Life After Bankrkuptcy: Yes, you can still get credit!

According to the Federal Judicial Caseload Statistics there are literally millions of people filing bankruptcy each year. The statistics reveal that Chapter 7 is by far the most frequently filed Chapter with 958,634 non – business of consumer filings for the period ending December 31, 2011. The reason for this is that a Chapter 7 bankruptcy releases individual debtors from personal liability for most debts and prevents the creditors owed those debts from taking any collection actions against the debtor. 11 U.S.C 727

One of the single most important questions that people considering bankruptcy pose to their attorney when contemplating filing bankruptcy is “ Will I be able to get credit, after filing bankruptcy?"
While the answer to this question varies from individual to individual, this article seeks to provide some insight into the factors which go into answering this question.

The common misconception among those considering filing for bankruptcy, is they will no longer be able to buy a home, car or even get credit. While it is true that a bankruptcy can appear on your credit report for years, a bankrupt’s ability to get credit post – bankruptcy is dependent on two factors. The first is the debtor’s income post – bankruptcy. The second is the debtor’s ability to show that they can manage their post – bankruptcy debt.

The single most important factor in securing credit post – bankruptcy is a demonstrating ability to pay. Extreme examples that demonstrate the importance of ability to pay are the unemployed debtor versus the lottery winner. Needless to say if after you filed for bankruptcy you are unemployed, it does not matter that you filed bankruptcy and discharged your debt, you still will not be able to get a credit card, a new car or home mortgage financing. Now the flip side to this extreme is the fortuitous lottery winner.

It goes without saying, that a bankrupt who wins the lottery after the entry of his or her discharge will be able to buy virtually anything and the obtaining of credit will be little or no problem.
Between these two extremes is the typical consumer, who makes a living wage and has through bankruptcy shed all of his or her debt. For the typical consumer, it is their financial condition, post – bankruptcy, and their ability to manage their post – bankruptcy debt that determines the extent of credit that will be extended after filing for bankruptcy.

To understand how this works, let’s use the example of a typical consumer with $50,000 in credit card debt pre – bankruptcy, consisting of ten (10) unsecured creditors. Let’s also assume that the consumer has a steady job and is making $4,000.00 a month. Now imaging that you are a banker and this consumer walks into your office with $50,000.00 in debt, ten creditors and a yearly income of $48,000.00. If you were a banker, would you give this consumer a loan, knowing that the consumer already has ten outstanding creditors and debt equal to over a year’s worth of income?

Contrast this with the same debtor, post – bankruptcy. As mentioned above, a debtor receives a discharge in Chapter 7. What this means is that all existing unsecured debt, with few exceptions like taxes and child support, are wiped out. Again put yourself in the shoes of a banker. If that same consumer walked into your office making $4,000.00 with absolutely no debt and no other creditors, wouldn’t you be more inclined to grant that consumer a loan? Especially knowing that the consumer had already filed a Chapter 7 and couldn’t again file another for at least another eight years. 11 U.S.C. 727 (a)(8)

Let me put it another way, if I walked into to see you and you were a banker and I had $50,000 worth of debt, was making $4,000 month and had ten credit cards that I couldn’t pay, would you be willing to be the eleventh creditor?

In contrast, if I walked in to see you the banker and had absolutely no debt and not a single credit card or other outstanding bill, still making $4,000.00 per month would you find me a better risk knowing that you would be first in line to be paid, not eleventh.

Post - bankruptcy a credit card company or your mortgage banker knows two pivotal things. First, that the consumer has no debt having already discharged it in a Chapter 7. Second, that the consumer can’t file Chapter 7 again for eight more years.

In sum, the filing Chapter 7 is designed to give the debtor a “fresh start." Part of the “fresh start" means a fresh look by bankers of all kinds. As such the debtor in a post – bankruptcy world is a much better credit risk that the same debtor pre – bankruptcy. Thus, the important thing to remember is that your ability to secure credit post – bankruptcy depends not so much on your prior credit history but how you manage your financial affairs after filing bankruptcy.

California Homeowner's Bill of Rights

California, which has been called the “epicenter" of the foreclosure and mortgage crisis by Attorney General Kamala Harris, was one of the hardest states hit by the economic meltdown and real estate crash brought on by the latest financial crisis. According to a recent report, in 2011, seven of the nation’s 10 hardest-hit cities by foreclosure were in California.

 

All told, in the last three years with California suffering from a prolonged real estate slump, more than one million California homes were lost to foreclosure. Not just in foreclosure pipeline, but lost.
Moreover, while parts of the California real estate market are recovering, statewide there are an additional 700,000 properties currently in various stages of the foreclosure process.

In order to stem the wave of foreclosure, on July 11, 2012, California enacted into law a “Homeowner Bill of Rights" for the purpose of aiding embattled homeowners and bring fairness, accountability and transparency to the state’s foreclosure process.

Some of its key provisions include the ban on “dual tracking," a practice whereby the lender on one hand gives the illusion of working with the borrower to secure a modification and at the same time, is foreclosing. Needless to say, many homeowners are lulled into a false sense of security by such practice, thinking they will get a modification, when in reality the bank wants to do nothing more than foreclose and take the home.

