Yes Virginia, it is possible to both discharge unsecured debts forever (Chapter 7) and strip down secondary mortgages (Chapter 13). The result is a so-called "Chapter 20." But should Debtors file two cases when it's hard enough to put themselves through one? Read on and find out.
When Is Chapter 20 a Good Idea?
There are situations that fairly cry out for Chapter 20 treatment:
Situation #1: Debtor is burdened with priority unsecured obligations like IRS debt, that must be completely retired in Chapter 13. But that would yield unsustainably high monthly payments. By contrast, once the Debtor's unsecured obligations are discharged, the resulting Chapter 13 plan payments become downright manageable. Chapter 20 is the solution.
Situation #2: Debtor's mortgage exceeds the value of the Debtor's home (i.e. the property is "underwater"). Chapter 7 cannot help the Debtor ameliorate their high payments or deal with their delinquent second mortgage. All Chapter 7 can do is give the Debtor an opportunity to reaffirm the mortgage(s) on the same outrageous terms. Chapter 20 is the solution because it permits the Debtor to treat its second mortgage like an unsecured debt and pay only pennies on the dollar to retire it.
How Does Chapter 20 Help, Exactly?
Chapter 20 works by reducing the overall amount of debt to be paid, then stretches that smaller sum over as many as 60 months. Practically speaking, Chapter 13 plan payments are determined by 2 factors:
- The Means Test imposed by the 2005 BAPCPA Amendment to the Code; and
- The amount of secured claims, arrears, and priority debts the Debtor must pay
This is where Chapter 13 Debtors may take advantage of the lien strip - an option not available in Chapter 7 - that allows them to treat secured loans on owner-occupied property as unsecured, and pay down those loans at far less than face value.
What is Lien Stripping, Again?
Lien stripping is the process of treating some "secured" loans as unsecured: it applies only when the property in question is "underwater" - i.e. its market value is exceeded by the face value of the primary mortgage. In that case the 2nd mortgage or home equity line of credit (HELoC) is really unsecured and may be paid under the plan of reorganization at the same rate as other unsecured debt - $.10 on the dollar, $.50 on the dollar, etc. And Boom! goes the dynamite.
Are People Using Chapter 20 Successfully?
In re Davis, 4th Cir., slip opinion 12-1184 (2013), the latest case to discuss the legitimacy of Chapter 20 lien strips, points out that Chapter 7 eliminates personal liability but leaves in rem interests like mortgage liens undisturbed. It goes on to point out that an interest is "secured" only to the extent of the creditor's interest in the underlying real estate. See Code §506. Thus, if a house is worth less than its primary mortgage then 2nd and 3rd liens are unsecured by definition. And since §1322 of the Code permits the modification of the rights of unsecured creditors, a lien strip is both warranted by the facts and supported by the law. Finally, the Davis Court points out that while not every circuit has explicitly ruled on lien stripping, the 2nd, 3rd, 4th, 5th, 6th, 9th, and 11th Circuits have, and all have permitted it. (Id. at 7).
Last But Not Least...
The only remaining question is whether a Debtor must receive a discharge at the end of its Chapter 13 case in order to complete a lien strip; or if the mere completion of its plan of reorganization is sufficient. The issue arises here because the BAPCPA mandates that once a discharge is received in a Chapter 7 case the Debtor must wait 4 years to file Chapter 13 and obtain another discharge. Realistically however, a Debtor that has received a Chapter 7 discharge does not need a Chapter 13 discharge on top of it. Unfortunately, there is no consensus in this area. Even in the Northern District of Illinois the answer may depend on your Judge (cf In re Fenn, 428 B.R. 494 (Bankr. ND Ill. 2010) with In re Anderson, 10-B-45294 (unreported)).
Bankruptcy discharges affect only personal ("in personam") liability: a discharge does not simply cause liens on property to disappear. As set forth in Sec.1322(b)(2) of the Bankruptcy Code, a plan of reorganization may only modify the rights of unsecured creditors. A lien strip exposes the wholly-unsecured lien on real property and, under the auspices of Code Section 506, allows the Debtor to pay off that "secured" interest for pennies on the dollar, as if it were merely an unsecured interest (which it really is).
Sure, a Chapter 20 lien strip is just the thing for homeowners with too much unsecured debt and a lousy second mortgage or HELoC hanging over their heads. But is it right for you. Call us in confidence to find out. Happy stripping!