McFerran & Burns, P.S.
Practicing Real Estate Law in Western Washington since 1986
October 28th, 2013
Lien Avoidance/Lien Stripping
Did you know judgment liens can be removed from a property through bankruptcy? Did you know a bankruptcy can reduce junior mortgages to the status of unsecured debt? Today I want to discuss the tools in our bankruptcy tool box that allow us to do just that.
Lien Avoidance
The other day a broker called me with a problem. She had a Purchase and Sale Agreement for a piece of property. Unfortunately, the seller did not tell her there were two judgments against him. Her first notice was the title report. She wanted to know if there was anything that could be done other than paying the judgments. The answer was yes; if the seller qualifies for a Chapter 7 bankruptcy, the judgment liens can be “avoided.”
Let me explain. The standard rule in bankruptcy is that debts are discharged, but liens pass through bankruptcy unchanged by the bankruptcy discharge. So, while the debtor is no longer personally liable on the debt, the lien survives. Fortunately, we have the ability to avoid a judgment lien in a Chapter 7 under Section 522 of the Bankruptcy Code, if it impairs an exemption.
Both the State of Washington and the Bankruptcy Code allow a debtor to “exempt” a certain amount of value in residential real estate. If the judgment lien has attached to that real estate and “impairs” the exemption, then the judgment lien can be avoided in its entirety. The result is a discharge of the debt and the removal of the lien.
So, how do we determine if the judgment lien impairs an exemption?
The Bankruptcy Code sets for a formula to determine if an exemption is impaired. Under the Code, if the lien to be avoided and all other liens on the property and the debtors’ exemption exceed the value of the debtors’ interest in the property, the exemption is impaired and the judgment lien can be removed from the property.
Here’s an example:
In Washington, debtors are allowed to exempt $125,000.00 in equity in real estate. So, if there is a judgment against the debtors for $20,000.00 and the property is worth $150,000 with a $100,000.00 mortgage, would the judgment lien be avoided?
Mortgage: $100,000
Exemption: $125,000
Judgment lien: $20,000
Total of liens and exemption: $245,000
Debtor’s interest in the house (value): $150,000
Because the total of the liens and exemptions on the property ($245,000) exceed the debtor’s interest ($150,000), the judgment lien can be avoided in a Chapter 7. As a result the debtor’s personal liability would be discharged and the property would be free of the judgment lien.
Practice Pointer: The filing of a bankruptcy does not automatically avoid the lien. A separate motion must be filed with the court, and a Court Order avoiding the lien must be obtained. Due to laziness or lack of diligence, some bankruptcy attorneys do not take this crucial step. As a result, the lien survives the bankruptcy. Because we focus on real estate issues at McFerran and Burns, we always check for judgments and if appropriate, take the necessary steps to remove judgment liens in Chapter 7 bankruptcies.
Lien Stripping (Chapter 13)
As indicated above, the standard rule in bankruptcy is that debts are discharged, but liens pass through bankruptcy unchanged by the bankruptcy discharge. So, while the debtor is no longer personally liable on the debt, the lien survives.
An exception to that rule is provided by Chapter 13. When the value of the collateral available to secure the lien is less than the debt secured by the lien, the lien may be “stripped” off and the debt “crammed down” to the value of the collateral that secures it. The exception to the exception is mortgages on the debtor’s primary residence. In that case it’s all or nothing.
Here’s how it works. The first mortgage cannot be modified by a Chapter 13. The first position lender must be paid its regular payments. However, if there is more than one lien on the debtor’s residence, and the value of the property is less than the balance on the first mortgage, junior mortgages or liens can be “stripped”, and the debts paid the same as unsecured creditors. However, if there is any equity above the first mortgage balance, the second gets the same treatment as the first.
I realize this can be confusing. I think some examples will help to clarify.
Example #1: The debtor’s home is worth $150,000. The first mortgage balance is $175,000 and the second is $100,000. Even though the balance on the first exceeds the value, the lender in first position is still entitled to its regular payments. But because the balance on the first mortgage ($175,000) exceeds the value of the property ($150,000), the second mortgage can be stripped. The second mortgage will be treated as an unsecured debt, and will be paid the same percentage as credit cards and medical debt. That percentage can be as low as 0% depending on the debtor’s circumstances. At the conclusion of the Chapter 13 (3-5 years) the second will be removed from the property, and the remaining debt discharged.
Example #2: The debtor owns a home valued at $150,000. There is a first mortgage of $125,000 and a second with a balance of $100,000. Because the value ($150,000) is greater than the amount of the first mortgage ($125,000), the second mortgage cannot be stripped. Both mortgages must be paid according to their terms. It doesn’t matter how much equity there is above the first. Even if it’s only $1.00, the second cannot be stripped.
Practice Pointers:
• The rules are different if the property is not the primary residence of the debtor.
• The key to the analysis for either lien avoidance or lien stripping is value.
• Lien stripping is only available in a Chapter 13, and is not final until the debtor completes the plan payments.
• Lien avoidance can be used in either a Chapter 7 or a Chapter 13, but only applies to non-consensual (judgment) liens.
• Lien stripping and lien avoidance can only be accomplished by pleadings separate and apart of the initial bankruptcy filing. Simply filing a bankruptcy will not strip or avoid any liens or mortgages.
The rules surrounding lien stripping and lien avoidance are complex, complicated and fact specific. The methods of stripping and avoiding liens are technical. Only an experienced bankruptcy practitioner is qualified to give advice and file the appropriate Chapter and the pleadings within the bankruptcy case to accomplish the ultimate goal of removing certain liens from your client’s real estate. I have seen many cases over the years where the debtor’s attorney failed to take the steps necessary to avoid a judgment lien. The failure and its consequences do not become apparent until the debtor tries to sell the property. By then, it may be too late.
If your client has an underwater second, we may be able to strip the lien in a Chapter 13. If you have a client with a judgment lien that’s holding up your sale, maybe we can help. Call 253-284-3838, Option 1 to set up a free bankruptcy consultation. We have offices throughout the Puget Sound; Tacoma, Seattle (Northgate), Kent, Silverdale, Kirkland and Everett. At McFerran and Burns, our practice is focused on all things real estate. Our bankruptcy group is now up and running at full speed. We want to make sure our clients get the full benefit of their bankruptcy, which may include more than just a discharge.
If you have a specific question, try our new “McFerran & Burns Legal Line”. It is available to our industry partners at no cost or expense when you email your questions to us at legalline@mbs-law.com.
Your question will be sent to each of our attorneys. One of us will get back to you within 24 hours of receipt. It may be an email answer or it may be a phone call back to you so please include your name, agency name and phone number with your question. There is no charge for this service. The only restrictions are that you must be a licensed real estate professional and it must pertain to areas of our real estate, tax, business and bankruptcy practice. Just email us at legalline@mbs-law.com.
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