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BANKRUPTCY |
BANKRUPTCY ARTICLES TABLE OF CONTENTS:
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We are a debt relief agency. We help people file for bankruptcy relief under the Bankruptcy Code.
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Short Sales and Deeds in Lieu of Foreclosure
by Attorney Stephen R. EliasA short sale or deed in lieu may help avoid foreclosure or a deficiency.
Many homeowners facing foreclosure determine that they just can’t afford to stay in their home. If you plan to give up your home but want to avoid foreclosure (including the negative blemish it will cause on your credit report), consider a short sale or a deed in lieu of foreclosure. These options allow you to sell or walk away from your home without incurring liability for a “deficiency.”
To learn about deficiencies, how short sales and deeds in lieu can help, and the advantages and disadvantages of each, read on.
Short Sale
In many states, lenders can sue homeowners even after the house is foreclosed on or sold, to recover for any remaining deficiency. A deficiency occurs when the amount you owe on the home loan is more than the proceeds from the sale (or auction) -- the difference between these two amounts is the amount of the deficiency.
In a “short sale” you get permission from the lender to sell your house for an amount that will not cover your loan (the sale price falls “short” of the amount you owe the lender). A short sale is beneficial if you live in a state that allows lenders to sue for a deficiency -- but only if you get your lender to agree (in writing) to let you off the hook.
If you live in a state that doesn’t allow a lender to sue you for a deficiency, you don’t need to arrange for a short sale. If the sale proceeds fall short of your loan, the lender can’t do anything about it.
How will a short sale help? The main benefit of a short sale is that you get out from under your mortgage without liability for the deficiency. You also avoid having a foreclosure or a bankruptcy on your credit record. The general thinking is that your credit won’t suffer as much as it would were you to let the foreclosure proceed or file for bankruptcy.
What are the drawbacks? You’ve got to have a bona fide offer from a buyer before you can find out whether or not the lender will go along with it. In a market where sales are hard to come by, this can be frustrating because you won’t know in advance what the lender is willing to settle for.
What if you have more than one loan? If you have a second or third mortgage (or home equity loan or line of credit), those lenders must also agree to the short sale. Unfortunately, this is often impossible since those lenders won’t stand to gain anything from the short sale.
Beware of tax consequences. A short sale may generate an unwelcome surprise: Taxable income based on the amount the sale proceeds are short of what you owe (again, called the “deficiency”). The IRS treats forgiven debt as taxable income, subject to regular income tax. The good news is that there are some exceptions for the years 2007 to 2009. To learn more, see “Income Tax Liability in Short Sales and Deeds in Lieu,” below.
Deed in Lieu of Foreclosure
With a deed in lieu of foreclosure, you give your home to the lender (the “deed”) in exchange for the lender canceling the loan. The lender promises not to initiate foreclosure proceedings, and to terminate any existing foreclosure proceedings. Be sure that the lender agrees, in writing, to forgive any deficiency (the amount of the loan that isn’t covered by the sale proceeds) that remains after the house is sold.
Before the lender will accept a deed in lieu of foreclosure, it will probably require you to put your home on the market for a period of time (three months is typical). Banks would rather have you sell the house than have to sell it themselves.
Benefits to a deed in lieu. Many believe that a deed in lieu of foreclosure looks better on your credit report than does a foreclosure or bankruptcy. In addition, unlike in the short sale situation, you do not necessarily have to take responsibility for selling your house (you may end up simply handing over title and then letting the lender sell the house).
Disadvantages to a deed in lieu. There are several downfalls to a deed in lieu. As with short sales, you probably cannot get a deed in lieu if you have second or third mortgages, home equity loans, or tax liens against your property.
In addition, getting a lender to accept a deed in lieu of foreclosure is difficult these days. Many lenders want cash, not real estate -- especially if they own hundreds of other foreclosed properties. On the other hand, the bank might think it better to accept a deed in lieu rather than incur foreclosure expenses.
Beware of tax consequences. As with short sales, a deed in lieu may generate unwelcome taxable income based on the amount of your “forgiven debt.”
Income Tax Liability in Short Sales and Deeds in Lieu
If your lender agrees to a short sale or to accept a deed in lieu, you might have to pay income tax on any resulting deficiency. In the case of a short sale, the deficiency would be in cash and in the case of a deed in lieu, in equity.
Here is the IRS’s theory on why you owe tax on the deficiency: When you first got the loan, you didn’t owe taxes on it because you were obligated to pay the loan back (it was not a “gift”). However, when you didn’t pay the loan back and the debt was forgiven, the amount that was forgiven became “income” on which you owe tax.
