- What Is Chapter 13 Bankruptcy?
- The Chapter 13 Bankruptcy Process and Discharge
- How Does Chapter 13 Treat Real Estate?
- The Benefits of Chapter 13 Bankruptcy to Real Estate Investors
- The Disadvantages & Limits of Chapter 13 Bankruptcies
- Chapter 13 Bankruptcy & Real Estate Investment: The Bottom Line
Chapter 13 bankruptcy might at first appear to be an ill-fit for Michigan real estate investors. It is, after all, a process in which the value of assets can be used as a basis for the amount of debt that must be repaid.
However, understanding that sentiment requires a basic understanding of the Chapter 13 bankruptcy process generally.
Understanding why and when it may not be true and when Chapter 13 may be, in fact, beneficial to a Michigan real estate investor requires an even deeper understanding of Chapter 13 and the types of real estate investment underway in the marketplace.
This Article aims to clarify both Chapter 13 bankruptcy and its treatment of investment real estate and the Chapter 13 processes undertaken by different types of real estate investors.
First, the basic question.
What Is Chapter 13 Bankruptcy?
Chapter 13 is a “reorganization” bankruptcy process. That is, in Chapter 13 bankruptcy, you do not simply discharge your debt flat-out. Instead, you reprioritize your debt.
This means that you pay some debt ahead of other debt.
The Chapter 13 payment plan is the document that your Michigan bankruptcy attorney will draft and file for you when you initiate a Chapter 13 case. This payment plan is essentially a motion filed with the US Bankruptcy Court in Detroit, Bay City, or Flint that makes a number of requests.
The Chapter 13 Payment Plan
First, the Chapter 13 payment plan requests that you be allowed to make a monthly Chapter 13 plan payment toward all the debt that you owe.
This plan payment is premised upon the net difference between your household take-home pay and your necessary household expenses. (What “household” and “necessary” mean is a discussion outside the scope of this Article. Refer to our other blog posts for discussion of these terms.)
Every filing Chapter 13 debtor (that’s you) will have a different plan payment amount than any other debt because no two household budgets are the same.
Chapter 13 Creditor Payment Priority
Next, the Chapter 13 payment plan requests that the Chapter 13 Trustee to whom you make your monthly play payment be required to pay your creditors in the priority order mentioned above.
But, no, you do not get to just pay your creditors in whatever order you want.
The US Bankruptcy Code is the Federal state governing the bankruptcy process in the United States. This Bankruptcy Code mandates a priority payment order based on the type of debt (or Plan expense) involved.
The priority payment order mandated by the Bankruptcy Code is as follows:
- Administrative Expense of the Plan (this means your own bankruptcy attorney’s fees and the Chapter 13 Trustee’s percentage-based fee);
- Secured Debt;
- Arrears on Secured Debt;
- Executory Lease and Contract Payments;
- Priority Unsecured Debt;
- Non-Priority Unsecured Debt.
A discussion of all of the differences between these different types of debt is, again, outside of the scope of this Article.
Suffice it to say that Secured Debts include mortgages. Leases and Executory Contracts, obviously, include rental leases, property management contracts, and other real estate-related contracts. Non-priority unsecured debt is debt that has not been classified as “priority” by the Bankruptcy Code and which is not secured with collateral.
The Chapter 13 Plan will also request that the Court approve any restructuring of debt that is allowed under the Bankruptcy Code’s provisions.
Mortgage lien strips, cramdowns, interest-rate adjustments are all powerful tools in the Chapter 13 toolbox. We will discuss the debt restructuring mechanisms relevant to real estate investment and investors below.
The Chapter 13 Bankruptcy Process and Discharge
So how does the Chapter 13 process actually work?
Once your Chapter 13 Plan is approved by the Court, you simply follow the rules of the Chapter 13 road for the next 3-5 years, depending upon your particular Chapter 13 payment plan.
That is, you make your monthly Chapter 13 plan payment in the right amount, on time, every month. You turn over tax returns and other documentation as required. You keep your bankruptcy attorney updated as to changes in your income, expenses, and other household, employment, and family circumstance.
When you have made the last payment required by your Chapter 13 plan, the Court will issue your discharge.
Any non-priority unsecured debt that has not been fully paid is then fully wiped out without the need for further repayment.
How Does Chapter 13 Treat Real Estate?
