The topic of mortgage strip offs and strip downs in bankruptcy, which generally affect second or third mortgages, such as home equity lines of credit, continues to generate fresh issues and court opinions. With an estimated 9.7 million homeowners still underwater on their mortgage, this topic is likely to remain relevant for a while. This article provides a summary of some of the key concepts and issues in mortgage strip offs and strip downs and notes some recent important court opinions.
1. What Is The Difference Between Strip Off And Strip Down?
Strip off is the complete removal of the mortgage’s lien from the real estate, i.e., the loan is no longer secured by the real estate. Strip off is based on there being no equity in the real estate to secure the loan. For example, assume a parcel of real estate valued at $300,000 is encumbered by a first mortgage with a payoff of $350,000 and a second mortgage with a payoff of $100,000. The payoff of the first mortgage exceeds the value of the real estate, thus there is no equity to secure the second mortgage, which may be stripped off.
Strip down, on the other hand, divides the loan into secured and unsecured portions based on the amount of equity that secures the loan. For example, if the real estate’s value is $300,000, and it is encumbered by a first mortgage with a payoff of $250,000 and a second mortgage with a payoff of $200,000, then the second mortgage can be divided into a $50,000 secured portion and a $150,000 unsecured portion. The $50,000 portion remains secured by a lien on the real estate, which will have to be repaid in full, but the unsecured portion is no longer a lien on the real estate and might be repaid only pennies on the dollar, based on the borrower’s ability to repay.
2. Is Either Strip Off Or Strip Down Possible In Chapter 7 Bankruptcy?
No. The U.S. Supreme Court and the Fourth Circuit Court of Appeals, which includes Virginia, are clear on this issue. In 2012, the Eleventh Circuit Court of Appeals, in a case arising out of Georgia, allowed a chapter 7 lien strip off, but there is no reason to believe the law on these issues will change in Virginia anytime soon.
3. Is Strip Down Possible In Chapter 13 Bankruptcy? The Home Mortgage Exception.
Yes, but there is a caveat known as the “Home Mortgage Exception,” or the “Principal Residence Exception.” The Home Mortgage Exception prevents strip down in chapter 13 where the affected lien is secured only by a consensual lien on the debtor’s principal residence. A debtor may not strip down a mortgage or deed of trust if the sole collateral and security is the debtor’s primary home.
The Home Mortgage Exception is limited, however, because it does not apply if the loan is secured by another parcel of real estate or by personal property in addition to the debtor’s home. There, the security interest is subject to strip down. Accordingly, it is important to consider the implications of strip down when making loans because a minimal increase in security could jeopardize the primary collateral if the borrower files for chapter 13 bankruptcy.
One bankruptcy court in Virginia has held that the Home Mortgage Exception still applies even though the deed of trust includes an assignment of rents. Also, bankruptcy courts outside Virginia have held that the Home Mortgage Exception does not apply if the borrower uses the real estate both as a principal residence and as a rental property, e.g., the borrower rents part of the real estate to another family or operates a bed-and-breakfast.
4. Are There Any Exceptions To the Home Mortgage Exception?
Yes. In addition to the limited application discussed above, the Bankruptcy Code provides that the Home Mortgage Exception will not apply in chapter 13 where the final payment due on the given loan is due at a date earlier than the last payment date contemplated by the debtor’s chapter 13 plan. For example, if the note on which the debtor is obligated has a final payment due in December 2016, but the debtor’s chapter 13 plan has a final payment date in December 2019, then the lien securing that note may be stripped down to the value of the principal residence. Lenders should be particularly concerned where a home equity loan, which typically has a shorter term than a 15 or 30 year mortgage, is secured by the debtor’s principal residence because that obligation could be stripped down.
5. Is Strip Off Possible In Chapter 13 Bankruptcy?
Yes, notwithstanding the Home Mortgage Exception, if there is no equity to secure the loan, i.e., the payoffs on the prior liens aggregate more than the value of the real estate, then the lien may be stripped off. Therefore, an appraisal of the real estate can carry high stakes. If the Home Mortgage Exception applies and there is even one dollar of equity to which the second lienholder’s lien attaches, then the lien cannot be stripped off or stripped down, i.e., the loan has to be paid in full according to its terms, albeit with the borrower given an opportunity to cure any arrearages. If, on the other hand, there is no equity, then the lien can be stripped off, which often means the lender will receive only pennies on the dollar on its loan over a period of years. A 2013 Western District decision held that a second lien could not be stripped off because that second lien-holder was partially secured by just $9. The first lien-holder was fully secured and the value of the collateral exceeded that first lien by $9.
6. Are The Rules The Same In Chapter 11 Bankruptcy?
Yes, but the lender gets an additional protection. The lender may elect to have its claim treated as fully secured so that a strip down is not possible. This is the “section 1111(b)(2) election.” If the loan payoff is $200,000 but there is only $50,000 of equity in the real property to which the lender’s lien attaches, the lender can nonetheless elect to have its claim treated as if the entire $200,000 is secured by equity, preventing a strip down. Section 1111(b)(2) protects lenders against borrowers who try to use bankruptcy to benefit from temporary dips in the real estate market to the barrower’s benefit. It is not available, however, if there is no equity in the real estate to which the lien attaches or if the real estate is going to be sold as part of the bankruptcy. Also, making the election deprives the lender of an unsecured claim, which can be a disadvantage to a lender who would like to block confirmation of the borrower’s proposed chapter 11 plan. The election should be made only after careful consideration of other possible strategies to deal with the bankruptcy.
