Eliminating Liability Resulting From a Foreclosure
When an individual purchases a home by utilizing a secured lender, they are signing both a promissory note and a mortgage instrument. The promissory note creates the monetary obligation for the borrower to repay the loan amount to the lender, while the mortgage instrument is what grants the lender the right to foreclose on the property if the obligation is not repaid. Often, when facing foreclosure, the focus is on the lender taking ownership of the property. However, this blog will explore the liability implications that come with a foreclosure and how it can be addressed through a chapter 7 or chapter 13 bankruptcy case as well as address some questions related to bankruptcy.
DEFICIENCY JUDGMENT
When a property is sold at a sheriff sale for less than the amount of the outstanding mortgage loan, the lender has the right to pursue a deficiency judgment against the borrower. A deficiency judgment is a monetary judgment for the difference between what was owed to the lender and what the property was sold for at the sheriff sale. In New Jersey, the lender must bring an action to seek a deficiency judgment within three months of the sheriff sale pursuant to N.J.S.A. 2A:50-2. The easiest way for someone to determine if a complaint is a foreclosure complaint or a complaint seeking a deficiency judgment is to look at the docket. If the docket number begins with an F, then it is a foreclosure complaint seeking possession of the property. On the other hand, the docket number will begin with an L if a lender is seeking a deficiency judgment.
Once three months from the foreclosure sale passes, then the lender will be barred from pursuing a deficiency judgment against the borrower. However, even if this deadline passes, the borrower may still receive a form 1099-C from the lender. Pursuant to the IRS Code, forgiven debt is taxable income. Therefore, the deficiency amount that a lender chooses not to pursue in the form of a deficiency judgment, can become taxable income to the borrower.
DEALING WITH THE DEFICIENCY THROUGH A CHAPTER 7 BANKRUPTCY CASE
One option that an individual has to eliminate the possibility of a deficiency judgment or a tax penalty stemming from the foreclosure for forgiven debt is to file a chapter 7 bankruptcy case. An individual chapter 7 bankruptcy is the liquidation chapter of bankruptcy where the individual is seeking to have his or her debt discharged without proposing to make any monthly payments to creditors. A bankruptcy discharge erases any individual monetary obligation that an individual has to a creditor. Any liability for a deficiency judgment to the lender stemming from the foreclosure whether the bankruptcy is filed prior to the sheriff sale or after a deficiency judgment is entered can be discharged in a chapter 7 bankruptcy case. Additionally, one of the benefits of a bankruptcy discharge is that discharged debt is not taxable income pursuant to 26 U.S.C. § 108(a)(1)(A). Therefore, while it is irrelevant for purposes of discharging personal liability on the deficiency judgment, it is very important to file the bankruptcy case prior to being issued a 1099-C from the lender to eliminate any potential income tax implications stemming from the foreclosure.
CHAPTER 13 BANKRUPTCY AS AN OPTION
Bankruptcy is not a one size fits all procedure in that an individual’s situation must be closely analyzed before deciding which chapter of bankruptcy is right for that individual. Some individuals will not qualify for a chapter 7 bankruptcy due to their income or a chapter 7 would not be right for them due to having significant assets that would be sold by a chapter 7 trustee. In that case, if faced with a foreclosure, then a chapter 13 bankruptcy proceeding is an option for discharging any potential liability for a deficiency judgment and eliminating the potential for tax liability resulting from the foreclosure.
Chapter 13 is the individual reorganization chapter of bankruptcy, which is done through a chapter 13 plan. In the chapter 13 plan, the individual can seek to surrender a real property to the mortgage holder. Choosing this option will allow the debtor to be discharged of his or her debt to the lender upon completion of the plan.
A common misconception of surrendering a property in a chapter 13 plan is that the real property must then be immediately turned over to the secured creditor. However, this is not the case. Surrendering a property through a chapter 13 plan simply means that the debtor is not seeking to retain the property through their individual reorganization and that the lender will be granted relief from the automatic stay upon confirmation of the chapter 13 plan by the Bankruptcy Court. The automatic stay is the mechanism within the Bankruptcy Code that prevents creditor collection actions from going forward while the bankruptcy case is pending. Therefore, upon confirmation of a chapter 13 plan that seeks to surrender real property, the secured creditor will be free to resume its foreclosure proceeding to take ownership of the real property in state court.
Written by David E. Sklar, Esq.
Bankruptcy Attorney, Scura, Wigfield, Heyer, Stevens & Cammarota, LLP. Prior to joining Scura, Wigfield, Heyer & Stevens, LLP, Mr. Sklar graduated from Rutgers University-Newark School of Law with a J.D., Cum Laude. Mr. Sklar represents individuals in bankruptcy and civil litigation.
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