Secured Debts in Bankruptcy
Secured debts are loans secured by collateral (aka security interest). If the collateral has a title, then the lender attaches a lien against the property. If the debtor defaults, the lender can repossess the property, then sell it to pay for the loan. If the sales proceeds is insufficient to repay the loan, then, if the loan was a recourse loan, the lender can go to court to get a deficiency judgment for the difference.
A secured debt in Chapter 7 bankruptcy has 2 components: personal liability and the collateral, or the security interest. Chapter 7 eliminates the legal liability for the debt, but still allows the secured creditor to repossess the property. However, the creditor will have to accept whatever the property will fetch, even if the sales proceeds does not cover the debt; the creditor will be barred from getting a deficiency judgment.
Equity in property is the amount of property value that exceeds the amount of a loan that is secured by the property. If the value of the property is less than the loan amount, then the owner has no equity in the property.
If you file for Chapter 7 bankruptcy, you will fill out forms, listing your assets and their value, and what you claim is exempt, which is determined and limited by law. Most debtors filing Chapter 7 have either little or no equity in their property, or an exemption covers the value of the property. In such a case, you can keep unsecured property.
However, even if your equity in the property is greater than your exemption amount and security interest, the trustee will only sell it if the sale price is likely to be greater than your exemption amount, plus the amount of the secured interest, plus the cost of selling it, plus the trustee's commission. If it is greater, then the property will be sold and the amount left over will be distributed equally to your unsecured creditors.
Warning! Beware of the Cross Collateral Clause
A cross collateral clause is a common provision in contracts used by credit unions for secured purchases, such as a car, that allows the credit union to not only secure the item purchased but also any other loans taken out at the credit union. The effect of this security lien is that it cannot be eliminated in Chapter 7 bankruptcy — the debtor will have to pay the full amount of all loans with the lender unless the debtor is willing to surrender the property back to the lender.
For example, suppose you take out a loan of $20,000 from a credit union to buy a car, then also accumulate $10,000 of debt on a credit card issued by the same credit union. Then you realize that you can't afford your payments, so you file for Chapter 7 bankruptcy. Without the cross collateral clause, you would have been able to discharge the credit card debt without paying anything over and above what would be available in a distribution to all of your creditors. Since most Chapter 7 petitioners have no assets that are available for distribution to creditors, the credit card debt could have been discharged completely without paying anything. However, Chapter 7 debtors must pay all loans covered by the cross collateral clause in full unless they are willing to surrender the property. Hence, in this situation, you would have to pay $30,000 of the debt instead of just $20,000 to keep the car.
The lien is the interest that a creditor or other entity has in specific property, where ownership of the property is evidenced by a legal title document. Although some creditors claim to have a lien on personal property that does not have a title document, these types of liens have little practical consequence, since the sale of the item cannot be prevented, and, in most cases, the personal property would not have enough value for the lienholder to take possession of the property, transport it, and sell it, in addition to the many other problems with untitled personal property, such as being able to locate it in the first place.
A recording of the lien on the title document can prevent the conveyance of a clear title to another, which, in most cases, will prevent the sale of the item. This means you will not be able to sell the item until the debt is paid and the lien is removed.
Consensual Liens — Security Interests
A consensual lien (aka voluntary lien) is one that you consented to by agreement or contract. If you miss payments, the creditor has the right to take possession of the collateral and sell it.
Purchase-money security interests secure loans where the money is used to purchase the security interest. Mortgages and auto loans are the most common examples of this type of secured loan. If you default on the payments, the lender has the right to repossess the property and sell it. These liens usually cannot be eliminated by bankruptcy.
Nonpurchase-money security interests are loans that are secured by an item that the borrower already owns. If the borrower keeps the item while it serves as collateral, then this is called a nonpossessory loan, because the lender does not possess the collateral. Liens on nonpossessory loans can be eliminated.
A possessory loan is obtained by giving the collateral to the lender in exchange for the loan. Pawnshops are a common example of this type of lender. The liens in possessory loans cannot be eliminated in bankruptcy.
Nonconsensual liens are liens imposed on titled property without your consent. Because these liens are not effective unless legal ownership is evidenced by a title, these liens are generally restricted to real estate and automobiles, or any other item where ownership is established by title. While the lienholder is usually entitled to sell the property, if necessary, to pay the debt, usually the lienholder will simply add the lien to the title, which will prevent you from transferring a clear title to anyone else until the debts are paid. There are 3 major types of nonconsensual liens: judicial, tax, and statutory liens.
- A judicial lien is recorded by someone who has won a money judgment against you in court.
- Tax liens are imposed by tax authorities for delinquent taxes.
- Statutory liens are liens created when work is done on the property on which the lien applies, and the workers are not paid in full for their work, such as when a handyman works on your house, and doesn’t receive payment.
Most judicial and statutory liens can be eliminated in bankruptcy, but not most tax liens.