7. What Is “Chapter 20,” And What Are The Strip Off And Strip Down Rules There?
There is no chapter 20 of the bankruptcy code. “Chapter 20” is a phrase that describes a situation in which the borrower obtains a chapter 7 bankruptcy discharge and then files a chapter 13 case (7+13=20). A Chapter 20 can give the borrower the best of both worlds. The Chapter 7 discharges personal liability on debts without having to engage in a repayment plan, as in chapter 13, and the debtor does not have to qualify for the chapter 13 debt limits. Next, chapter 13 provides for strip down, subject to the Home Mortgage Exception, or strip off secured debt, which chapter 7 does not permit. Additionally, after having already discharged personal liability in a chapter 7, the chapter 13 plan will likely be less burdensome and costly as it would have been had the debtor filed chapter 13 without a prior chapter 7 discharge.
Given the great benefits that Chapter 20 offers debtors, some have argued that strip off and strip down should not be allowed in the Chapter 20 context. Last year, however, the Fourth Circuit ruled that a borrower can strip off a junior mortgage in the Chapter 20 context. Presumably, strip down is also allowed. The Fourth Circuit stated, however, that if the debtor’s only reason for filing a chapter 13 case after completing a chapter 7 case is to strip off a lien, then the bankruptcy court may dismiss the chapter 13 case for lack of “good faith.” In the Chapter 20 context, in which the borrower is trying to strip off or strip down a mortgage, the lender needs to consider the entire context to determine if the borrower needs chapter 13 for legitimate reasons, such as additional time to cure arrearage on a first mortgage and avoid a foreclosure versus a lack of good faith where the debtor may be improperly using the bankruptcy system. If the latter, then the lender might avoid the strip off or strip down by filing a timely motion to dismiss the Chapter 13 case.
8. What Is The Relevant Date For Valuing Real Estate For Purposes Of Strip Off Or Strip Down, And Who Has The Burden Of Proof?
The petition date is the date on which courts will normally value real estate for purposes of strip-off litigation, as held by the Bankruptcy Court for the Eastern District of Virginia. The borrower has the burden of proving that the value of the real estate is so low that strip-off is allowed by the preponderance of the evidence.
9. What Happens If The Real Estate Is Owned By A Married Couple As “Tenants By The Entirety” But Only One Spouse Files Chapter 13?
In 2013, the FourthCircuit ruled that if only one spouse files bankruptcy, then the bankruptcy court does not have authority to strip-off a lien from real estate that a husband and wife, together, own as tenants-by-the-entirety. Only where both spouses who own property as tenants-by-the-entirety are in bankruptcy may the court strip-off a lien on that property because the marital unit owns the property, not an individual spouse with a partial interest in the property. It is likely that the courts would require husband and wife debtors to have filed a joint case together, but the authorities are not clear on this issue where the husband and wife have separate, pending bankruptcy cases.
10. What Happens If The Mortgage Is Stripped Down Or Off But Then The Bankruptcy Case Is Dismissed Before The Borrower Completes The Bankruptcy Plan?
When a bankruptcy case is dismissed, the parties revert to the status quo that existed prior to the bankruptcy filing, including reinstating liens that were avoided during the bankruptcy case. The Bankruptcy Code, however, provides to the judge discretion here, so a lien holder should request plans and subsequent confirmation orders have applicable language that conditions strip-off or strip down on the debtor’s completion of the chapter 13 plan.
 Zillow 2014 Q1 Negative Equity Report (May 19, 2014).
 Of course, this is not an exhaustive review of the law of mortgage strip downs and strip offs and is not intended as advice for any particular situation. Any specific questions related to mortgage strip downs or strip offs should be posed to legal counsel.
 Dewsnup v. Timm, 502 U.S. 410 (1992) (Chapter 7 strip down not allowed); Ryan v. Homecomings Fin. Network, 253 F.3d 778 (4th Cir. 2001) (Chapter 7 strip not allowed).
 McNeal v. GMAC Mortg., LLC, 735 F.3d 1263 (11th Cir. 2012).
 In re Didlake, 454 B.R. 349 (Bankr. W.D.Va. 2011).
 See, e.g., In re McVay, 150 B.R. 254 (Bankr. D. Or. 1993).
 11 U.S.C. § 1322(c)(2).
 In re Johnston, 2013 Bankr. Lexis 1850 (Bankr. W.D.Va. 2013).
 In re Davis, 716 F.3d 331 (4th Cir. 2013).
 In re Reconco, 2014 Bankr. Lexis 1219 (Bankr. E.D.Va. 2014).
 In re Alvarez, 733 F.3d 136 (4th Cir. 2013).