Discharge of Underwater Second Mortgage in Chapter 7 now Disallowed

June 2, 2015

The Case:

The debtors, respondents David Caulkett and Edelmiro Toledo-Cardona, each have two mortgage liens on their respective houses. Petitioner Bank of America (Bank) holds the junior mortgage lien—i.e., the mortgagelien subordinate to the other mortgage lien—on each home. The amount owed on each debtor’s senior mortgage lien is greater than each home’s current market value. The Bank’s junior mortgage liens are thus wholly underwater: because each home is worth less than the amount the debtor owes on the senior mortgage, the Bank would receive nothing if the properties were sold today.
In 2013, the debtors each filed for Chapter 7 bankruptcy. In their respective bankruptcy proceedings, they moved to “strip off ”—or void—the junior mortgage liens under §506(d) of the Bankruptcy Code. In each case, the Bankruptcy Court granted the motion, and both the District Court and the Court of Appeals for the Eleventh Circuit affirmed.

In March the Supreme Court heard the cases and on June 1st announced their opinion that reversed the previous rulings.

Up until now a homeowner filing Chapter 7 bankruptcy could ask the bankruptcy court to hold that a second mortgage that was wholly unsecured by the value of the property was void, or "stripped off", from the property. This in many cases allowed the property to be sold with the holder of the first mortgage being paid off and the bankruptcy filer able to walk away from the remaining debt as a part of the bankruptcy.

While the ruling only holds for those Filing a Chapter 7 bankruptcy, it still has a tremendous impact. Consider that in some states there are more than a million homes underwater and one report indicates that in Florida alone fully 23% of those properties are encumbered with a second mortgage.

Excerpt from Supreme Court Decision

Under the debtors’ approach, if a court valued the collateral at one dollar more than the amount of a senior lien, the debtor could not strip down a junior lien under Dewsnup, but if it valued the property at one dollar less, the debtor could strip off the entire junior lien. Given the constantly shifting value of real property, this reading could lead to arbitrary results. To be sure, the Code engages in line-drawing elsewhere, and sometimes a dollar’s difference will have a significant impact on bankruptcy proceedings.

The ruling covers a huge number of U.S. households that could have potentially used a Chapter 7 filing to create breathing room. However, consider that had the ruling gone against the banks that lenders might have been less willing to make second mortgages, including HELOCs. 

And bankruptcy lawyers remind us that filing a Chapter 13 bankruptcy will still afford the opportunity to strip off underwater mortgages. This process is much more costly (a Chapter 7 filing can cost just a few hundred dollars where a Chapter 13 filing can start at $2,500 with the debtor paying a portion up front and goes up from there) and Chapter 13 plans can last up to 5 years with the debtor being required to hold the property the entire duration of the bankruptcy plans lifespan.

This might prevent many from taking advantage of a Chapter 13 filing, but for those who can afford the expense and the time, this method of "stripping off" potentially thousands of dollars of debt can still be a viable path towards financial success.

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