Mortgages in Bankruptcy

It happens all the time.  People come into my office and sit down and the first thing they ask is what will happen to their house if they file for bankruptcy. Chalk it up to another example of the myths and misinformation that persist about bankruptcy.  I have so many people — lawyers even — that seem to believe that if you file a Chapter 7 bankruptcy you are not allowed to keep your house.  I’ve met some people that believe that mortgage debt cannot be discharged in bankruptcy.  I am sometimes amazed at the level of misinformation out there about the crossroads of bankruptcy, real estate and mortgages.

Whenever I sit down with an individual client (as opposed to a business entity seeking reorganization or liquidation in bankruptcy)  I explain the differences between Chapter 7, Chapter 11, Chapter 12 and Chapter 13.  I describe each Chapter as a different path to get to the same result — the Discharge.  I explain how the automatic stay works.  Sometimes it seems that people are unimpressed by these concepts.   What people really always want me to get to is what happens to their house!  So I explain it as follows:

When you buy a house you sign a whole slew of papers.  Sometimes you are signing your name so much that you don’t really take the time to understand the significance of the papers you are signing.  The two most important papers that you sign are the Promissory Note and the Mortgage.

Often people are left with the impression the Mortgage and Promissory Note are the same thing.  Accordingly, they don’t understand how part of something gets discharged and another part does not.  In fact, some clients will tell me something along the lines of: “my husband is on the deed, but not on the mortgage.”  I usually tell them they are likely wrong, and will often need to go to the registry of deeds website and print the mortgage to prove to them that not only are they listed, but their signature is right there in black and white.   What usually is happening is that the husband in this example is on the mortgage, but NOT on the promissory note.  Since most people thinks of it as a mortgage and not a promissory note, and since the only regular contact they have with the debt is with the statements they get each month that are addressed to those named on the promissory note, I can understand why.

So what exactly is a mortgage and what exactly is a promissory note, and how are they different?

A Promissory Note is a document that literally reads “I BORROWER promise to pay LENDER all this money back with interest as follows….”  That’s the magic language, I or We “Promise To Pay.”  It is a legal promise.  Black’s Law Dictionary defines a Promissory Note as “A written promise by one party (the maker) to pay money to another party (the payee) or to the bearer.”  A promissory note is an instrument creates actual legal liability for the money lent.  It is enforceable by the courts completely separately from any security that you pledge.

A Mortgage is a security instrument.  Black’s Law Dictionary defines “Mortgage” as “a conveyance of title to property that is given as security for the payment of a debt or the performance of a duty and that will become void upon payment or performance according to the stipulated terms.”  Signing the mortgage creates a liability upon land. It is a pledge of collateral to secure the debt evidenced by the Promissory Note.  A Mortgage is enforced by foreclosure on the property.  If the Mortgage is recorded with the registry of deeds (at least in Massachusetts, in other states the place for recording the mortgage may be different), it gives notice to all people that there is priority to the lender (i.e., the Mortgagee).  If it is not properly recorded, it is still valid, but in bankruptcy the Trustee may be able to avoid the mortgage for the benefit of unsecured creditors.

So, there is a big difference between the two concepts and the two documents.  A Promissory Note creates personal liability.  A Mortgage creates liability on the part of the real estate encumbered by the Mortgage.

So what happens in bankruptcy when there is a discharge of debts?

When a bankruptcy debtor gets a discharge, the Mortgage is still in place.  However, the Promissory Note is discharged.  You get to keep your house, as long as you stay current on the payments to the lender that would have been due under the (now discharged) Promissory Note.  If you do not stay current on your mortgage the house can still be foreclosed on.  So what’s the difference?

The difference is huge:  If there is a foreclosure and the amount of money the bank gets from the ultimate buyer at the auction — even if it is the bank itself — is less than the amount you owe under the Promissory Note, the amount due is a deficiency.  The Bank has a right to collect that deficiency because of the legal promise you made with the promissory note.  But here’s where things get complicated.  A creditor has a number of options in order to make themselves whole in that situation. They can sue you to get a judgment.  With the judgment they can, among other things, (1) get a lien on other real estate you own, (2) seize your bank accounts, (3) garnish your wages, or (4) even seize and sell your car.  In some situations, typically in the situation where the underlying promissory note was a commercial loan, they may even be able to set off against your bank accounts on deposit with the same lender — without any need for authorization or a judgment from any court.  They can also sell the debt to a collection agency who can take all of the actions described above.

If any of these issues arise, we can typically stop them, or even in some cases undue them, with a bankruptcy case.  However, the lender can also choose to simply forgive the debt.  To most people this sounds like a gift.  In reality it is anything but a gift.  (In general, if a bank is giving you something, be it a toaster or debt forgiveness, you should always realize that you will be paying for it in the end).  Debt forgiveness gives the mortgage lender the opportunity to take a tax deduction for their loss.  But the reverse is that YOU will face tax liability for the amount forgiven.  That means that come February of the following year, you will receive a 1099 showing the amount forgiven as income.  You will need to pay taxes on that income.  Taxes that you did not anticipate or plan for.  Taxes that you did not save money for nor have money withheld to pay. Taxes on income that, in reality, you never received.

As a rule of thumb, I tell my clients to expect a tax bill equal to about 25% of the amount forgiven between the Federal and State income taxes.  So, if you make $100,000 and face debt forgiveness of $10,000, well, the amount you had withheld from your paycheck might be enough to cover or at least soften the blow when you file your return the following year.  But, if you make $50,000 and face a debt forgiveness of $100,000 you might be looking at a whole new type of problem, because income tax liability is considered priority debt for at least three years and is, accordingly, not dischargeable.  While you could theoretically dodge the IRS for three plus years until the debt becomes dischargeable in bankruptcy, be advised that the IRS (and the state taxing authorities) can be a particularly difficult and persistent creditor.

If you are facing a foreclosure, or are struggling with other debts, you need to ignore the myths and talk to an experienced bankruptcy attorney immediately.  To schedule a free consultation call the Law Offices of James Wingfield at 508-797-0200 or visit the contact page of our website today.

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