by: Kathleen Michon, J.D.
If you know you're going to lose your house in foreclosure, and you also plan on filing for bankruptcy, should you file for bankruptcy before or after foreclosure? Sometimes you have no choice. But if you do, you will most likely benefit more if you file for bankruptcy before your house is foreclosed. Read on to find out why.
(For the purpose of this article, we assume you will file for Chapter 7 bankruptcy rather than Chapter 13 bankruptcy. See How Chapter 13 Bankruptcy Affects Mortgages and Foreclosure for information on Chapter 13 bankruptcy and foreclosure.)
When a house is sold in foreclosure, the price at which the home is sold is often much less than the outstanding amount of the mortgage. This is especially true these days, when home prices are depressed throughout the U.S. The difference between the amount owed on the mortgage and the foreclosure sale price is called the "deficiency." (Some states cap the amount of the deficiency to the difference between the property's fair market value and the foreclosure sale price.)
Whether your lender can come after you for the deficiency depends on the state you live in. Some states, including California, bar lenders from going after borrowers for a deficiency if the underlying mortgage was secured by the borrower's principal residence. 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 of the expense (and because borrowers who lose their homes in foreclosure often don't have much in the way of income or assets), lenders frequently forego this right. (To find out what the law is in your state, see the Mortgage Deficiency Laws topic page and the article on Anti-Deficiency Laws.)
If your lender doesn't pursue you for the deficiency and instead cancels the debt, in the eyes of the IRS you have just received taxable income. As far as the IRS is concerned, you once owed a certain amount of money (say, $20,000); you now no longer owe the $20,000; therefore, you've received a windfall of $20,000. You will have to pay income tax on that forgiven debt unless you qualify for one of two exceptions: the Mortgage Debt Relief Act of 2007 exception or the insolvency exception.
The Mortgage Debt Relief Act of 2007 is a federal law that excludes from taxable income forgiven debt that was (a) taken out to buy, build, or substantially improve the borrower's principal residence (or to refinance a mortgage taken out to buy, build, or substantially improve the borrower's principal residence), and (b) secured by the borrower's principal residence. The maximum amount of forgiven debt that can be claimed under this exception is $2 million (or $1 million if you're married but you file separately). This exclusion only applies to loans taken out during the calendar years of 2007 through 2013. (Congress is currently considering a bill which would extend that through 2015.) For more details and updates on this Act, see Nolo's article Canceled Mortgage Debt: What Happens at Tax Time?
To qualify for the insolvency exception, you must show the IRS that you were insolvent when the debt was cancelled. You were insolvent if the total of all of your liabilities was greater than the total of all of your assets
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."
Filing for bankruptcy will eliminate some but not all of your debts. If your lender comes after you for the deficiency, and you file for bankruptcy afterwards, bankruptcy will wipe out the deficiency debt. On the other hand, if your lender forgives the deficiency before you file for bankruptcy, and you don't qualify for any of the exceptions that would exclude the cancelled debt from your taxable income, filing for bankruptcy afterwards will most likely be of no help in eliminating your tax debt.
If you file for bankruptcy before foreclosure, your mortgage debt will be discharged. (Although the lien will remain, which means that if you default on payments, the lender can still foreclose.) Because there is no longer any mortgage debt, after the foreclosure sale there will be no deficiency and no tax liability for any cancelled deficiency debt.
As soon as you file for bankruptcy, an order called an "automatic stay" is issued by the court. The automatic stay prohibits your creditors from pursuing any collection activities, including any action related to a pending foreclosure. While your bankruptcy winds its way through the court system, which could take three or four months, you have the opportunity to build up your savings by living in your home without paying any mortgage or rent.
Your lender has the right to ask the bankruptcy court to lift the automatic stay and allow them to go forward with the foreclosure. Nowadays, with the glut of foreclosed homes on the market, many lenders are foregoing this right and waiting for bankruptcy cases to conclude before continuing with foreclosures.