The IRS learns of the deficiency when the lender sends it an IRS Form 1099C, which reports the forgiven debt as income to you.
No tax liability for some loans secured by your primary home. In the past, homeowners using short sales or deeds in lieu were required to pay tax on the amount of the forgiven debt. However, the new Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) changes this for certain loans during the 2007, 2008, and 2009 tax years only.
The new law provides tax relief if your deficiency stems from the sale of your primary residence (the home that you live in). Here are the rules:
- Loans for your primary residence. If the loan was secured by your primary residence and was used to buy or improve that house, you may generally exclude up to $2 million in forgiven debt. This means you don’t have to pay tax on the deficiency.
- Loans on other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence (for example, a loan on your vacation home), you’ll owe tax on any deficiency.
- Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence, but use it to take a vacation or send your child to college, you will owe tax on any deficiency.
The insolvency exception to tax liability. If you don’t qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief. If you can prove you were legally insolvent at the time of the short sale, you won’t be liable for paying tax on the deficiency.
Legal insolvency occurs when your total debts are greater than the value of your total assets (your assets are the equity in your real estate and personal property). To use the insolvency exclusion, you’ll have to prove to the satisfaction of the IRS that your debts exceeded the value of your assets.
Bankruptcy to avoid tax liability. You can also get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn’t much point in doing the short sale or deed in lieu of, because any benefit to your credit rating created by the short sale will be wiped out by the bankruptcy.
To learn more about short sales and deeds in lieu, including when these options might be right for you, see Nolo's Bankruptcy and Foreclosure Blog or the bestselling Foreclosure Survival Guide, now available online at no charge. Both are written by practicing attorney Stephen R. Elias, president of the National Bankruptcy Law Project.
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How Bankruptcy Can Help With Foreclosure
by Attorney Stephen R. EliasAvoid or delay foreclosure of your home by seeking bankruptcy protection.
If you are facing foreclosure and cannot work out a deal or other alternative with the lender, bankruptcy may help.
If you get behind on your mortgage payments, a lender may take steps to foreclose—that is, enforce the terms of the loan by selling the house at a public auction and taking payment of your loan out of the auction.
This won’t happen overnight. The foreclosure process typically starts after you fall behind on your payments for at least two months, and often three or four. That gives you time to try some alternate measures, such as loan forbearance, a short sale, or a deed in lieu of foreclosure.
But if you've already tried and failed with these measures, now is a good time to consider bankruptcy as a possibility for avoiding or stalling foreclosure. Here are some ways that filing for bankruptcy can help you.
The Automatic Stay: Delaying Foreclosure
When you file either a Chapter 13 or Chapter 7 bankruptcy, the court automatically issues an order (called the Order for Relief) that includes a wonderful thing known as the “automatic stay.” The automatic stay directs your creditors to cease their collection activities immediately, no excuses. If your home is scheduled for a foreclosure sale, the sale will be legally postponed while the bankruptcy is pending—typically for three to four months. However, there are two exceptions to this general rule:
Motion to lift the stay. If the lender obtains the bankruptcy court’s permission to proceed with the sale (by filing a “motion to lift the stay”), you may not get the full three to four months. But even then, the bankruptcy will typically postpone the sale by at least two months, or even more if the lender is slow in pursuing the motion to lift the automatic stay.
Foreclosure notice already filed. Unfortunately, bankruptcy’s automatic stay won’t stop the clock on the advance notice that most states require before a foreclosure sale can be held (or a motion to lift the stay can be filed). For example, before selling a home in California , a lender has to give the owner at least three months’ notice. If you receive a three-month notice of default, and then file for bankruptcy after two months have passed, the three-month period would elapse after you’d been in bankruptcy for only one month. At that time the lender could file a motion to lift the stay and ask the court for permission to schedule the foreclosure sale.
How Chapter 13 Bankruptcy Can Help
Many people will do whatever they can to stay in their home for the indefinite future. If that describes you, and you’re behind on your mortgage payments with no feasible way to get current, the only way to keep your home is to file a Chapter 13 bankruptcy.
How Chapter 13 works. Chapter 13 bankruptcy lets you pay off the “arrearage” (late, unpaid payments) over the length of a repayment plan you propose—five years in some cases. But you’ll need enough income to at least meet your current mortgage payment at the same time you’re paying off the arrearage. Assuming you make all the required payments up to the end of the repayment plan, you’ll avoid foreclosure and keep your home.
