4. Lien Stripping – Removing Second Mortgages or Other Junior Liens Asserted Against a Residence
a. Lien Stripping – Generally
A second major exception to the anti-modification rule is “lien stripping” – a process which allows the court to approve a plan that completely erases the obligation to pay all secondary mortgages and junior liens, leaving the homeowner responsible to pay only the first mortgage. The junior liens that can be eliminated include traditional second mortgages (20% loans used to fund a down payment), home equity loans, home improvement loans, mechanic's liens and liens for homeowner’s association dues and assessments. The ability to lien strip junior liens is extremely beneficial for individuals filing for Chapter 13 and can potentially save the homeowner a large amount of money after filing for bankruptcy protection.
b. Limitations on Lien Stripping
i. Available Only in Reorganization Cases. Lien stripping only applies to Chapter 11 and Chapter 13 cases. The U. S. Supreme Court has prohibited lien stripping in Chapter 7 cases.
ii. Senior Liens Must Be Underwater – Wholly Unsecured. The primary requirement is that lien stripping only applies to loans that are considered “wholly unsecured.” Junior liens can be stripped away in a bankruptcy case only when the combined amounts owed on all senior mortgages are considered “under water” and the borrower owes more on the senior mortgages than the property is worth.
For example, assume the following facts:
In this situation, the $5,000 second mortgage can not be stripped off because the pay off balance due on the first mortgage ($100,000) does not exceed the fair market value of the property ($101,000). However, the $2,500 HOA lien can be stripped off because the combined value of both senior liens ($105,000 – $100,000 for the first mortgage and $5,000 for the second mortgage) exceeds the market value of the property ($101,000).
c. Treatment of Lien Stripped Debt. A debt owed to a creditor that has it’s lien stripped away is not automatically forgiven. Any creditor that has its lien stripped off will still have a claim for the debt on an unsecured basis. However, in most Chapter 13 cases, unsecured creditors will be paid only a small percentage of any unsecured debts owed to them. Unsecured creditors will only receive a significant payment in high income cases where the debtor’s budget establishes that he has sufficient income to pay some or all of the unsecured debt.
A debtor must also complete the payments on his bankruptcy plan to gain the benefits of lien stripping. Unless the bankruptcy court orders otherwise, the dismissal of a bankruptcy case will reinstate any stripped lien to the legal posture it had before the case was filed.