As noted, Chapter 13 treats secured debts differently than non-priority debts. They are paid first. A secured debt that is in arrears can be brought current through the Chapter 13 plan.
Real estate, however, is an asset, not a debt.
In Chapter 7 bankruptcy, assets are subject to seizure and liquidation. The sale of a debtor’s assets is the mechanism by which creditors are repaid in Chapter 7 bankruptcy. That said, assets that are “exempted” from the legal bankruptcy “estate” created with the filing of the case are not subject to liquidation.
An asset that is “exempted” is protected from liquidation, in short. The exemptions themselves are just statutory provisions from the Bankruptcy Code or, alternatively, Michigan state law that allow certain assets to be exempted, up to certain dollar value limits.
Both Michigan law and the Bankruptcy Code contain an exemption for real estate serving as the debtor’s primary residence.
Neither statute contains any exemption for real estate that is not the debtor’s primary residence.
Real estate investors owning one or more investment properties are well-advised, therefore, to steer clear of Chapter 7 bankruptcy—unless the goal is to allow a Chapter 7 Trustee to seize and liquidate investment properties that are no longer wanted or valued.
Property is not, however, liquidated in Chapter 13 bankruptcy. Instead, the payment plan repayment scheme is the creditor payment mechanism in Chapter 13. This does not mean that non-exempt assets do not create an issue in Chapter 13, however.
Normally, non-priority unsecured creditors are not required to be paid any minimum amount through a Chapter 13 plan. However, the presence of non-exempt assets changes this.
That is, the value of non-exempt assets—including investment and other real estate—constitutes a minimum amount that must be paid to unsecured creditors through your Chapter 13 plan on a dollar-for-dollar basis.
Thus, for example, if you own an investment property in Ferndale, Michigan with $50,000 in equity, you will be required to pay your unsecured creditors at least $50,000 through your Chapter 13 plan. $50,000, that is, after all of the higher priority parties are paid first.
It is, however, only the equity that must be exempted. If that Ferndale rental or investment property is actually worth $400,000, it is only the $50,000 in equity, after mortgage and other encumbrances, that must be exempted.
The Benefits of Chapter 13 Bankruptcy to Real Estate Investors
Despite the potential costs involved, Chapter 13 bankruptcy has many potential benefits for real estate investors.
It is worth mentioning before diving into those benefits that Chapter 13 is a form of personal bankruptcy. It is not a corporate or business bankruptcy. Chapter 11 is the form of reorganization bankruptcy available to corporate entities.
High asset individuals are also eligible to file an individual Chapter 11 bankruptcy. The best form of bankruptcy for any real estate investor is a subject that should be discussed with only a highly experienced bankruptcy attorney.
That said, onward we go to the benefits of Chapter 13 bankruptcy.
Protection of the Automatic Stay
The first benefit of Chapter 13 bankruptcy is the protection of a Federal injunction called the Automatic Stay against Collections. The Automatic Stay prohibits any collection activity during a Chapter 13 proceeding.
Recalling that the Chapter 13 process is 3-5 years long, this is a powerful tool in a real estate investor’s hands. No foreclosure, no lien enforcement, no phone-calls, no harassment … Gone for the duration.
Bring Arrearages Current
As noted above, the second or third highest priority payee in a Chapter 13 payment plan is an arrearage owed on a secured debt.
Thus, if you’re behind in your mortgage on a rental or investment property, you have the ability in Chapter 13 to pay the ongoing contractual mortgage installment payment in the first priority position through your plan—and then pay the arrearage off at 0% interest in the second priority position.
Cramdown, Lien Strip, and other Debt Restructuring Mechanisms
You can do a number of interesting things with secured debt in a Chapter 13 bankruptcy that are not possible in Chapter 7. These include the stripping off of second (or third) mortgages or liens on real estate and cramming down the secured amount owed on investment real estate.
We will not discuss the particulars of these processes in great detail here. Briefly, however:
A lien strip is the reclassification of a legally secured junior mortgage debt as unsecured in a Chapter 13 Plan.
This maneuver is possible when your property’s appraised value is less than you owe on a first or primary mortgage. In this case, any second or additional mortgage is “wholly unsecured.” The value of the house is not sufficient to actually secure it, in other words.
When a junior lien is “stripped,” it is treated as unsecured debt: paid only to the same extent the other unsecured creditors are at the end of the Chapter 13. After the discharge is issued, the discharge order and the lien strip order can be filed with the Wayne County or other county register of deeds, removing it as an encumbrance upon the property’s title.
