A Short Sale Alternative for Underwater Homeowners?

While it may appear that the housing market is rebounding, there remains a vast pool of homes that are "underwater" - their owners obligated to pay substantially more to first, second and even third mortgage lenders. Short sales have been one solution.  In a short sale, the owner agrees to sell her property for a price which is less than the debt owed and asked her lender(s) to agree to release their lien voluntarily.  But that solution has its limitations.  First, the owner has to be able and willing to sell.  What if the owner wants to stay?  Second, the short sale process is grueling in terms of the documentation that lenders require and ultimately the owner is at the whim of the lender(s) to approve.

So, if not a short sale then what?  A chapter 13 bankruptcy may be the best alternative. In a chapter 13, an underwater homeowner may be able to "strip off" (void) all junior liens which are below the present value of the property and use a chapter 13 plan to repay past due installments over the life of a 3-5 year bankruptcy plan.  Additionally, chapter 13 offers even greater possibilities for those owning mixed-use property (2-4 flats), investment property, vacation homes and any loan where the security given to the lender includes something in addition to the owner's principal residence.  In those situations, chapter 13 not only allows the owner to "strip off" junior liens but to also "strip down" the first mortgage to the present value of the property.  For example, assume an owner has a 2-flat with a first mortgage of $250,000 and a second mortgage of $50,000 and further assume that the property has a present value of $175,000.  The owner could propose a plan the voids entirely the second mortgage and pays the first mortgage back based upon a principal amount of $175,000.  The owner has, in effect, shed $75,000 of mortgage debt while getting to keep their home.

"Strip offs" and "strip downs" are important tools to consider when working with a homeowner with an underwater mortgage. Clients seeking to pursue such a strategy should consult with an attorney experience in bankruptcy and real estate.  Short sales have their place, but there are alternatives for those who seek them out.

Rusty Payton is a partner with the Illinois law firm of Payton Legal Group.  He has over 27 years experience in real estate and bankruptcy matters.  He may be contacted at 773-682-5210 or at [email protected]