Mortgage Cramdown v. Lien Stripping in Chapter 13 and an Interesting Strategy

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This article is intended for educational purposes only and not as legal advice

November 6, 2015

A Mortgage Cramdown can be utilized by the Chapter 13 Debtor in certain circumstances to modify the terms and amount of ANY lien on investment real estate of the Debtor.  It enables the Chapter 13 Debtor to reduce the interest rate and the principal value  of the amount owed to the value it is secured by.  Hence, if there is a junior lienholder such as a second mortgage holder that would receive little to nothing in foreclosure, it may be drastically reduced or eliminated entirely.  If it’s drastically reduced, it’s bifurcated into two claims: (1) A secured claim based on the equity actually secured by the creditor.  This amount is paid off in full and typically over 5 years at a reduced interest rate. (2) The remainder is deemed unsecured putting that claim in the same category as credit card companies.  So, this is dealt with through the repayment plan, and the creditor likely only sees a fraction of what they were owed on this portion of the debt.  It it’s eliminated entirely, the entire amount of the debt becomes an unsecured claim dealt with through the payments the Debtor makes through their repayment plan.  Again, the creditor likely ends up receiving a small portion of the amount of their debt.  After the Debtor complies with the plan and the case is discharged, the lien holder must release their lien if it was eliminated entirely by the Bankruptcy Court.

However, a Cramdown cannot be used to modify the terms of a mortgage of the Debtor’s primary residence per 11 U.S.C. 1322(b)(2).   On the Debtor’s primary residence, Lien Stripping is often used by the Chapter 13 Debtor, and I understand it may be used by Chapter 7 Debtors too in Alabama, Florida and Georgia.  Lien stripping enables the Debtor to reduce or eliminate junior liens on their primary residence when the junior lien holders are effectively unsecured because nothing or next to nothing would exist to pay them if the first lien holder foreclosed.  This predictably was/is the case with declining property values and high mortgage debt.

Of the two, the Cramdown is more powerful.  So, one strategy employed by some Chapter 13 Debtor’s counsel is to advise their clients to move out of their homes and rent them out prior to filing.  This enables the Debtor to claim the property on the date their petition is filed as investment property thereby enabling them to use a Cramdown instead of Lien Stripping allowing them to modify liens, including first mortgage liens and HELOCs on what was their primary residence.  The plan is obviously for the Debtor to one day move back into the residence.  In certain circumstances this could be perceived as bad faith, but the operative date for determining the petitioner’s residence is the date of filing.   If a Debtor chooses to go this route, it would seem advisable that they turn their home into a rental months before they file Chapter 13 and not the week before.