2nd and 3rd mortgage payments. Chapter 13 may also help you eliminate the payments on your second or third mortgage. That’s because, if your first mortgage is secured by the entire value of your home (which is possible if the home has dropped in value), you may no longer have any equity with which to secure the later mortgages. That allows the Chapter 13 court to “strip off” the second and third mortgages and recategorize them as unsecured debt —which, under Chapter 13, takes last priority and often does not have to be paid back at all.
Canceling debt. Chapter 7 bankruptcy will also cancel all the debt that is secured by your home, including the mortgage, as well as any second mortgages and home equity loans.
Canceling tax liability for certain property loans. Thanks to a new law, you no longer face tax liability for losses your mortgage or home-improvement lender incurs as a result of your default, whether you file for bankruptcy or not. This new law applies to the 2007 tax year and the following two years.
However, the new tax law doesn’t shield you from tax liability for losses the lender incurs after the foreclosure sale if:
- the loan is not a mortgage or was not used for home improvements (such as a home equity loan used to pay for a car or vacation), or
- the mortgage or home equity loan is secured by property other than your principal residence (for example, a vacation home or rental property).
This is where Chapter 7 bankruptcy helps. It will exempt you from tax liability on losses the lender incurs if you default on these other loans.
Chapter 7 Cannot Cancel the Foreclosure
With all this debt being cancelled, you may be wondering why the foreclosure on your home won’t be cancelled too. The trouble is, when you bought your home you probably signed two documents (at least)—a promissory note to repay the mortgage loan, and a security agreement that could be recorded as a lien to enforce performance on the promissory note.
Chapter 7 bankruptcy gets rid of your personal liability under the promissory note, but it doesn’t remove the lien. That’s the way Chapter 7 works. It gets rid of debt but not liens—you’ll still probably have to give up the house under the lien since that’s what provided collateral for the loan.
Chapter 7 Bankruptcy May Not Be Right For You
Not everyone can or should use Chapter 7 bankruptcy. Here’s why:
You could lose property you want to keep. Chapter 7 might cause you to lose property you don’t want to give up. As an example, if your wedding ring is particularly valuable, it may exceed the dollar amount of jewelry you’re allowed to keep in a bankruptcy (under something called the "jewelry exemption"). In that case, the bankruptcy trustee could order you to turn the ring over to be sold for the benefit of your creditors.
You may not be eligible. Even if Chapter 7 bankruptcy would work for you, you may not be eligible. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, you are not eligible if your average gross income for the six-month period preceding the bankruptcy filing exceeds the state median income for the same size household. Nor are you eligible if your current income provides enough excess over your living expenses to fund a reasonable Chapter 13 repayment plan.
Bankruptcy’s Effect on Your Credit Score
Both bankruptcy and foreclosure will damage your credit score. However, sometimes bankruptcy is the preferable option when trying to rebuild credit. Here’s why:
A foreclosure will damage your credit score for many years, will not get rid of your other debt, and is particularly harmful if you are house shopping.
In contrast, discharging your debts in bankruptcy will harm your credit score, but can help you rebuild your score quicker than after a foreclosure. This is because bankruptcy will leave you solvent and debt-free—and therefore able to start rebuilding good credit sooner.
Keep in mind that the current mortgage meltdown and credit crunch (which are prevalent at the time this article is being written) may change the way bankruptcy and foreclosure affect credit ratings.
If All Else Fails: Relief From Debt and Tax Liability
If you’re certain you won’t be able to propose a Chapter 13 repayment plan that a bankruptcy judge will approve, and Chapter 7 will provide only a temporary delay from the foreclosure sale, then what’s the point of either?
If you have to lose your home—a bitter result to be sure, but sometimes unavoidable—you can at least view bankruptcy as the best way to get out from under your mortgage debt and tax liability. Bankruptcy also offers a way to save some money, which will help you find new shelter and weather the psychological and economic shocks that lie ahead.
To learn more about Chapter 13 bankruptcy and how it can help you avoid foreclosure, get Chapter 13 Bankruptcy: Repay Your Debts, by Robin Leonard and Stephen Elias (Nolo). For information on Chapter 7 bankruptcy, including forms and instructions for filing yourself, get How to File for Chapter 7 Bankruptcy, by Stephen R. Elias, Albin Renauer, and Robin Leonard (Nolo).
If you're having trouble making your mortgage payments or already in jeopardy of foreclosure, see Nolo's Bankruptcy and Foreclosure Blog or the bestselling Foreclosure Survival Guide, now available online at no charge. Both are written by practicing attorney Stephen R. Elias, president of the National Bankruptcy Law Project.
