Most people buy real estate hoping that its value will increase, but it doesn’t always happen. When the economy has a turn for the worse, housing values can decline in value, just like property that’s expected to do so, such as cars or household goods.
One of the benefits of filing for Chapter 13 bankruptcy is that in some instances, you can reduce the balance of your loan when your property’s value drops below what you owe on the mortgage. You can do this using a cramdown on your investment or rental properties.
And while you can’t use a cramdown to lower the mortgage on your principal residence, you can use another mechanism to strip off junior loans. Learn more by reading What Happens to My Upside-Down Mortgage in Bankruptcy?
Let’s say you bought a rental property in 2014 for $200,000 and took out a mortgage for $190,000. In 2019, you still owed $175,000 on your mortgage, but the house is only worth $100,000. If the mortgage company foreclosed on the house and sold it, the lender would recover the $100,000 equity. So the secured portion of the mortgage equals $100,000.
Through a Chapter 13 bankruptcy, you can reduce, or “cram down,” the principal balance of your mortgage to the $100,000 secured portion. Here’s how it works.
During your Chapter 13 repayment plan, you will pay $100,000 instead of the $175,000 owed to your mortgage lender. At the end of the plan, you’ll own the rental property free and clear. As an added benefit, you might be able to reduce your interest rate as well. The bankruptcy court will set the interest rate, and it will usually be lower than your note rate.
Learn about Chapter 13 cramdowns for other types of property.
The remaining $75,000 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 qualifying unsecured debt balances such as credit cards and medical bills.
Typically, these creditors receive only a small fraction of the balance owed or nothing at all. So you will likely pay much less than $75,000. Any amount you don’t pay in your plan will get discharged (wiped out) along with your other unsecured debts upon completion of your bankruptcy plan.
In addition to the principal residence restriction, other limitations for rental or investment properties exist. The most important one is that most courts require the crammed down balance to be paid off through your Chapter 13 repayment plan, which will be either three or five years in length. 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.