Example: Your rental property in Madison Heights is worth $125,000 (appraised value, not Zillow!). Your first mortgage on the property has a note balance of $130,000. Your second mortgage (balance: whatever amount) is not truly secured by the property’s value. It can be stripped off and discharged in Chapter 13.
A cramdown is only applicable to investment properties. It is ideal for real estate investors. You cannot cramdown a primary residence.
The cramdown is essentially the bifurcation of a legally secured debt into two portions: one secured portion paid at high priority in the Chapter 13 and one unsecured portion paid at low priority.
This is possible when the value of the investment property is less than is owed on the mortgage (or mortgages) securing its payment. For example, a rental property in Monroe is appraised at $75,000 but has a mortgage encumbering it with a $100,000 balance.
The cramdown will split the $100,000 mortgage debt into a high priority $75,000 portion and an unsecured $25,000 portion.
If you make all of your Chapter 13 plan payments in sufficient amount, paying off the $75,000 portion in full through the 5-year bankruptcy process, you will exit the Chapter 13 owning the investment property free and clear. The $25,000 unsecured portion is paid (whatever) and then discharged.
Other Restructuring Mechanisms, Property Tax Payment, & Property Surrender
It is also possible to cramdown or restructure interest rates attached to secured debts, to reject land contracts or other leases, and, finally, to catch back property taxes up and avoid tax foreclosure on your investment properties in Chapter 13 as well.
Finally, if an investment property is not profitable, it can be surrendered in a Chapter 13 just as in a Chapter 7 bankruptcy. The Chapter 13 does not cause title of a surrendered property to transfer back to the lender automatically, however.
Instead, at some point, your mortgage servicer will file a motion for relief from the Automatic Stay allowing it to proceed with a foreclosure proceeding under Michigan state law or negotiate a deed-in-lieu of foreclosure with your bankruptcy attorney and the Chapter 13 Trustee.
The Chapter 13 discharge will eliminate your personal liability for the mortgage on the surrendered property.
In short, for the struggling real estate investor, Chapter 13 holds many possible benefits.
The Disadvantages & Limits of Chapter 13 Bankruptcies
There are, of course, disadvantages to Chapter 13 bankruptcy—in addition to the usual “what about my credit score?” concerns. (Discuss those with your bankruptcy lawyer: Such concerns are usually pointless.)
Chapter 13 does not have an income eligibility “means test” for entry as Chapter 7 does. However, there are debt limits that may apply.
As of this writing, if your combined total secured and unsecured debt is more than $2,750,000, you are ineligible for Chapter 13 bankruptcy.
Obviously, this limitation will not affect most Metro Detroit residents seeking bankruptcy protection. For real estate investors, however, it may only take one or two high-value investment properties with serious mortgage baggage to push up against it.
When Chapter 7 is not an option and the Chapter 13 debt limits are a problem, an individual Chapter 11 bankruptcy may be an option worth discussing with an experienced bankruptcy attorney.
Just because the Chapter 13 process allows all of the above options does not mean that you can afford them. Whatever you do with your investment properties and property tax debt, whether stripping liens or cramming down or anything else, you will still need to make a payment of $X per month in order to maintain those properties rather than surrendering them.
It is possible that your income is simply not sufficient to allow this.
Properties Must Be Profitable
Finally, the Chapter 13 Trustee will object to any Chapter 13 plan proposing to retain investment property that is not generating income for the bankruptcy estate and your creditors. If investment property is costing you money every month, you’ll be required in most cases to surrender it before the Court will approve your Chapter 13 plan.
The property needs to generate monthly profit in order to be retained in Chapter 13. A vacation home that does not serve this purpose is thus not the sort of “investment property” that anything discussed above applies to.
The good news is that rental income is still “income” for Chapter 13 purposes and can be used to fund the Chapter 13 payment itself.
Chapter 13 Bankruptcy & Real Estate Investment: The Bottom Line
The bottom line with regard to real estate investment is that you need a highly experienced bankruptcy attorney to assist you as an investor.
Attorney Walter Metzen is a Board Certified Bankruptcy Expert who has successfully assisted Chapter 7 and Chapter 13 bankruptcy clients in Metro Detroit for over 30 years.
If you are a real estate investor considering filing for bankruptcy in Michigan, contact us now to discuss your options.