Most people buy real estate hoping that its value will increase, but it doesn’t always turn out this way as houses sometimes decline in value as well. So if your mortgage company told you that it was going to reduce the balance of your loan because your property was now worth less than your mortgage, you would likely be thrilled to hear this. Well this is exactly what you can do in a Chapter 13 bankruptcy on your investment or rental properties. This is called a “cramdown.” However, you must be aware that you cannot cram down the mortgage on your principal residence.
Let’s say you bought a rental property in 2005 for $200,000 and took out a mortgage for $190,000. Now it's 2011, you still owe $175,000 on your mortgage but the house is only worth $100,000. This means that only $100,000 of the mortgage is secured (if the mortgage company foreclosed on the house and sold it this is the amount they would recover from the sale). Through a Chapter 13 bankruptcy, you can cram down the principal balance of your mortgage to the secured portion ($100,000).
This means that during your Chapter 13 repayment plan, you will only pay $100,000 (instead of the $175,000 balance) to your mortgage lender and own the rental property free and clear at the completion of the plan. As an added benefit, you may be able to reduce your interest rate as well. The interest rate will be set by the bankruptcy court and will depend on which district you live in, but will usually be lower than your note rate.
The remaining $75,000 of your mortgage will be treated as unsecured debt since this is the portion of your mortgage balance above what the house is worth. This portion will get the same treatment in bankruptcy as your other unsecured debts such as credit cards and medical bills. Normally, these creditors receive only a small portion of what they are owed in a Chapter 13 bankruptcy or nothing at all. So it is likely that you will pay much less than $75,000. Any portion you don’t pay in your plan will get discharged (wiped out) along with your other unsecured debts upon completion of your bankruptcy plan.
If the mortgage lender forecloses on your investment property but the foreclosure sale proceeds are not enough to pay off your entire mortgage, the difference is called a “deficiency” balance. In many states, the lender can sue you personally to collect this amount. Also, even if the mortgage lender decides to forgive this amount then this may create tax problems in the future because the IRS sometimes views the forgiven amount as income which results in increased tax liability. However, if you discharge the unsecured portion through a Chapter 13 cramdown, then the lender can no longer sue you for any deficiency and the IRS cannot claim the discharged portion as income.
In addition to the principal residence restriction, there are also other limitations to using a cramdown for rental or investment properties. The most important one is that most courts require the reduced balance of the crammed down mortgage to be paid off at the completion of your Chapter 13 repayment plan (which usually lasts 3 to 5 years and cannot be longer than 5 years). Since most people cannot pay off a mortgage in this short amount of time, they are unable to take advantage of an investment property cramdown.