Lien stripping in bankruptcy

As we have discussed in prior e-mails, based on the depressed market for real estate in New York City and the surrounding areas, many co-ops, condos and houses are "underwater." As we have discussed, "underwater" means that the value of the property is less than the amount of the mortgages and tax liens that encumber the property. Let's start with an example to illustrate the point:

Three years ago an individual bought a house for $750,000. The first mortgage on the house is $650,000 and there is a second mortgage on the house for $50,000. A recent appraisal valued the house at $600,000. Since the appraised value of the house ($600,000) is less than the amount of the mortgages that encumber the house ($650,000 + $50,000=$700,000), the house is "underwater" and the second mortgage is totally unsecured. What can a client do under this fact pattern?

In bankruptcy, if the home owner files for Chapter 13 bankruptcy, then they may avoid the second mortgage for $50,000 pursuant to §1322(b)(2) of the Bankruptcy Code. This result is allowed by the Second Circuit in Pond v. Farm Specialist Realty (In re Pond), 252 F. 3d 122 (2001). When the second mortgage of $50,000 is voided, it is no longer deemed to be a second mortgage against the house; but it is in fact an unsecured claim, and must be treated as such in a Chapter 13 Plan. In order to obtain this result, the homeowner or homeowners must file for Chapter 13 bankruptcy. They must have the property appraised to determine its value and then they must commence an adversary proceeding (litigation in the Bankruptcy Court) pursuant to Rule 7001(2) of the Federal Rules of Bankruptcy Procedure to determine the value of the property and the mortgage and to have the mortgage voided.

The next issue is whether a homeowner can accomplish this result in a Chapter 7 bankruptcy, which results in a "fresh start" and the liquidation of debts. Interestingly, in the Eastern District of New York (which is Brooklyn, Queens, Long Island and Staten Island), there is a split among the bankruptcy judges as to whether a Chapter 7 debtor can strip off a second mortgage in a property that is underwater. Judge Eisenberg has ruled in two cases ( In re Lavelle, 2009 WL 4043089 (Bankr. E.D.N.Y. 2009) and Smoot v. Wachovia Mortgage (In re Smoot), 465 B.R. 730 (Bankr. E.D.N.Y. 2011)) that a Chapter 7 debtor can strip off an unsecured second mortgage. Judge Grossman in Pomilio v. MERS (In re Pomilio), 425 B.R. 11 (Bankr. E.D.N.Y. 2010) has rules that the strip off of a second mortgage is not allowed in Chapter 7 bankruptcy cases.

Accordingly, owners of property that is "underwater" should consider a bankruptcy filing to void their second mortgage if they desire to retain the property in the bankruptcy. Any individuals or clients that have questions regarding the strip off of mortgages in bankruptcy should contact Jim Shenwick.