When you file for personal bankruptcy, you will have to decide whether to use Chapter 7 or Chapter 13. If you own investment property, this choice will have significant consequences. In Chapter 7, you will have to give up any property you own that isn't protected by an exemption, which almost always includes investment real estate. If you have significant equity in this property, the trustee can take it, sell it, and distribute the proceeds to your creditors (after paying off the mortgage and any other loans or liens on the property). In Chapter 13, you can keep all of your property -- but you'll have to repay a portion of your debts in a three- to five-year repayment plan.
Investment Real Estate and Chapter 7
In Chapter 7, you won't lose any property that's protected by an exemption. Exemptions are determined by state law (or federal law, if your state allows you to choose between the state list of exemptions or the federal list). Exemptions typically protect needed items such as a car, clothing, furniture, tools of the trade, and at least some equity in a home. However, homestead exemptions apply only to your residence, not to property you own as an investment, such as rental property. Investment real estate is generally not exempt, and could be lost in Chapter 7. (For more information on exemptions, and links to each state's rules, see Bankruptcy Exemptions - What Do I Keep When I File for Bankruptcy?)
If you are underwater on your investment property loans -- that is, you owe more than the property is worth -- and you are willing to give it up, Chapter 7 might not be a bad choice. The trustee won't take the property, even though it's exempt, because any money earned from a sale would go to those holding liens and loans on the property, with nothing left for your other creditors. However, in Chapter 7, you get to decide how you want to handle your secured debts, including those secured by your investment property. One option is to simply surrender it to your creditors. Surrendering the property eliminates your liability for the debt, even if you owe more than it's worth. Any amount you owe that exceeds the value of the property will be discharged (wiped out) in your bankruptcy case.
If you have some equity in the property, however, you might well lose it in Chapter 7. Even if you tell the court that you'd like to keep the property by reaffirming the loan or continuing to make your payments, the trustee might take it and sell it if doing so would raise some real money for your other creditors.
Investment Real Estate and Chapter 13
By using Chapter 13, you can keep your investment property. In Chapter 13, you don't have to give up any property. Instead, you must repay a portion of your debts over time, in a Chapter 13 repayment plan. Your investment property will still play a role in your bankruptcy case, however, in the following ways:
- It may increase your required payments. In Chapter 13, you must repay your unsecured creditors at least the value of your nonexempt property, including your investment property. This rule is intended to make sure that these creditors get at least as much out of your Chapter 13 case as they would have if you used Chapter 7. So, if you have substantial unprotected equity in your investment property, it could increase your Chapter 13 plan payments.
- You can pay off arrearages in your plan. If you have missed a few payments on your investment property, you can roll the money you owe into your Chapter 13 repayment plan and pay it back over three to five years. As long as you stay current on your payments going forward, this will allow you to avoid foreclosure -- without having to come up with all of your missed payments in one lump sum.
- You may be able to cram down your mortgage. In Chapter 13, you can ask the judge to reduce the amount you owe on certain types of investment property to the property's current value. For example, if you owe $100,000 but the property is worth only $50,000, you can ask the judge to reduce your debt to $50,000. This is called a cramdown, and it isn't available for your residence, only for property you don't use as your home. There's a major drawback to getting a cramdown, however: You have to pay back the entire new loan amount during your three- to five-year repayment plan. For most debtors, coming up with this much money in just a few years is next to impossible.
Getting Legal Help
If you have valuable investment property that you want to keep, consider a consultation with an experienced bankruptcy attorney. An attorney can explain your options and help you choose the strategy that makes the most sense in your situation.