Second mortgage on home could be "stripped off" in Chapter 7 bankruptcy

In a Chapter 7 bankruptcy proceeding, it is possible for a debtor to be relieved of most of his or her debts, making a fresh financial start. One drawback, however, is that this relief may come at the price of a loss of some property.

Questions may arise around a debtor's home, especially if the value of the home is exceeded by the mortgage on it. However, what if there are two mortgages, and the second mortgage greatly exceeds the home's value? Could a debtor avoid liability for that second mortgage? A recent United States Court of Appeals decision discussed this situation.

A second mortgage . . . exceeding the home's value

In the case of In re McNeal, the debtor filed a petition for Chapter 7 bankruptcy, noting that her home was subject to two mortgages. The first mortgage lien was for more than $176,000, and the second mortgage with another company was for more than $40,000. However, the home's fair market value was just over $140,000.

As part of the bankruptcy proceeding, the debtor sought to "strip off"-that is, no longer be liable for-the second mortgage, under the applicable federal bankruptcy law. The debtor argued this stripping off was justified because even the first mortgage was greater than the home's fair market value.

The Bankruptcy Court refused to strip off the second mortgage and the District Court agreed. These decisions were appealed by the debtor to the United States Court of Appeals.

Could the second mortgage be voided?

In reviewing the case, the Court of Appeals noted that the United States Supreme Court had decided in Dewsnup v. Timm that a Chapter 7 debtor could not strip down a mortgage that was partially secured by the home's value. In other words, if the value of the house covered the value of the first mortgage and at least part of the value of the second mortgage, then the second mortgage loan could not be stripped off.

However, the Court of Appeals explained that the Dewsnup decision only disallowed a strip down of partially secured mortgage liens. It did not address the strip off of a wholly unsecured loan, as in this case. In fact, the Supreme Court had even noted in its earlier decision the ambiguities in the federal Bankruptcy Code and the difficulty of interpreting the applicable statute in a way that would apply to all possible situations in the future.

Looking at the facts in this case, the Court of Appeals held that an allowed claim that was not secured by any property-just as the second mortgage was unsecured here-could be avoided under a plain reading of the applicable statute. Thus, the second mortgage could be stripped off in this bankruptcy proceeding and the Court of Appeals reversed the decisions of the lower courts.

Determining the best solution

If you are struggling financially, a Chapter 7 bankruptcy proceeding may provide relief. Even if a Chapter 7 bankruptcy does not suit your situation, there are other bankruptcy options available. A knowledgeable and experienced bankruptcy attorney can review your specific circumstances and work with you to determine the best solution for your needs.