Keeping a rental property in bankruptcy isn’t easy, but in the right instance, it can be done. In Chapter 7, you’ll need to protect all of the rental’s equity with a bankruptcy exemption and keep the payment current. In Chapter 13, you’ll pay an amount equal to any unprotected equity through a Chapter 13 repayment plan and keep the payment current. You can also reduce or “cram down” the amount you owe on the rental property to reflect the actual value, but you’ll have to pay the reduced balance in full through your repayment plan (which for most is not an easy feat).
In Chapter 7 bankruptcy, you don’t give up everything. You can keep property that you can exempt (protect) under your state’s exemption laws. The Chapter 7 trustee appointed to oversee your case sells any property that you can’t protect with a bankruptcy exemption and uses the proceeds to pay your creditors.
If your rental property is worth more than the amount you owe on it, you must exempt its equity using an exemption if you want to keep it. If you can exempt all of the equity in the rental property, then the trustee won’t be able to sell it.
Exemption laws and amounts vary significantly from state to state; however, states don’t have exemptions for rental property. The typical real estate exemption—known as a homestead exemption—applies to the residence you live in. You can’t use it for properties that aren’t your principal residence. Typically, you’ll have to use a wildcard exemption. But not all states have one, and even if one exists, it might not be very substantial or it might not cover real estate.
If the property has only a small amount of equity, you might not need to worry. The trustee could abandon it if nothing would be left for your creditors after deducting sales costs. Or you might be able to pay the trustee an amount equal to the nonexempt equity (and get a discount equivalent to the sales costs).
The trustee won’t want the property if the mortgage balance exceeds the rental’s value. The lender’s lien rights you agreed to when you put up the house as collateral to guarantee the payment require the trustee to pay off the mortgages upon sale. So in this situation, nothing would be left to pay to creditors. The Chapter 7 trustee would have no incentive to sell the rental.
But that’s not the end of the equation. You’ll need to continue making your regular mortgage payment if you want to keep the property. Here’s why. Although you can discharge (erase) your obligation to pay the mortgage in bankruptcy, the lien will remain. If you don’t stay current, your lender can exercise the lien rights and foreclose on the house after you complete your bankruptcy (or during bankruptcy if the court gives the lender relief from the automatic stay).
In Chapter 13 bankruptcy, the Chapter 13 trustee doesn’t sell your nonexempt assets. But that doesn’t mean that your creditors get less in Chapter 13. Instead, you must pay your unsecured creditors an amount equal to the value of your nonexempt assets through your repayment plan—or the same amount the trustee would have paid to your creditors had you filed for Chapter 7. You’ll pay to keep the property you can’t protect with an exemption.
However, if your rental property is losing money each month, you might not have that option. If keeping it would require you to supplement the rental income with your personal income and leave less for other creditors, the trustee will argue that your case should be dismissed unless you surrender the rental property back to the lender. Because the bankruptcy judge would likely agree with the trustee, you shouldn’t expect the court to let you keep rental property with negative cash flow.
You’ll have a much stronger case, however, if you’re paying back all of your unsecured creditors in full—credit card balances, medical bills, and the like—in what is known as a 100% plan. In that scenario, if you have enough remaining to support the rental unit, you’ll likely be allowed to do so.
Another way to retain rental property is to reduce expenses and generate positive cash flow by cramming down the rental property debt. If the rental’s mortgage is upside down, you’ll be able to reduce how much you owe on the mortgage to the actual value of the property. But here’s the trick—you must repay the reduced balance through the repayment plan in its entirety. Most people don’t have a sufficient income stream to pay off a mortgage in three to five years.
The bankruptcy rules that apply to real estate are some of the trickier rules to navigate, and making a mistake can be costly. Plus, for most people, real estate represents the most valuable asset that they bring into bankruptcy. Because understanding what will happen to your real estate is essential, consider meeting with a bankruptcy attorney before filing your case. A knowledgeable lawyer can explain your property options in bankruptcy.