Avoiding Liens On Secured Property
You must file a motion to eliminate a lien on secured property. If the lien is successfully removed, then it will be classified as an unsecured debt, which will allow you to pay the same percentage of that debt as you are paying on your other unsecured claims rather than the 100% of the value that would have to be paid for a fully secured claim.
To summarize, only certain liens can be stripped. A security interest can be voided only if:
- the security interest on the loan is a nonpurchase-money security interest;
- the property pledged is exempt, which usually includes household furnishings and goods, at least up to a certain value, clothing, appliances, or health aids prescribed professionally for you or a dependent.
A judicial lien can be avoided if the property is exempt, and the lien, if honored, will deprive you of your full exemption. Judicial liens can also be removed from real estate and motor vehicles.
Tax liens are usually not voidable, but since tax liens expire after 10 years, older tax liens can be avoided. A tax lien may also be avoided if the IRS made a mistake in filing the tax lien, which it often does, such as:
- never recording the lien;
- recording it after the automatic stay took effect;
- recording it in a county where the real estate is not located;
- recording the lien against the wrong assets;
- or the tax itself was an invalid assessment.
You must file your motion to strip the lien within 30 days after you file for bankruptcy or before the creditors meeting, if the local rules require it. A copy of the notice of motion must be sent to each affected creditor who has a lien on the property.
If you have a right to strip the lien from the property, most creditors will not respond to the motion, allowing you to ask the court for a default judgment.
Keeping Secured Property
In order to eliminate liens in bankruptcy, you will have to take certain steps required by law; otherwise the liens will remain after your discharge. When you file for Chapter 7, the automatic stay will prevent all repossessions for secured property, but the creditors can ask the court to lift the automatic stay, and, in most cases, it will be granted.
If you are behind on your payments for secured property that you want to keep, then, if your creditors accept, you will have to make up the missing payments, and continue making regular payments, or you will have to pay for the item in full.
If you can’t do this, but really want to keep the property, then you can file for Chapter 13 bankruptcy, which allows you keep all of your property if you can maintain payments, and will give you time to make up arrearages. However, you will have to set up a payment plan that will pay all secured and priority payments, and at least 25% of your unsecured debt or the value of all of your nonexempt property, whichever is greater, over a 3 or 5 year period. If you are unable to do this, then you will probably not be approved for Chapter 13.
If you are current on your payments, then you have 3 options in Chapter 7 bankruptcy:
- Surrender the property by giving it back to the lender. In this case, you would notify the creditor that you intend to surrender the property. If the creditor does not pick up the item within a specified time, then the creditor is deemed to have abandoned the property.
- Redeem the property (redemption) by paying its replacement value in a lump sum, which is what the item is currently worth in the market, and usually is less than the amount of the secured debt.
- Reaffirm the debt. You can sign a new contract with the creditor, called a reaffirmation agreement, with terms at least as good as you had, and, maybe, you can even negotiate better terms. The reaffirmation agreement must contain certain disclosures, and, if you are not represented by an attorney, it must be approved by the bankruptcy judge. This is to ensure that you understand what you are doing, and that you are not being pressured by creditors. The reason for filing for Chapter 7 bankruptcy is for a fresh start—free of debt. If you do reaffirm, then the debt will not be discharged in bankruptcy, and you will have to continue making payments.
Statement of Intention
The Statement of Intention is the form that you must fill out to inform the court and your creditors which of the 3 options—surrender, redeem, or reaffirm—that you intend to do for each secured item. The automatic stay will be lifted for secured debt if the Statement of Intention is not filed within 30 days after filing for bankruptcy, or you don’t follow through with the plan within 45 days after the creditors’ meeting.
In a Chapter 13 bankruptcy, the debtor arranges to pay back at least some of the debt over a 3 or 5 year period. One benefit of Chapter 13 is that you can keep all secured property as long as you can continue making payments on the debt as well as pay your other debts. You can also pay for any arrearages over time instead of paying a lump sum as you would have to in Chapter 7. As in Chapter 7, you can surrender the property, or, if you want to keep it, you either pay the current replacement value of the item, or continue to pay as agreed.
When you chose to surrender property, the remaining debt becomes an unsecured debt, some of which you will have to pay as part of your repayment plan.
You can pay the replacement value of a secured item instead of the full amount—this is sometimes called a cram down (or cramdown). Property is then owned free and clear. However, in Chapter 13, the payments can be spread over time, as part of the repayment plan, instead of the lump sum payment required in Chapter 7.
To deter fraud, the Bankruptcy Act of 2005 has placed restrictions on cramdowns, which can only be applied to personal property that was purchased more than 1 year before filing, or automobiles purchased before 910 days (=30 months=2.5 years) before filing. Cramdowns cannot be applied to real estate, except in special cases.
For property that is not subject to a cramdown, such as recently purchased property and real estate, you can continue to pay on the contract as part of your repayment plan. If your chapter 13 plan is not completed, you can continue making payments outside of bankruptcy.
If the collateral is destroyed, such as a car in an accident, your chapter 13 plan can be amended to reclassify the debt as unsecured.