Living Underwater After Bankruptcy

Scenario: Homeowners with both a 1st and 2nd mortgage or just a 1st mortgage had to file Chapter 7 bankruptcy and still wish to continue residing in the property which was part of the bankruptcy. They are either ineligible for a Chapter 13 or simply qualify for a Chapter 7. In any event they have, hopefully, retained an attorney specialized in bankruptcy.

Fact 1: The homeowner understands there either will not or may not be a rapid resurgence of property values in the near term. In fact, they realize such a long-lasting recovery in value may be years out. Most experts say we will experience a hill and dale recovery as opposed to a constant increase in values. In all events, only time will tell.

Fact 2: The homeowner understands that the Promissory Note(s) have been Discharged in the Chapter 7 however the Deeds of Trust are still attached to the real estate.

Fact 3: The homeowner is current on the 1st mortgage and continues to voluntarily remain current on the 1st mortgage. The homeowner has likely been advised by their bankruptcy attorney not to reaffirm the discharged mortgage debt.

Fact 4: The homeowner is behind on their 2nd mortgage which is or was upside down – meaning more is owed against the property than the value of the property. Because they are upside down, the 2nd mortgage company is unlikely to foreclose in the near term as it is economically not worthwhile.

Let’s now get our crystal ball out and project what happens after the homeowner continues to live in house for 3-5 years or more. Eventually they need to sell the home but they are still upside down as to unpaid 2nd. How do they sell or get clear title?

Option 1:  Instead of selling they simply surrender the home.  All the while they have considered the 1st mortgage payment equals a rental payment for continuing to live there AND they get the tax benefits of the mortgage tax deduction for all the post-bankruptcy years.

Option 2: Homeowner sells as a short sale wherein the 1st gets paid off or a short-payoff and the 2nd may or may not get anything.  The 2nd mortgage cannot pursue “deficiency” given the debt was Discharged in the Chapter 7.  The 2nd issues a 1099-C and due to the apparent insolvency of the Debtor, the Debtor may wish to file IRS Form 982 and avoid having to pay taxes on the forgiven debt.  Regarding IRS Form 982, many public accounts and particularly the seasonal tax preparers know not of this provision in the IRS Code. You may have to point out IRS Form 982 to your tax preparer.

Option 3: Homeowner continues living in the house and eventually pays off the 1st. The problem here is that the 2nd still has a deed of trust on the property and will need to be dealt with. In the real world, the rights to enforce the 2nd trust deed will have been sold. The point is this – for so long as the 2nd trust deed remains on the property, the homeowner will be prevented from ever obtaining clear title without dealing with the 2nd mortgage.

Option 4: At some point the 2nd may be willing to negotiate a settlement payment to voluntarily release the lien from the property.

Disclaimer: I am not an attorney and I do not provide legal advice – I am simply pointing out my observations of what is occurring in the mortgage market pertaining to Chapter 7 bankruptcy as this is written. I have helped several people negotiate resolution regarding the zombie 2nd. This resolution often also requres the assistance of an attorney to gain optimal benefit. Contact me to discuss further as this is and will remain fluid for several years.

As always do not hesitate to write back with comments or questions.  I read everything that comes back, even though I don’t always get a chance to respond as quickly as I would like.

Financially Speaking – James Spray, CCMB, CNE, FICO Pro – December 19, 2010

Legal Notice: Use of this article without permission is a violation of Federal copyright laws.

One comment on “Living Underwater After Bankruptcy

  1. James Spray says:

    Underwater is now a recognized real estate word according to the MirriamWebster Dictionary. See –


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