary residence is $400,000, the first mortgage was for $500,000 and a second mortgage was taken for $150,000. Because there is no equity remaining in the home after accounting for the first mortgage, the second mortgage can be converted to an unsecured loan and stripped.

    However, if the current value of the primary residence is $600,000, the second mortgage cannot be stripped. This is because, after $500,000 is secured for the first mortgage, $100,000 in equity is available to secure the second mortgage. If the second loan was not secured by a primary residence, $100,000 would be secured debt and the remaining $50,000 would be converted to unsecured debt through lien stripping.

    But, the unique rules for loans on primary residences say that, as long as there is equity remaining for the second mortgage on a primary residence, the second mortgage cannot be divided into secured and unsecured debt and stripped. In the second example, then, the entire $150,000 second mortgage would remain secured debt because it was secured by a primary residence.

Source: Lien Stripping in Chapter 13 Bankruptcy (Individuals with second mortgages and underwater mortgages may benefit from changing the character of their second-mortgage debt from secured to unsecured debt through Chapter 13 lien stripping).

(1) In this situation, I wonder if it would be viable if the homeowner, shortly before filing the Chapter 13 petition, converted the home from a primary to a non-primary residence by moving out and renting out the premises to a tenant, in an attempt to position himself for a subsequent lien-strip of the undersecured portion of the 2nd mortgage when the bankruptcy petition is eventually filed?

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