Should I File for Bankruptcy Before or After Foreclosure?

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 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, 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.

How Deficiency Judgments Work

When a house is sold at a foreclosure sale, the borrower's total debt sometimes exceeds the foreclosure sale price. The difference between the sale price and the amount owed is called a "deficiency."

Example. Say you owe your mortgage lender $200,000, but your home 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.

In some states, the lender can seek a personal judgment, called a "deficiency judgment," against the borrower to recover the deficiency. Generally, once the lender gets a deficiency judgment, the lender may collect this amount using typical collection techniques. For example, it might tell your employer to deduct money from your paycheck (a wage garnishment) or force your bank to take money out of your account (bank levy).

Other states prohibit lenders from going after a borrower for a deficiency under certain circumstances, such as if the borrower's principal residence secured the loan.

The Lender Must Sue You to Get a Deficiency Judgment

After nonjudicial foreclosures and in a few judicial foreclosure states (states that require the lender to go through the court system to foreclose), a lender can recover a deficiency only if it files a separate lawsuit against you. In some judicial foreclosures, though, the deficiency judgment can be included in the foreclosure judgment.

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

Of course, if your state's laws prevent the lender from getting a deficiency judgment, you don't need to take this approach.

Filing Bankruptcy to Avoid Tax Liability for Forgiven Debt

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 might have to include the canceled amount as income on your tax return. If that happens, you generally must pay tax on that forgiven debt unless you qualify for an exception or exclusion such as:

The Mortgage Debt Relief Act of 2007 (Qualified Principal Residence Indebtedness Exclusion)

The Mortgage Debt Relief Act of 2007 and its various extensions exclude forgiven debt from your taxable income if the loan:

• 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.

This "Qualified Principal Residence Indebtedness (QPRI) Exclusion" applies to debt forgiven in calendar years 2007 through 2025. The exclusion can also apply to debts forgiven as the result of a written agreement entered into before January 1, 2026, even if the actual discharge happens later. If your forgiven mortgage debt qualifies, as of December 31, 2020, you can exclude up to $750,000 ($375,000 if married and filing separately). Before this date, taxpayers could exclude $2 million ($1 million if you're married and filing separately).

The Insolvency Exception

If you were insolvent when the debt was canceled, some or all of the debt might not be taxable to you. You're 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

If your lender forgives the deficiency before you file for bankruptcy, and you don't qualify for an exclusion or exception that would exclude the forgiven debt from your taxable income, filing for bankruptcy afterward 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 you wouldn't incur federal tax liability because there won't be any forgiven deficiency debt.

Be aware, though, that forgiven debt might affect your state taxes.

Bankruptcy Cancels Other Mortgage Debt

If you have any other mortgage debt, like a second mortgage or a HELOC, it could 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. But 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 a foreclosure sale, you'll get 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.

Because the automatic stay prevents the foreclosure case from moving forward, you get 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 process 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. Or the lender might forgo this right and simply wait for the bankruptcy case to conclude before continuing with the foreclosure.

Either way, you'll probably get a few extra months to live in the home without making payments, which would allow you to build 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.