Ask Brian: Should a Homeowner File for Bankruptcy if They Have Equity in their Home?



Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to askbrian@realtybiznews.com.

Question from Michael in AL: Hi Brian, I’ve experienced several years of financial troubles. Even before the pandemic, I had health problems keeping me from working full time that led to financial problems as far back as the summer of 2019. In one sense, the pandemic shutdowns and uncertainty made everything worse. In other ways, the pandemic helped a little because I was able to take advantage of some financial help that became available, including the mortgage forbearance program that suspended mortgage payments. I’m not actually in a forbearance program but I am about three months behind on my payments. I had some security knowing the forbearance program was there as a backstop if I slipped further behind on my payments. Now, that security is fading away. There seems to be a lot of uncertainty about exactly when the forbearance programs will end but I know it’s coming. I’m thinking that bankruptcy might be my only option. What’s important for me to know about filing bankruptcy as a homeowner?

Answer: Hello Michael. I empathize with you. How bankruptcies work out is highly dependent on personal circumstances. You definitely want to talk to a bankruptcy attorney before making any final decisions or taking action. If you have equity in your home, your state’s homestead exemption and your financial circumstances will dictate whether bankruptcy is a good idea. I’m assuming that you want to come out of bankruptcy still owning your home. However, keeping your home in bankruptcy is not a given. The huge run-up in home values means most people have more equity in their homes than they likely realize. Too much equity can make your home a target for the bankruptcy trustee to sell to pay off creditors. Michael, you didn’t say if you have other debt that would be part of the bankruptcy but that is also part of what you must consider in your circumstances. Bankruptcy might slow down a mortgage foreclosure, but it could be just another temporary solution.

You want to begin a conversation with an attorney to understand the differences between Chapter 7 and Chapter 13 bankruptcies along with the role a homestead exemption can play. There is a federal homestead provision, but most people go with their state homestead laws. In a Chapter 7 bankruptcy, the bankruptcy trustee has the power to sell your nonexempt assets (including your home, depending on the homestead provision) to pay back your creditors. In a Chapter 13 bankruptcy, you must pay the value of your nonexempt assets to your unsecured creditors through your repayment plan. In a nutshell, Chapter 7 requires that many of your assets be sold to settle debts. Chapter 13 allows you to keep the assets, but you’ll have to comply with a closely supervised court-ordered payment plan.

However, Chapter 7 doesn’t mean that your house will automatically be sold to pay creditors. Whether or not that happens is determined mostly by how much equity you own in the house and your state’s homestead laws. Remember, you’re not the person making these calculations and determinations. The court and the court trustee have the biggest and final say. (Michael, in Alabama, your homestead provision is worth up to $16,450 in equity and up to 160 acres of real estate and the residence upon it, including a house, mobile home, or similar dwelling place. Ala. Code 6-10-2.)

I can’t emphasize enough how important it is to work with a bankruptcy attorney but here is the basic formula for determining if you have enough equity in the home to force a sale to pay your creditors.

  1. Determine the current fair market value of the house.
  2. From the fair market value, you subtract out the homestead exemption.
  3. Next, subtract out the trustee’s commission which is on a sliding scale based on the value of the property.
  4. Subtract out the remaining balance on the mortgage because the lender needs to be repaid.
  5. Subtract out the cost to sell the house because this money will not be available to pay debts (typically 8% of the fair market value).
  6. Finally, subtract out any other liens currently secured by the house (such as tax and mechanic liens).

A negative number on the bottom line works in your favor because it means you do not have enough equity to repay any debt. There is no reason for the trustee to sell the house. If the bottom line is a positive number, you should receive a payment for the homestead exemption, but the rest of the money will go towards paying creditors.

However, talk to your lender before or at the same time you talk to a bankruptcy attorney. I don’t know how many, but there are certainly a lot of people coming out of the pandemic facing similar circumstances. Your lender might still be willing to talk with you about a “mortgage workout.” This could mean renegotiating your payments terms with a loan modification or refinancing. Of course, if you can’t make the mortgage payments, you’ll eventually lose your home in foreclosure outside of bankruptcy, even if the bankruptcy trustee doesn’t sell your home.

Michael, there are other things that an attorney can help with in bankruptcy such as possibly keeping a car through a reaffirmation agreement with the lender.

Your thoughts on foreclosures and bankruptcy? Please comment.

Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to askbrian@realtybiznews.com.

Photo by Melinda Gimpel on Unsplash

Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for 12 years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, near a national and the Pacific Ocean.