In some states, homeowners who lose their home through the foreclosure process may still be responsible for paying the amount of the mortgage that was not paid off by the sale of the house, called a mortgage deficiency. Chapter 13 bankruptcy may be the only reasonable way for these former homeowners to eliminate what can be a substantial amount of debt; however, the Chapter 13 bankruptcy process takes several years to complete, and there may be serious tax consequences even if bankruptcy eliminates the mortgage deficiency.
Chapter 13 vs. Chapter 7 Bankruptcy
Both Chapter 13 and Chapter 7 bankruptcies result in the discharge of debts, meaning that the person who owes the debt is no longer legally obligated to pay the amount owed. The primary difference between the two bankruptcy types is how those debts are discharged. Chapter 7 bankruptcy is designed for individuals who have little, if any, disposable income; the debtor's non-exempt assets are seized and liquidated to help repay creditors. Filers who do have disposable income are required to make payments to their creditors over a three- to five-year payment period under Chapter 13. At the end of the payment period, any remaining balance is discharged.
A mortgage deficiency occurs if real estate is sold and the proceeds from the sale are not enough to pay off the mortgage(s) on the property. The sale of a property as the result of foreclosure is a common way in which deficiencies arise. In some states, the mortgage lender can look only to the property for reimbursement of the mortgage balance. For example, if a mortgage balance is $200,000 and the house sells for $150,000, the lender loses $50,000. The former homeowner is not liable for the $50,000 deficiency. These states are often called “non-recourse states.” In other states, the former property owner may still be legally obligated to pay the mortgage balance if the lender follows all state laws with respect to the foreclosure.
Mortgage Deficiencies as Unsecured Debt
The primary purpose of bankruptcy is to discharge unsecured debt. Unsecured debt is debt for which there is no collateral. For example, credit cards are usually unsecured debt because the credit card company cannot seize property if the debt is not paid. By contrast, a car loan or real estate mortgage is usually secured debt. The debt is secured by the car or by the real property. If the debtor does not make the payment, the lender can repossess the car or sell the property. Secured debt is only secured up to the value of the collateral. Therefore, if a house is worth $150,000 and the mortgage balance is $200,000, the debt is only secured for $150,000. The remaining $50,000 mortgage deficiency is unsecured debt. From this example, the former property owner could file for Chapter 13 bankruptcy, make payments on that $50,000 deficiency and, if the debtor makes all of the payments required by the court, receive a discharge of the remaining mortgage deficiency balance.
Tax Implications of Forgiven Debt
Whether a mortgage lender pursues a deficiency amount is up to the discretion of the lender. If the amount of the deficiency is relatively small and if the debtor has few assets, the lender may decide to forgive the deficiency amount. While the former owner may no longer be obligated to pay the lender in this event, that forgiven amount could be subject to federal income tax. If the mortgage deficiency involved the former owner’s principal residence, the deficiency is excluded from taxation as income, but the debtor must file the exclusion with the IRS. If the property was not the former owner’s principal residence, as in the case of an investment property, this exclusion does not apply. If the exclusion does not apply and the former owner cannot pay the tax, Chapter 13 may be an option. If the deficiency is discharged through bankruptcy, the discharged amount is excluded from income taxation.