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The New Bankruptcy Law: Changes to Chapter 7 and 13
Chapter 7 bankruptcy may be harder to file under the new law.
The latest changes to bankruptcy law may be making it harder for some people to file bankruptcy. And a few filers with higher incomes are no longer allowed to use Chapter 7 bankruptcy, but will instead have to repay at least some of their debt under Chapter 13. All debtors now have to get credit counseling before they can file a bankruptcy case -- and additional counseling on budgeting and debt management before their debts can be wiped out. And, because the law imposes new requirements on lawyers, it is sometimes tougher to find an attorney to represent you in a bankruptcy case.
Here are some of the most important changes.
Restricted Eligibility for Chapter 7 Bankruptcy
Under the old rules, most filers could choose the type of bankruptcy that seemed best for them -- and most chose Chapter 7 bankruptcy (liquidation) over Chapter 13 bankruptcy (repayment). The new law prohibits some filers with higher incomes from using Chapter 7 bankruptcy.
How High is Your Income?
Under the new rules, the first step in figuring out whether you can file for Chapter 7 bankruptcy is to measure your "current monthly income" against the median income for a household of your size in your state. If your income is less than or equal to the median, you can file for Chapter 7 bankruptcy. If it is more than the median, however, you must pass "the means test" -- another requirement of the new law -- in order to file for Chapter 7.
The Means Test
The purpose of the means test is to figure out whether you have enough disposable income, after subtracting certain allowed expenses and required debt payments, to make payments on a Chapter 13 plan. To find out whether you pass the means test, you subtract certain allowed expenses and debt payments from your current monthly income. If the income that's left over after these calculations is below a certain amount, you can file for Chapter 7.
If you're looking for an easy way to determine your eligibility under the means test, use our online means test calculator, created by the author of Nolo's book How to File for Chapter 7 Bankruptcy, Albin Renauer, J.D. Once you enter your zip code, the calculator uses the applicable income and expense standards for your state, county, and region to determine your eligibility.
Counseling Requirements
Before you can file for bankruptcy under either Chapter 7 or Chapter 13, you must complete credit counseling with an agency approved by the United States Trustee's office. (To find an approved agency in your area, go to the Trustee's website, www.usdoj.gov/ust, and click "Credit Counseling and Debtor Education".) The purpose of this counseling is to give you an idea of whether you really need to file for bankruptcy or whether an informal repayment plan would get you back on your economic feet.
Counseling is required even if it's obvious that a repayment plan isn't feasible or you are facing debts that you find unfair and don't want to pay. You are required only to participate, not to go along with any repayment plan the agency proposes. However, if the agency does come up with a repayment plan, you will have to submit it to the court, along with a certificate showing that you completed the counseling, before you can file for bankruptcy.
Toward the end of your bankruptcy case, you'll have to attend another counseling session, this time to learn personal financial management. Only after you submit proof to the court that you fulfilled this requirement can you get a bankruptcy discharge wiping out your debts. (The website above also lists approved debt counselors.)
Lawyers May Be Harder to Find -- and More Expensive
As you can see, the new law adds some complicated requirements to the field of bankruptcy. This makes it more expensive -- and time-consuming -- for lawyers to represent clients in bankruptcy cases, which means attorney fees have gone up.
The new law also imposes some additional requirements on lawyers, chief among them that the lawyer must personally vouch for the accuracy of all of the information their clients provide them. This means attorneys have to spend more time on bankruptcy cases, and charge their clients accordingly. This combination of new requirements have driven some bankruptcy lawyers out of the field altogether.
Some Chapter 13 Filers Will Have to Live on Less
Under the old rules, people who filed under Chapter 13 had to devote all of their disposable income -- what they had left after paying their actual living expenses -- to their repayment plan. The new law added a wrinkle to this equation: Although Chapter 13 filers still have to hand over all of their disposable income, they have to calculate their disposable income using allowed expense amounts dictated by the IRS -- not their actual expenses -- if their income is higher than the median in their state. And these allowed expense amounts must be subtracted not from the filer's actual earnings each month, but from the filer's average income during the six months before filing.
Other Changes
There are other changes that can affect bankruptcy filers negatively, including how property is valued (at replacement cost instead of auction value) -- this means more debtors are at risk of having their property taken and sold by the trustee -- and how long a filer must live in a state to use that state's exemption laws (this can make a big difference in the amount of property a bankruptcy filer gets to hold on to). These changes and others are explained in The New Bankruptcy: Will It Work for You?, by Attorney Stephen Elias (Nolo).
