I frequently receive calls from prospective clients asking what the effect of their filing bankruptcy would be on their residence. There are several different scenarios which can play out. Which scenario applies to a particular debtor depends upon the bankruptcy chapter chosen, the amount owed on the property, and whether and to how much the loan is in arrears.
A bankruptcy case is opened by filing a bankruptcy petition with the Bankruptcy Court. Immediately upon the filing of the petition, an “automatic stay” comes into effect. The automatic stay operates to prevent creditors from taking any acts in connection with collecting on the debt. Among other things, this means that any pending foreclosure sale would need to be canceled or postponed.
The automatic stay also stops creditor actions other than foreclosure. For example, it prohibits repossession of cars and other personal property. It causes the sheriff to stop any pending levy or garnishment. It stops all pending lawsuits in any court.
The automatic stay is temporary. It’s designed to freeze the status quo as much as possible in order to allow the debtor some breathing room to sort out the options. The longest the automatic stay can last is until the termination of the case. Under certain circumstances the stay can also be terminated earlier. This frequently happens if a creditor files a motion for relief from the stay in order to pursue collection of the debt, and demonstrates to the court that such a request is justified.
In Chapter 7 bankruptcies, the bankruptcy trustee controls the debtor’s assets. In theory, if there is equity in a residence or any other property, the trustee could sell it and apply the net proceeds to the debtor’s unsecured debt, usually on a pro rata basis. Under such circumstances, the debtor’s homestead exemption would likely protect some of the equity. If there is less equity than the amount of the homestead exemption, then the trustee has no incentive to sell the property because the debtor would receive the funds anyway. Under such circumstances, the trustee usually abandons the property, which means that the debtor regains control of it.
If there is no equity in the property, then the trustee has no interest in pursuing a sale of the property. What happens as a result depends on whether and how much the loan or loans against the property are in arrears. For purposes of this article, I’ll assume that there is only one mortgage loan against the property. If there are multiple loans, the situation becomes more complicated.
If the debtor’s residence is “under water” and the loan payments are current, then the residence is essentially unaffected by the bankruptcy. At the end of the case, the trustee abandons it to the debtor. The lender can’t foreclose, because the debtor isn’t in breach of his promissory note or trust deed covenants. If the remainder of the bankruptcy case has proceeded normally, the debtor emerges from bankruptcy with all unsecured debts discharged. So the debtor presumably would have more cash flow each month to continue to make the mortgage payments.
At the close of the case, there is nothing more to do for the debtor to keep the residence, other than to continue to make the monthly payments. Some lenders will request that the debtor sign a reaffirmation agreement, confirming their continuing to owe on the promissory note. Frequently, however, this is not necessary, and the debtor may simply continue to reside in the residence and make the payments.