The dual tracking ban set forth in the statute would prohibit a mortgage servicer, mortgagee, trustee, beneficiary, or authorized agent from recording a notice of default or recording a notice of sale or conducting a trustee's sale while a complete loan modification application is pending on a first lien mortgage or deed of trust secured by residential real property not exceeding 4 dwelling units that is owner-occupied.

In addition, mortgage servicers will be required to designate a “single point of contact" for borrowers who are potentially eligible for a loan modification. The new law requires the single point of contact be responsible to coordinate the flow of documentation between borrower and mortgage servicer and be knowledgeable about the borrower’s status and foreclosure prevention alternatives.

The new law also establishes procedures to be followed in connection with a modification application on a loan secured by a first lien. There are also procedures that must be followed in connection with the denial of an application, and most importantly it provides for a borrower's right to appeal a denial.

The enforcement provisions of the Bill of Rights authorize a borrower, who is forced to litigate with his/her lender, to seek an injunction and damages for violations of certain of the provisions described above. Under its provisions, for the first time in the state of California, a homeowner will be able to secure injunctive relief without having to cure arrears or post expensive bonds.

In addition to injunctive relief, California’s Homeowner Bill of Rights authorize the greater of treble actual damages or $50,000 in statutory damages if a violation of certain provisions of the law is found to be intentional, reckless or resulting from willful misconduct. Prevailing borrowers may also receive attorneys' fees.

Other changes include changes to the notice provisions of Trustee’s Sales. Formerly, a Trustee’s Sale could be continued for as much as a year without written notice being provided to the borrower of the continued date. Under the new law, once foreclosure begins, if a Trustee’s Sale date is postponed, the new law requires that written notice be given to the borrower after the postponement in order to advise the borrower of any new sale date and time.

California’s Homeowners Bill of Rights legislation is effective January 1, 2013, and can be found in the recent amendments and additions to the California Civil Code Sections relating to mortgages.

Additional resources provided by the author

California Civil Code 2920.5, 2923.4, 2923.5, 2924, 2923.6, 2923.7, 2923.55, 2924.9, 2924.10, 2924.11, 2924.12, 2924.15, 2924.17, 2924.18, 2924.19 and 2924.20

Foreclosure and the IRS

In a recent issue of Niche Report I wrote an article on how to safely “walk away” from your mortgage. That article discussed consumer protection statutes enacted by such states as California known to lawyers and  real estate professionals alike as “anti – deficiency” legislation. This legislation protects homeowners who could no longer afford to debt service their mortgage from personal liability on their mortgage and allows them to simply “walk away” from an over encumbered or “underwater” property.

That article sparked a number of inquiries from our readers many of whom wondered what the impact of the Internal Revenue rules on cancellation of debt had on those homeowners who elected to “walk away” from their mortgage, lost their home through foreclosure or benefited from a short – sale or modification that included a principal reduction. This article attempts to shed some light on that subject.

Generally, if a debt for which you are personally liable is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income.  

In the context of today’s real estate market, this means that when your property is foreclosed upon or repossessed and sold, you are treated for purposes of income tax as having sold the property at the fair  market value.  Whether you ultimately have a recognizable gain for tax purposes depends upon whether you are personally liable for the debt and whether the outstanding loan balance is greater than the fair market value of the property. 

 

When a foreclosure takes place, whether by a strategic “walk away” default or otherwise, it is common for the underlying debt securing the home to be far greater than the current fair market value of the property being foreclosed upon. Why else would someone “walk away” and allow their property to be foreclosed, but for the fact that there is no equity?

Should you lose your home by foreclosure, cancellation of debt occurs.  However, foreclosure is not the only situation in which cancellation of debt occurs. Homeowners who were able to secure a short sale, deed in lieu or for those lucky enough to have negotiated a principal reduction modification are all subject to the Internal Revenue rules on cancellation of debt. 

Given that foreclosure, short sales and modifications are pervasive in this economy the subject of cancellation of debt is something that all homeowners must consider when deciding on how to deal with their over encumbered property. 

While the general rule is that tax payers who receive the benefit of a cancellation of indebtedness are subject to taxation for a recognizable taxable gain, fortunately there are several exclusions and exceptions which may result in part or all of the forgiven debt not being nontaxable.  

The first and most often used exclusion is the “Bankruptcy” exclusion. Under this exclusion a debt cancelled as a result of filing for bankruptcy under Title 11 of the United States code would be excluded and non - taxable.

The second most common exclusion is the “Insolvency” exclusion. This provision of the IRS code provides that if the total of all your liabilities was greater than the fair market value of your assets at the time the debt was cancelled, there is no recognizable gain from the cancellation for tax purposes.

By far, however, the most important exclusion can be found in the Mortgage Debt Relief Act of 2007.   Enacted by Congress as a direct result of the crash in Wall Street, our economy and the real estate market this legislation was specifically designed to protect those homeowners who are burdened by a mortgage they can no longer afford and a principal residence they are unable to sell.

This Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for this relief.

The provisions of this Congressional enactment apply to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.

Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion. 

One must be careful, however, proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.  In addition, debt forgiven on second homes or rental property does not qualify for this tax relief provision. In some cases, however, other tax relief provisions – such as insolvency or bankruptcy – may be applicable.

More information on this subject including detailed examples can be gotten from your tax professional or found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17.