Cram Down a House

“Cram down” is lawyer-speak for a bankruptcy court reducing a secured interest to the value of the property. For instance, if a bass boat is worth $2,000 and there is a $4,000 balance owed to the bank, the bankruptcy court can cram down the secured interest to $2,000. The remaining $2,000 is now unsecured and paid at the same rate as other unsecured debts.

The Bankruptcy Code allows cram down of many secured debts in a Chapter 13 bankruptcy. One notable exception is a mortgage on the debtor’s primary residence found in Section 1322(b)(2). A Chapter 13 debtor may not reduce the amount of a primary or secondary home mortgage simply because it is underwater. The debtor may strip off a wholly unsecured junior lien (thereby making the debt unsecured), but if any part of the junior debt is secured, lien stripping is not allowed. Cram down is never allowed for a debtor’s home.

The exception in Section 1322(b)(2) only applies to the debtor’s primary residence, not to other property owned by the debtor. This distinction seems simple enough, but reasonable minds can disagree about the details, and often do in the world of bankruptcy. Take for example the case of In re Benafel, 461 B.R. 581 (9th Cir. BAP 2011). In Benafel, the debtor moved out of her home under threat of foreclosure. Benafel rented out her home in March of 2010 and filed Chapter 13 bankruptcy that same month. She proposed to cram down her rental property and the trustee objected.

The issue before the Ninth Circuit Bankruptcy Appellate Panel was when the court should determine the real property as a Chapter 13 debtor’s principal residence for purposes 11 U.S.C. §1322(b)(2)’s prohibition. The court said that the date for this determination should be the day the bankruptcy case is commenced – the day the debtor files for bankruptcy. On that day Ms. Benafel no longer lived in her home, so she was allowed to cram it down to value.

Moving out and filing bankruptcy can be tricky business. If this is done solely for the purpose to avoid the Section 1322(b)(2) prohibition, the bankruptcy court may find the debtor has acted in bad faith. Obviously, the risk of a court finding bad faith diminishes the more time between the date the home is rented and the date of the bankruptcy filing.

While lien stripping a home loan only applies to a junior mortgage, cram down of investment property applies to all mortgages. Suppose the debtor has a first mortgage of $100,000, a second mortgage of $100,000, and the real estate has a fair market value of $90,000. In a lien stripping situation, the second mortgage can be entirely stripped off as unsecured, and the first mortgage is fully secured to $100,000. In a cram down situation, the second mortgage is crammed down to zero and the first mortgage is crammed down to $90,000, the value of the real estate. In effect, the second mortgage is now unsecured, and the first mortgage is bifurcated into a $90,000 secured debt and a $10,000 unsecured debt.

The problem with cram down is that most courts require the crammed down mortgage must be paid in full through the Chapter 13 plan. This not only adds trustee fees to the cost of the mortgage, but also places the burden to increase the monthly payments to the creditor or refinance the loan before the close of the bankruptcy case. On the other hand, cram down can be useful if a junior mortgage is undersecured. The debtor may cram down the junior mortgage and pay it off over the bankruptcy term.

For instance, say the amount owed on a first mortgage is $100,000, a second mortgage is $100,000, and the debtor’s rental property has a fair market value of $120,000. The debtor could cram down the property to $120,000 value, continue paying the first mortgage at the contract rate, and pay the remaining $20,000 crammed down second mortgage over five years. The unsecured $80,000 on the second mortgage is paid at the same rate as other unsecured creditors and the remaining balance is discharged at the end of the case. 

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