Do you own rental property? If you own a house, apartment, commercial space, or multi-unit building that you rent out to tenants, then you should consider how it will be affected if you file for bankruptcy. Whether you get to keep the property may depend on whether you file under Chapter 7 or Chapter 13 bankruptcy.
You won't necessarily have to give up your rental property if you file a Chapter 7. But it will depend on whether you have equity in the property and your state allows an exemption that can cover it.
When you file for bankruptcy under Chapter 7, you get to keep any property that's "exempt" (protected from turnover in bankruptcy) under state law (or under federal law, in states that allow filers to choose between the state's exemption system or the federal exemption system). Unfortunately, most states allow a debtor to apply the exemption to homestead (the debtor's residence) property but not to rental property.
No matter how much equity your state's law protects, however, it applies only to your residence: the home in which you live. It doesn't protect other property you own and don't use as a residence, such as rental property.
(Learn more about exemptions—and find links to state exemption lists—in Bankruptcy Exemptions: What Do I Keep When I File for Bankruptcy?)
If you have a relatively small amount of equity in your rental property, you may be able to protect it with a "wildcard" exemption: an exemption amount that you can apply to any property.
Not all states have a wildcard exemption; in those that do, the amount you can protect is typically small (often in the hundreds of dollars). However, some states have higher wildcard exemptions. If your equity is minimal, using a wildcard exemption may tip the scales in your favor.
When you file for Chapter 13 bankruptcy, you don't have to give up any of your property. Instead, you use your income to repay some or all of your debts, over a three- to five-year repayment period.
Your rental property isn't just another asset you account for in your bankruptcy paperwork. Your rental property can affect your Chapter 13 bankruptcy case and your repayment plan in several ways.
Some of the circumstances you need to consider if you plan to keep your rental property through your Chapter 13 bankruptcy case include:
Read on for more information on these topics.
Filing bankruptcy often seems like a never ending quest to gather every minute piece of data about the debtor, their assets and their income. One reason detailed accounting is important in a bankruptcy case is because income from a rental property can have a significant effect on whether the debtor has enough cash to fund a Chapter 13 plan.
The debtor must disclose any income the rental property produced during the six months prior to filing the bankruptcy case. The debtor will offset income with any reasonable and necessary expenses used to maintain the property. The net income (gross income minus expenses) is added to the rest of the debtor's income and is used to determine the amount of disposable income the debtor can use to fund a Chapter 13 plan.
Having rental property in a Chapter 13 may require you to pay back a substantially larger portion of your debt.
When you file for Chapter 13, the amount you pay your creditors must be at least equal to the value of your nonexempt property. This rule (called the "best interest of creditors test") is intended to make sure that your creditors won't be worse off if you use Chapter 13 than they would have been if you had used Chapter 7. If you have significant equity in your rental property, you will be able to keep that property but will have to repay your creditors at least this much in your plan.
Example: You own a vacation home that the bank has appraised at $250,000. You owe $200,000. Your equity is $50,000. Your state has no exemption for second homes or rental properties. If you file a Chapter 7 case, the trustee will likely sell the vacation home and distribute the proceeds of $50,000 (after the mortgage is paid off) to the unsecured creditors. If you want to keep the property, you can file a Chapter 13 case. But you must devise a repayment plan that ensures your unsecured creditors will receive at least $50,000 over the life of the plan.
Rental property also affects a Chapter 13 case by allowing you to pay off any arrearages you owe on the property a little at a time over the course of your repayment plan.
Example: You've missed a couple of mortgage payments on a home you rent out, at $1,000 each. You can include that $2,000 in your repayment plan, paying off a little each month. As long as you can continue making your payments, you can avoid foreclosure.
With Chapter 13, you may be able to "cram down" your mortgage on rental property. Cramming down means reducing the amount you owe to the value of the property at the time you file for bankruptcy. For example, if you owe $200,000 on a rental home that's worth only $100,000, you can reduce your debt to $100,000.
Although you generally can't cram down a mortgage on your residence, this remedy is available for certain types of rental property. There is a major catch, however: You must pay off the full amount you still owe in your repayment plan.
In our example, you'd have to pay off $100,000 during the three to five years you are in Chapter 13 bankruptcy. Repaying such a large amount in such a short period of time is very difficult for most people, particularly those whose debt problems have already led them to bankruptcy.
Related to cramming down, lien stripping is another way of reducing a debtor's obligation on a rental property.
If you've taken out both a first mortgage and a second mortgage (or more) on property that isn't your primary residence, it might be possible to completely strip off the second lien, leaving only the main mortgage to service. Stripping off a lien in this way can only happen when the value of the property drops below the balance of the principal mortgage. The property is said to be "under water."
When a property is under water, any second lien will be wholly unsecured, meaning a sale of the property won't garner enough proceeds to pay any of the second lien.
Lien stripping cannot be used in a Chapter 7 case and cannot be used to strip a lien on a debtor's principal residence.
This article provides an overview of some ways you might be able to keep rental property when filing for bankruptcy. But if you have rental property you really want to keep, consider consulting with an experienced bankruptcy attorney in your state to learn all the available options and which strategy would best protect your investment.