Also, you might find author Stephen Elias's podcast helpful: What Are the Rules Under the New Bankruptcy Law?
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Foreclosure FAQ
Avoid or delay foreclosure with short sales, deeds in lieu of foreclosure, bankruptcy, and other tactics.
What's Below:
Will my bank negotiate with me or lower my rate so I can avoid foreclosure?
Can I sell my house for less than I owe on my mortgage (short sale)?
Can bankruptcy stop a foreclosure?
What is a deed in lieu of foreclosure?
What happens to renters when a property is foreclosed on?
Are there foreclosure protections for military personnel?
Will my bank negotiate with me or lower my rate so I can avoid foreclosure?
Your lender may modify your loan if you have an adjustable rate mortgage or if you are several months behind on your mortgage. Call and ask to speak to your lender’s loan modification or loss mitigation department. The lender may accept partial payments for a few months (though you may have to agree to make up the difference later), accept a late payment, or agree to modify the terms of your loan.
There are several plans offered by the federal government to help homeowners avoid foreclosures, including FHASecure and Hope for Homeowners. The most recent program to be announced is the Homeowner Affordability and Stability Plan, which is aimed at helping homeowners refinance their mortgages to lower their mortgage payments. Homeowners might qualify for a refinance at a 15- or 30-year fixed-market-interest-rate (currently around 5%).
This plan would ease the rules so that homeowners whose loans are owned or guaranteed by the Fannie Mae and Freddie Mac could have a chance to refinance even if they have little or no equity in their home. A separate part of the plan would bring mortgage payments down for some homeowners to a total of 31% of their gross income. Both parts of the plan would apply only to homeowners with conforming loans.
Can I sell my house for less than I owe on my mortgage (short sale)?
If the sales price you are offered falls short of the amount you owe the lender -- called a "short sale" -- you need to get permission from your lender. This is because in most states, technically a lender is allowed to sue you after the house is sold (or foreclosed on) to recover any remaining deficiency -- the difference between the sales price and what you owe on the mortgage. In most cases, however, a lender is not likely to sue for a deficiency.
If you live in a state that doesn’t allow a lender to sue you for a deficiency, you don’t need to arrange for a short sale. In this case, if the sale proceeds fall short of your loan, the lender can’t do anything about it.
Short sales usually aren't possible if there is a second mortgage, unless the same lender owns both loans. Also, some homeowners may be better off letting a foreclosure take place, saving a few month's mortgage payments until it happens.
Can bankruptcy stop a foreclosure?
Bankruptcy can delay a foreclosure, but won’t stop it permanently. Here’s how it works: When you file bankruptcy, the court automatically issues an "automatic stay." The automatic stay directs your creditors to cease all collection activities and foreclosures immediately. If your home is scheduled for a foreclosure sale, the sale will be postponed while the bankruptcy is pending -- typically for three to four months.
However, if your lender obtains the bankruptcy court's permission to proceed with the sale (by filing a "motion to lift the stay"), the sale may be allowed to go forward after a couple of months. But during a Chapter 7 bankruptcy, you can live in your home for free for several months while your bankruptcy is pending. You can then use that money to help secure new shelter.
If you're having trouble making your mortgage payments or already in jeopardy of foreclosure, see Nolo's Bankruptcy and Foreclosure Blog or the bestselling Foreclosure Survival Guide, now available online at no charge. Both are written by practicing attorney Stephen R. Elias, president of the National Bankruptcy Law Project.
What is a deed in lieu of foreclosure?
With a deed in lieu of foreclosure, you give your home to the lender (the "deed"), and in exchange, the lender cancels the loan rather than foreclosing on the property. In most states, a lender is allowed to sue you to recover any remaining deficiency—the difference between what the lender can sell the house for and what you owed on the mortgage. Before you agree to a deed in lieu of foreclosure, make sure that the lender agrees, in writing, to forgive any deficiency that exists. Deeds in lieu of foreclosure are not possible if there is a second mortgage, unless the same lender owns both loans.
What happens to renters when a property is foreclosed on?
Most renters will lose their leases upon foreclosure. The rule in most states is that if the mortgage was recorded before the lease was signed, the lease will be wiped out when a foreclosure occurs. That doesn't mean a renter will have to leave immediately -- but those who remain in the rental join the ranks of month-to-month renters, all of whom can be terminated with proper notice -- usually 30 days, but 60 days in California. The new owner (usually the lender) may or may not move quickly to terminate the rental.
Are there foreclosure protections for military personnel?
A mortgage lender can't foreclose on a house owned by military personnel on active duty unless the lender seeks special permission from the court.
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