Chapter 13 Lien Strip Primer

Synopsis: The once obscure practice of lien stripping has enabled thousands of homeowners to remove 2nd and 3rd mortgages for good, while paying only a small percentage of their face value. The result has been to give homeowners back their power, putting them in the driver’s seat for the first time in years.

What is a Lien Strip?

Lien Stripping refers to the practice permitted by 11 USC 1322(b), which provides that wholly undersecured liens against real property may be removed or “stripped,” and the debt to which they relate treated as unsecured in a Chapter 13 Plan of Reorganization. Liens may not be stripped in Chapter 7 cases. Even in Chapter 13 cases, only liens against the debtor’s principal residence may be stripped.

Lien stripping has 2 distinct, and very desirable, benefits for debtors:

(1) At the conclusion of the lien strip the underlying property is no longer be encumbered by that undersecured lien and that creditor cannot prevent the sale or refinancing of the real estate; and

(2) Instead of having to pay the debt secured by that stripped lien in full, the debtor need only pay the same percentage of the claim as it plans to pay unsecured creditors – often 10% or less.

Can a Partial Lien Strip Succeed?

There is no such thing as a partial lien strip . Bankruptcy Courts will only allow a lien to be stripped if it is wholly undersecured: that is, the secured potion is zero or negative. Moreover, lien stripping is permissible only for claims secured by the Debtor’s principle residence because a lien strip modifies the “total package of rights for which the claim holder bargained.” Since most Federal circuits have interpreted the term “undersecured” to mean that there is some equity to secure the lien, in order to be stripped liens must be wholly unsecured. Note that the 7th circuit has yet to directly decide a lien stripping case. As such, some Bankruptcy Courts within the 7th circuit have followed the majority view and allowed for wholly unsecured liens to be stripped, while others have espoused the minority view that even undersecured liens are not strippable per se.

Qualifying for a Lien Strip

A lien strip can only be accomplished in the course of a confirmed Chapter 13 plan of reorganization. The practice of lien stripping refers to bifurcation of a secured interest in real or personal property into a secured and unsecured portion. The calculations behind lien stripping are simple:

V - D[- Ɵ] ≤ $0

V: market value of that property

D: debt encumbering a property

Ɵ: target debt (i.e. 2nd mortgage)

In other words, for a lien to be stripped and the lienholder’s interest treated as unsecured, so it receives far less than all its money plus interest, the value of the debtor’s property at the time of filing, less the fully-secured non-target debts, must be less than or equal to $0. Once upon a time meeting these requirements could be challenging. However, in market conditions such as those prevailing today where many homeowners are “underwater” as to their first mortgage and have a HELOC or 2nd mortgage on top of that, the conditions necessary for a lien strip to take place are relatively straightforward and can sometimes be met without much resistance from the affected creditor.

Stripping the Lien – When, Where, How?

Federal Appellate circuits follow different approaches when it comes to lien stripping. Some Bankruptcy Courts for instance, require no more than a listing in the debtor’s Petition that bifurcates the creditor’s interest into secured and unsecured portions. Should the creditor fail to timely object, their lien is stripped.

On the other hand, other Courts require that the debtor bring a motion to strip the lien. Again, if the creditor fails to respond their lien is stripped. Still other circuits, the most conservative ones, require the debtor to bring a separate adversary case against the creditor whose lien is to be stripped. Often the latter 2 kinds of situations – motions and adversary actions – become hotly contested and require massive amounts of preparation as well as expert testimony. This kind of attention and resources is required because often the value of the underlying property is in dispute. The amount of the first mortgage on the property however, is seldom in question.

What about the taxes?

Neither Federal nor State taxes can be discharged in Bankruptcy except under extreme circumstances, and if real estate is sold or transferred following a Bankruptcy filing the tax man must still be paid – regardless of any lien strip action.

Conclusions

While not foolproof and often misunderstood, lien strip actions can, and often should, be used to the advantage of Chapter 13 debtors. This will be the case more and more as the economic recession drags on and middle class debtors find themselves squeezed between escalating obligations and dwindling incomes.