Should You File for Chapter 7 Bankruptcy Before or After Foreclosure?

When planning to let go of a home and file for Chapter 7 bankruptcy, you’ll want to time the bankruptcy filing to minimize future financial and legal liability as much as possible. The timing can impact whether you remain responsible for a mortgage deficiency balance, income taxes, or homeowner association (“HOA”) fees. Property tax and personal injury liability are additional issues to consider.

Practically speaking, avoiding all potential problems is nearly impossible, so you’ll want to weigh and balance competing issues before deciding what is best for you. However, when you have a choice, in most cases, filing for Chapter 7 after foreclosure will be the most beneficial and limit the most potential liability.

Keep in mind that filing for Chapter 13 bankruptcy is the better option if you want to save your home. You'll learn about the requirements in How Chapter 13 Bankruptcy Affects Mortgages and Foreclosure.

Timing Chapter 7 Bankruptcy and Foreclosure

Your timing decision will likely be easy if the foreclosure sale date is close. In this situation, most people file on the eve of foreclosure because the “automatic stay” the court puts in place will stop collection actions, including foreclosure proceedings, and buy more time in the home.

How much time you’ll gain will depend on what the lender chooses to do next. If the lender waits to proceed with foreclosure until the case is over, you’ll likely gain another four months.

The lender could instead file a motion to “lift the automatic stay” with the court, which would likely shorten the time to about two months. The court will grant the lender’s motion unless you can bring the loan current or the Chapter 7 trustee wants to sell the home for the benefit of creditors because it has significant equity—both of which would be unusual.

Note. If you file shortly before foreclosure and want to prevent the sale from going forward, you or your attorney should let the lender know of the bankruptcy case immediately. It will take several days for the creditor to receive notice of the bankruptcy from the bankruptcy court.

Benefits of Filing for Chapter 7 Before Foreclosure

Chapter 7 bankruptcy will eliminate or “discharge” your mortgage balance, utility bills, HOA fees, and other qualifying debts owed as of the filing date. Also, if the filing stops the foreclosure sale, you'll have more time in the home. The primary benefit of this approach is that it eliminates the mortgage before foreclosure, along with the possibility of being assessed additional personal income tax due to a “deficiency” balance.

In short, a deficiency is the difference between the auction price and the outstanding mortgage balance. Sometimes, there’s a risk of getting assessed tax if the lender cancels deficiency debt after the foreclosure sale and before bankruptcy (more below). However, because other ways of eliminating a deficiency tax exist, the value of avoiding this risk is somewhat minimized.

That's not to say filing before foreclosure isn't beneficial. Many appreciate the significant emotional benefits of moving past a challenging life phase and rebuilding finances and credit. Not only does peace of mind have value, but many home lenders will work with people as soon as a few years after bankruptcy.

Problems With Filing Chapter 7 Before Foreclosure

Surrendering a home in Chapter 7 doesn’t automatically transfer ownership to the lender or a new owner. The fact that the house will remain in your name until the lender sells it at auction to a new buyer—which could take months or years—will cause some inconvenience.

Until the transfer occurs, creditors will continue to bill you because Chapter 7 filing discharges debt before the filing date but not postpetition debts incurred after the bankruptcy. The situation will resolve in time, but in the meantime, here's what will happen.

You’ll likely continue to be assessed property tax, HOA fees, and possibly utility bills. If they remain unpaid, liens could appear on your credit report. However, the situation should be temporary because it will be in the lender’s interest to pay the liens to prevent a tax sale. Also, all liens must be paid before the home’s title can be transferred to the new buyer.

Another potential problem is that if someone is injured on the property, you’ll be the party sued in a personal injury lawsuit even though you voluntarily vacated the property and no longer have access to it. Although this would be an unusual occurrence, some property owners feel more comfortable remaining on the property as long as possible. This approach allows them to maintain the property's condition while reducing the possibility of trespassers.

Benefits of Filing for Chapter 7 After Foreclosure

The longer you remain in the home, the more you can build up your savings by living in it without paying any mortgage or rent. Also, most problems you might face when filing for bankruptcy before foreclosure are handled more efficiently by filing after the foreclosure takes place and the home is in the hands of the new owner.

