Much talk has been made recently about President Obama’s proposed “cram down” provision that would allow bankruptcy judges in Chapter 13 case reduce the principal owed on mortgage loan secured by a debtors principal residence. While the bill seems to have stalled in the Senate, another provision of the bankruptcy code may be particularly interesting to individuals finding themselves struggling to make their payments on vacation or investment properties. Under 11 USC 506, a person filing for bankruptcy under Chapter 13 can in fact “cram down” the amount owed on certain types of property to the current market value. This of course depends on the nature of the property we are dealing with.

While the provision is most commonly linked to consumer purchases, for example, an automobile, household appliances or even furniture that are bought on credit and those goods in turn secure the repayment of the credit extended, the provision also applies to mortgages other than acquisition loans on a principal residence.

Essentially the way this provision works is that the debtor can file a 506(a) motion to revalue the collateral (secured by in most cases a Deed of Trust) and seek to reduce the security to the market value at the time of the filing of the petition so as to prevent the property from being oversecured, ie, securing more debt than the value of the property. What this motion seeks to do is to bifurcate the security (split it into two parts). If the court grants the revaluation of the property, the Creditor retains a secured interests in the property only to the extent of the value of the collateral. In the situation where the value is less than the amount owed on the mortgage, that portion of the mortgage that exceeds the value of the property then becomes an unsecured debt and leaves the creditor standing in line with the rest of the unsecured creditors, seeking a pro rata share of the monthly trustee payments.

In essence the way this plays out most frequently is when a debtor purchases a second property, they can not secure financing for the entire balance of the unpaid purchase price. So the either entice a second bank to give them a smaller loan in second position (which during the housing boom, banks were entirely to eager to accommodate) or the seller would carry back a note and deed of trust in second position securing the balance of the purchase price. The debtor then finds themselves upside down on the property and struggling to make payments. So they file a Chapter 13 bankruptcy petition to reorganize their debt. At the time they file their repayment plan they also file a 506 motion to revalue the collateral. The property they bought two years ago for $400,000 which is secured by a First Deed of Trust in the amount of $340,000 and a Second Deed of Trust in the amount $60,000 is now valued at $350,000. The Court can under the bankruptcy code bifurcate the status of the Second Deed of Trust, by treating $10,000 as secured (value of the collateral = to amounts owed 340,000 on first deed of trust plus $10,000 owed on the second deed of trust) and the remaining $50,000 owed on the Second Deed of Trust then becomes unsecured.

While the provision has historically been utilized to cram down payments on personal property, most commonly automobiles, the courts are allowing qualified debtors to cram down certain mortgages. See generally In Re: Latimer, 395 B.R. 304 (Bankr.W.D.N.Y. 2008) (cram down of a second mortgage held by State Farm Bank); In re: Paschen, 296 F.3d 1203, (11^th Cir. 2002) and In Re: Eubanks, 219 B.R. 468 (6^th Cir. BAP 1998). All of these cases also involve other sections of the bankruptcy code that deal with cram down provisions currently contained in the code. But that is a whole different article.

If you think that a Section 506 Motion will benefit you in coping with your upside down investment or second home properties, seek the advice of competent bankruptcy counsel as soon as possible to determine if you - and your property - qualify for this treatment.

If you have specific questions about your liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/