Legal Definitions - lien-stripping

Lien-stripping is a legal process available in certain bankruptcy cases that allows a debtor to reduce the amount of a secured debt (like a mortgage) to the current market value of the property it secures. Essentially, it "strips away" the portion of the debt that exceeds the property's value, reclassifying that excess amount as unsecured debt.

To understand this, consider a property with a mortgage. The mortgage creates a "lien," which is a legal claim on the property, making the debt "secured" by the property. If the property's value drops below the amount owed on the mortgage, the debt is said to be "underwater." Lien-stripping aims to split this underwater debt into two parts:

• The secured portion, which is equal to the current market value of the property.
• The unsecured portion, which is the remaining debt that exceeds the property's value. This unsecured portion is then treated like other unsecured debts in bankruptcy, such as credit card debt, and may be partially paid or discharged.

It is crucial to note that federal law significantly limits lien-stripping. For a debtor's principal residence (the home where they live), lien-stripping is generally not allowed for the primary mortgage in most common bankruptcy chapters (Chapter 7, Chapter 13, and Chapter 11 for individuals). This means you usually cannot reduce the amount owed on your main home's first mortgage, even if the home's value has dropped below the loan amount. However, there are specific circumstances where it might apply, particularly to junior liens (like second mortgages or home equity lines of credit) on a principal residence if the value of the home is less than the amount owed on the first mortgage. It can also apply to mortgages on investment properties or secondary homes.

Here are some examples to illustrate the concept:

• Example 1: Second Mortgage on a Principal Residence

  Scenario: Maria owns a home valued at $280,000. She has a first mortgage with an outstanding balance of $300,000 and a second mortgage (a home equity line of credit) with a balance of $60,000.

  Application of Lien-Stripping: In this situation, the first mortgage of $300,000 already exceeds the home's value of $280,000. This means there is no remaining equity in the home to secure the second mortgage. If Maria files for Chapter 13 bankruptcy, she might be able to "strip" the second mortgage. The entire $60,000 second mortgage would be reclassified as unsecured debt. This unsecured debt would then be treated similarly to her credit card debt and potentially paid back at a much lower percentage or discharged entirely through her bankruptcy plan, while the first mortgage remains intact and unaffected by the stripping.

  How it illustrates the term: This example demonstrates lien-stripping because a junior lien (the second mortgage), which was originally secured by the home, is reclassified as entirely unsecured due to the lack of equity available after accounting for the senior lien (the first mortgage). The "strip" removes the secured status of the second mortgage.

• Example 2: Mortgage on an Investment Property

  Scenario: Robert owns a rental property, which is not his primary residence, currently valued at $150,000. He has a mortgage on this property with an outstanding balance of $200,000.

  Application of Lien-Stripping: If Robert files for Chapter 13 bankruptcy, he might be able to "strip" the lien on this investment property. The secured portion of his mortgage would be reduced to $150,000 (the current market value of the property). The remaining $50,000 ($200,000 - $150,000) would then be reclassified as unsecured debt. Robert would then pay back the $150,000 secured portion through his bankruptcy plan, and the $50,000 unsecured portion would be treated like other unsecured debts, potentially receiving only a partial repayment or being discharged.

  How it illustrates the term: This example shows how lien-stripping can reduce a secured debt to the actual value of the property, reclassifying the "underwater" portion as unsecured. This is permissible because the property is not the debtor's principal residence, where the rules regarding lien-stripping are more flexible.