At that point, the Chapter 7 filing should erase all outstanding debts related to the property, and it will be far less likely that you'll incur more in the future. The most pressing problem you'll have is the possibility of being taxed on a deficiency balance. But most filers can remedy deficiency problems using one of the exceptions discussed below.

Deficiency After Foreclosure: When You Owe Money After the Foreclosure Sale

In most cases, you can eliminate a deficiency balance by filing for Chapter 7 before or after foreclosure. Filing Chapter 7 before foreclosure will erase the mortgage before an auction occurs, preventing a deficiency altogether. If the lender forecloses your home and you owe a deficiency balance, filing Chapter 7 will erase it.

However, you might face a tax problem if the lender "forgives" a deficiency before you file for bankruptcy. Keep reading to learn more about deficiency balances, when a deficiency will create a tax liability, and the tax liability exceptions that might apply to you.

What Is a Deficiency?

When a lender sells a foreclosed house at auction, the price received can be less than the outstanding mortgage balance, especially when home prices are depressed. The difference between the amount owed on the mortgage and the foreclosure sale price is called the “deficiency.”

Your lender will take steps to collect the deficiency to whatever extent your state’s law allows it. For instance, some states cap the deficiency amount to the difference between the property’s fair market value and the foreclosure sale price.

Can the Lender Collect the Deficiency?

Whether your lender can come after you for the deficiency depends on the state in which you live. Some states, including California, bar lenders from going after borrowers for a deficiency if the borrower’s principal residence secured the underlying mortgage.

In most nonjudicial foreclosure states—states that allow lenders to pursue foreclosure without suing the borrower in court—and a few judicial foreclosure states—states that require lenders to sue borrowers in court before foreclosing—lenders have the right to recover a deficiency only if they file a separate lawsuit against the borrower.

Because borrowers who lose their homes in foreclosure don’t usually have much in the way of income or assets, lenders don’t always pursue this right. Instead of incurring a collection expense with little chance of receiving a return, some lenders will forgive the deficiency. While this sounds like a good result, it often comes with tax liability.

Learn more about mortgage deficiency laws in your state and anti-deficiency laws.

Will You Owe Taxes If Your Lender Forgives the Deficiency?

When your lender doesn’t pursue you for the deficiency and instead cancels the debt before you file for bankruptcy, in the eyes of the IRS, you have just received taxable income. For instance, if the lender forgave $20,000, you’ve received a windfall of $20,000. As far as the IRS is concerned, you once owed a certain amount of money you no longer owe, which is essentially income.

When you have income of $600 or more from debt forgiveness, you must pay income tax on that forgiven debt. This problem can arise when a lender forecloses on a home but forgives the deficiency before the borrower files for bankruptcy.

Because a bankruptcy filing after the forgiveness won't erase tax debt already owed, the filer must qualify for a debt forgiveness exception to exclude the canceled debt from taxable income. Fortunately, two exceptions exist, and bankruptcy filers usually qualify for one or both.

Qualified Principal Residence Indebtedness Exclusion

The "Qualified Principal Residence Indebtedness" (“QPRI”) exclusion excludes mortgage debt forgiven by a lender during the calendar years of 2007 through 2025. As long as the law is still in effect (it's regularly extended), you won’t need to worry about being taxed on a deficiency balance forgiven by your lender.

You can find a complete description of the qualification requirements and learn whether the exemption is still available in Canceled Mortgage Debt: What Happens at Tax Time?

The Insolvency Exception

To qualify for the insolvency exception, you must show the IRS that you were insolvent when the lender canceled the debt. You were insolvent if the total of all of your liabilities was more significant than your assets, which is the case for most bankrupt individuals before filing for bankruptcy. A tax accountant can help you qualify for and claim this exception.

To learn more about the Mortgage Debt Relief Act of 2007 and insolvency exceptions, visit the IRS website at www.irs.gov and search for “mortgage debt forgiveness” and “publication 4681.”