When housing prices fluctuate, your investment property may lose so much value that you end up owing more on your mortgage than your property is worth. If you cannot make the mortgage payments, your lender may begin the process of foreclosing on the property. Filing for bankruptcy before the foreclosure is completed may allow you to reduce your debt, or tax burden if your property is sold.
Foreclosure is the process whereby your lender takes control of your property and sells it to pay your loan, essentially repossessing the property. Bankruptcy is governed in part by federal law, but state law governs foreclosures as well as certain aspects of bankruptcy. Typically, your lender cannot foreclose until you have defaulted on your loan by failing to make payments as required, and lenders must file a public default notice. Depending on your state's laws, you may be able to reinstate your loan by paying on it. Otherwise, your property will be sold to satisfy the debt you owe. You can work with your bank to sell the property without a foreclosure appearing on your credit report, or the bank can sell the property on its own. However, you remain responsible for the property until the title is out of your name, so you must pay fines, homeowners association dues and other costs.
If a lender forgives or writes off more than $600 of your debt, it is required to issue a Form 1099C for tax purposes by February of the year following the property's foreclosure sale. Typically, the IRS considers forgiven debt as income for the person who benefits, so you could end up paying taxes on the amount of debt your lender wrote off because of your foreclosure. For example, if you owed $2,000 more on your property than you bank sold it for during foreclosure, your bank must send you a 1099C for $2,000 and you must claim that as income on your taxes. To avoid paying these taxes, you can file a Chapter 7 bankruptcy to eliminate your mortgage debt and your tax liability for the forgiven amount before your lender issues the 1099C. Not everyone qualifies to file Chapter 7 bankruptcy, but if your income is low enough, Chapter 7 allows you to protect certain assets while other assets are sold to satisfy your creditors. Once the 1099C is issued, the forgiven debt officially becomes income, and income cannot be eliminated in bankruptcy.
Surrendering Property in Bankruptcy
You may also have the option to surrender your investment property in a bankruptcy to end your liability for the property. By surrendering your property in a bankruptcy, you can eliminate both a first and second mortgage on the investment property that is underwater, meaning you owe more than the property is worth. A surrender means you offer the property as satisfaction of the mortgages you owe, and you are not liable to pay more to your lenders even if your property sells for less than the owed amount. However, you must file your bankruptcy case before your lender forecloses since you cannot surrender property that is already foreclosed.
In a Chapter 13 bankruptcy, which requires full or partial repayment of your debts over a three- to five-year period, the court can allow you to “cram down” the mortgage on your investment property to the property's current value, helping you avoid foreclosure. For example, if you owe $200,000 on your property but it is only worth $150,000, the court can change your mortgage amount to $150,000 while changing the remaining $50,000 into unsecured debt. Since unsecured debt is eligible for discharge, or elimination, at the end of your repayment plan, you may pay little of that $50,000. However, bankruptcy rules do not allow a cram-down unless you are able to pay off the new value of the mortgage in its entirety within the life of the repayment plan.