Lien Stripping in Colorado

July 23, 2012

By: David M. Serafin

As a way for Colorado homeowners to keep their homes while simultaneously going through bankruptcy to eliminate debts and stop creditor harassment, Congress created Section 506 of the U.S. Bankruptcy Code for those eligible (in chapter 13 only, not chapter 7) to eliminate a second mortgage. Section 506 is an ‘all or nothing’ provision in that the value of the home must be shown to be less than what’s owed on the first mortgage on the date of the chapter 13 filing. Bankruptcy debtors who purchased their property back when real estate values were considerably higher and who now have a greatly reduced value home will primarily benefit from Section 506. As an Aurora and Centennial, Colorado based bankruptcy attorney, I successfully gotten rid of countless numbers of second mortgages in chapter 13.

For instance, suppose that a local realtor opines that your house is worth $200,000. You may be eligible to get rid of the second mortgage if the first mortgage balance is over $200,000. In other words, there needs to be negative equity (e.g. being upside down or underwater) as to the first mortgage alone in order to render the second mortgage unsecured and to strip it off. Section 506 is completely ineffective if it is shown that the property value is higher than the first mortgage balance (e.g. if the second mortgage is even partially secured – even by the smallest margin).

Note that even debtors who pass the chapter 7 Means Test and who can obtain full debt relief from a chapter 7 discharge, may choose chapter 13 relief instead in order to strip a second mortgage lien. I sometimes joke that those clients are actually making money by opting for chapter 13. For example, a single debtor with a gross income of $45,000 will be eligible for chapter 7 and would not need to make any payments to anybody (other than attorney’s fees and court costs) to get a discharge. But, if the Plan payments in chapter 13 – based upon disposable income over 36 months – are only $200/month for 36 months (equals $7,200 total funded into the Plan) compared to immediately stopping a $400/month second mortgage payment (at a higher interest rate to compensate the mortgage lender for taking on the risk of being a junior lien holder) on a $40,000 second mortgage balance, then lien stripping in chapter 13 is a no brainer.

Occasionally, a second mortgage holder will object to eliminating the second mortgage by citing to its own valuation showing a higher value. The risk for both the bankruptcy debtor and creditor is going to contested hearing whereby the judge will find for one side over the other. In lieu of an ‘all or nothing’ solution under Section 506, the parties may opt to negotiate an agreement to keep the second mortgage outstanding but reduce both the principal balance, monthly payments and interest rate. Using the above example, I’ve successfully negotiated payment of $100/month on the second mortgage (for 36 to 60 months) with the debt being discharged at the end of the Plan.

Even if the home is upside down as to the first mortgage alone, a portion of higher income debtors will not be eligible for Section 506 relief. Recall that Section 506 does not completely remove the second mortgage debt; it merely renders it unsecured and equivalent to lower priority credit card debt or medical bills. The Means Test may still require that some, most or all of the total of unsecured debt be paid back over five year Plan.