The homestead exemption is designed to protect the equity (value of your property less the balance of your mortgages or other liens on it) in your home if you file for bankruptcy. If you file a Chapter 7 bankruptcy, it will be a determining factor in whether you will be able to keep your home. In a Chapter 13 bankruptcy, it will affect how much certain creditors will get paid through your bankruptcy. But keep in mind that you can only use the homestead exemption for your principal place of residence.
Here's how the homestead exemption works.
The answer depends on which state you live in. The federal bankruptcy exemption system and the exemption laws of most states have a homestead exemption you can use. The federal homestead exemption amount is currently $23,675 as of 2016 (or $47,350 if you are a married couple filing a joint bankruptcy) but this amount is adjusted every three years.
If you live in a state that allows you to choose between the federal exemptions and its own state exemptions, then you can take advantage of either system. However, if you live in a state that requires you to use only its state exemptions, then you will not be able to use the federal homestead exemption and must look to your state’s exemptions to determine how much home equity you can protect in bankruptcy. Some states have unlimited or very generous homestead exemptions while others don’t have any.
If your home is worth more than the balance of your mortgages or other liens on it, then you have equity. The amount of your equity is an asset in bankruptcy and a Chapter 7 trustee may be able to sell your house and use the equity to pay your creditors. The homestead exemption allows you to exempt a certain amount of your equity and protect it from the bankruptcy trustee.
For example, if you own a home worth $200,000 and you have a $150,000 mortgage on it, then you have $50,000 of equity in your home. If you live in a state that has a homestead exemption of $75,000, your equity is protected and the bankruptcy trustee cannot go after your house. However, if you live in a state that only has a $10,000 homestead exemption, then the bankruptcy trustee will likely take your house and sell it. From the proceeds of the sale, you will receive the exemption amount of $10,000 and the rest will be used to pay off your mortgage as well as pay the trustee’s fee and your creditors.
Even if you live in a state with an unlimited homestead exemption, federal law will cap your exemption amount at $155,675 if you have not owned your home in that state for at least 40 months prior to filing the bankruptcy. One exception to this rule is if you sold a home and used the proceeds to buy a new home in that same state then you can use the length of ownership of both homes to satisfy the 40 month rule.
Similar to the domicile requirements mentioned above, if you have committed bankruptcy fraud or certain other crimes, federal law will cap your homestead exemption at $160,375.
Some states allow you to use their homestead exemption automatically while others require that you declare the property to be your homestead (principal place of residence). If your state requires a declaration, then you may have to record a homestead declaration with your county recorder prior to filing the bankruptcy.