Should I File for Bankruptcy Before or After Foreclosure?

It's often advantageous to file for Chapter 7 bankruptcy before you lose your home to foreclosure.

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Question

I’m planning on filing a Chapter 7 bankruptcy and have also fallen behind in my mortgage payments so I’m expecting to lose my home to a foreclosure. Should I file bankruptcy before or after the foreclosure?

Answer

You’ll most likely gain more if you file for bankruptcy before your home is foreclosed. For one thing, this way you’ll prevent the lender from getting a deficiency judgment (if one is allowed in your situation). You’ll also get to stay in your house longer than if you let the foreclosure happen and later file bankruptcy. Keep reading to learn more about the reasons why you should consider filing bankruptcy before foreclosure.

Understanding Foreclosure Deficiencies

When a house is sold at a foreclosure sale, the total amount owed by the homeowner on the mortgage to the lender often exceeds the foreclosure sale price. The difference between the sale price and the amount owed on the mortgage is called a deficiency.

Example. Say you owe your mortgage lender $200,000, but your home only sells for $150,000 at the foreclosure sale. The deficiency is $50,000. (Some states limit the deficiency to the difference between the property’s fair market value and the total debt. In this example, if the home’s fair market value was $175,000, the deficiency would be limited to $25,000.)

Deficiency Judgments After Foreclosure

Whether your lender can get a deficiency judgment depends on the state law where you live. Some states prohibit lenders from going after a borrower for a deficiency under certain circumstances (such as if the mortgage loan was secured by the borrower’s principal residence). In other states, the lender can come after you for the deficiency by seeking a personal judgment against you.

The Lender Must Sue You to Get a Deficiency Judgment

In most nonjudicial foreclosure states (states where the foreclosure takes place without court approval) and a few judicial foreclosure states (states that require the lender to go through the court system to take back ownership of the property), a lender can only recover a deficiency if it files a separate lawsuit against you. (In other judicial foreclosures, the deficiency judgment can be included in the foreclosure judgment. To learn more about deficiency judgments and find out what the law is in your state, see our Deficiency Judgments After Foreclosure area.)

Filing Bankruptcy to Avoid a Deficiency Judgment

If your lender comes after you for the deficiency, and you later file for bankruptcy, bankruptcy will discharge (eliminate) the deficiency debt.

However, for many people it makes more sense to file bankruptcy before foreclosure to preemptively discharge the mortgage debt. Then you don’t have to worry about the possibility of a deficiency judgment. This can provide peace of mind since, once the mortgage debt is discharged, you know you won’t have to face a lawsuit from the lender to recover the deficiency after the foreclosure.

Of course, if your state’s laws prevent the lender from getting a deficiency judgment, this doesn’t apply to you.

Filing Bankruptcy to Avoid Tax Liability for Forgiven Amount

Another reason to file bankruptcy before the foreclosure is because if your lender forecloses and cancels the deficiency debt (rather than seeks a deficiency judgment), you may have to include the cancelled amount as income on your tax return. If that happens, you generally must pay tax on that forgiven debt unless you qualify for one of two exceptions:

The Mortgage Debt Relief Act of 2007 Exception

The federal Mortgage Debt Relief Act of 2007 excludes from taxable income forgiven debt that:

  • was taken out to buy, build, or substantially improve your principal residence (or refinanced a mortgage taken out to buy, build, or substantially improve your principal residence), and
  • is secured by your principal residence.

The maximum amount of forgiven debt you can claim under this exception is $2 million (or $1 million if you’re married but filing separately). The exclusion applies to debt forgiven in calendar years 2007 through 2013, though Congress is currently considering a bill that would extend this timeframe. (To learn more about the Mortgage Debt Relief Act of 2007, see Nolo's article Canceled Mortgage Debt: What Happens at Tax Time?)

The Insolvency Exception

If you were insolvent when the debt was cancelled, some or all of the debt may not be taxable to you. You are considered insolvent if your total liabilities (debts) are more than the fair market value of your total assets. (To learn more about the insolvency exception, visit the IRS website.)

The bottom line is that if your lender forgives the deficiency before you file for bankruptcy, and you don’t qualify for either of these exceptions that would exclude the forgiven debt from your taxable income, filing for bankruptcy afterwards probably won’t eliminate your tax debt. On the other hand, if you file bankruptcy before the foreclosure, the mortgage debt will be discharged and there will be no tax liability since there won't be any forgiven deficiency debt.

Bankruptcy Cancels Other Mortgage Debt

If you have any other mortgage debt, such as a second mortgage or a HELOC, it may be wise to file bankruptcy before the foreclosure to wipe out your personal liability for those debts.

When the first mortgage lender eventually forecloses, any junior mortgage lenders (second mortgages and HELOCs for example) will also be foreclosed and lose their security interest in the real estate. Generally, if a junior mortgage lender has been sold-out in this manner, that junior mortgage lender could potentially sue you personally to collect the debt. However, a bankruptcy will eliminate any debt secured by a second mortgage or a HELOC and you can avoid future lawsuits from these lenders.

Bankruptcy Buys You Time in the Property by Delaying Foreclosure

If you file for bankruptcy before your home is sold at foreclosure, this can give you more time to live in the home.

When you file bankruptcy, an "automatic stay" goes into effect. The stay acts as an injunction, or bar, against any attempts by creditors to collect debts or enforce liens, including taking any action related to a pending foreclosure. (Learn more in Bankruptcy's Automatic Stay and Foreclosure.)

Since the automatic stay prevents the foreclosure case from moving forward, this buys you some extra time in the home. (The lender does have the right to ask the bankruptcy court to lift the automatic stay, which would allow it to continue with the foreclosure, but this will still take some time. In the meantime, you get to remain in the home.)

You Can Save Money During the Foreclosure Delay

You can live in your home without making any mortgage payments during the bankruptcy -- at least until the lender obtains relief from the stay and completes the foreclosure. (The lender may even forego this right and simply wait for the bankruptcy case to conclude before continuing with the foreclosure.) Either way, this will probably take a few months. This allows you to take advantage of the extra time filing bankruptcy buys you by building up your savings. For instance, if your mortgage payment is $1,000 a month, you could end up saving several thousand dollars by staying in the home and not making payments during this time. (Learn more in How Foreclosure Can Help You Save Money.)

by: , Contributing Editor

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