What most residential mortgage borrowers do not understand is the a bankruptcy only discharges personal debt. A bankruptcy will not eliminate a security interest in property. In reality, a bankruptcy discharge may have no effect whatsoever on a borrower in relation to the mortgage if the debt is a non-recourse debt.
To truly understand the effect of bankruptcy discharge on mortgages and deeds of trust (hereinafter referred to collectively as “mortgage”), it is first important to understand how mortgage debt is treated upon default or foreclosure. There are two important California statutes that govern deficiencies upon foreclosure:
- California Code of Civil Procedure § 580b – no deficiency for purchase money mortgages
- California Code of Civil Procedure § 580d – no deficiency to lender foreclosing non-judicially
(California Code of Civil Procedure hereinafter referred to as “CCP.)
Let me explain these concept further by using an example:
Jane wants to buy a new home. In order to purchase the new home priced at $100,000, she executes a 1st mortgage with XYZ Lender for $80,000 and makes a down payment of $20,000. A few years down the road, Jane loses her job and can no longer afford her mortgage payments. She defaults on the mortgage payments. For the two years of the loan, Jane was making interest only payments and her principal remains $80,000. Jane has no other debts.
Under California law, Jane’s mortgage is a non-recourse debt whether judicially or non-judicially foreclosed under CCP § 580b. This means that XYZ can only take back the property to satisfy the debt. If XYZ non-judicially forecloses on the property and the property sells at foreclosure for $60,000, XYZ cannot come after Jane personally for the remaining balance of $20,000 ($80,000 owed – $60,000 collected from sale of property). XYZ has to take a loss on that amount.
Now, let’s look at another example. Joe has a home worth $100,000 with a current first mortgage of $60,000. Joe wants to buy a boat and decides to take equity out of his home with a refinance. He refinances the property for $80,000, pays back the original 1st with $60,000 and gets $20,000 cash back. He buys a boat with the $20,000 cash received. Joe also is in an interest only loan and defaults a few years after refinance because he loses his job. Joe’s principal balance remains $80,000. At foreclosure, Joe’s home also sells for $60,000 leaving a balance owed of $20,000.
In this example, Joe is not protected from a deficiency judgment under CCP § 580b. But, if Joe’s lender choses non-judicial foreclosure, it will not be able to go after Joe personally for the $20,000 deficiency under CCP § 580d. If Joe’s lender wants to pursue a deficiency, it must have judicially foreclosed. Another important issue to note in regard to Joe is that, the lender must decide from the beginning whether to pursue non-judicial or judicial foreclosure. Once it has begun one or the other method of foreclosure, it cannot go back and change its mind. So, if Joe is non-judicially foreclosed and the lender is left with a larger than anticipated deficiency, it cannot go back and try to judicially foreclose on Joe to collect the deficiency.
Here’s where bankruptcy comes in. In bankruptcy, Joe could discharge personal liability on the loan. What that means is, if Joe’s lender decides to judicially foreclose on Joe to obtain a deficiency judgment, Joe’s bankruptcy could eliminate Joe’s liability for the deficiency even though he would not otherwise be protected by CCP §§ 580b or 580d.
What bankruptcy does not do is eliminate the lender’s security interest in the property. So, even if Joe files bankruptcy pre-foreclosure, obtains a discharge, and remains in possession of the property post-discharge, the bank can foreclose on the property. Joe can later be evicted from the property by the owner after foreclosure (which could be the bank or a third party).
I often see clients post-discharge who have made payments to the lender after the bankruptcy was filed or discharged. This is an interesting situation. Although the debt may not have been formally reaffirmed in the bankruptcy, there may be some argument that the loan was reaffirmed by acts of the parties. If you are in this situation and want to continue in possession of your home, I recommend contacting an attorney to discuss any remaining options you may have.
Another important issue of concern after bankruptcy discharge is that any claims Joe or Jane may have had against their lenders could be barred by doctrines of res judicata or collateral estoppel after the bankruptcy has been discharged. It is very important that borrowers list any potential claims they may have against their lenders in their bankruptcy schedules if they want to preserve their right to pursue those claims. This can be done in one of two ways: 1) the claim can be listed as a contingent asset on the bankruptcy schedules, or 2) the claim can be listed as a potential offset to the debt owed to the lender. If a borrower is interested in pursuing claims against his/her lender, attorney involvement is highly recommended.