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Considering the Amount of a Debtor's Mortgages in Relation to the Homestead Exemption

In states that provide a homestead exemption for debtors who have filed or are contemplating filing for bankruptcy, a debtor’s personal residence will be shielded to some extent from the reach of creditors seeking payment, to allow the debtor to keep her home. In the few states that offer an unlimited homestead exemption, creditors will not be able to seek payment from a debtor’s personal residence, regardless of the value of the home (provided the residence falls within certain limitations on the size of acreage). Other states provide homestead exemptions with a specific dollar limit, and some states provide no homestead exemption at all.

Despite the protections a homestead exemption can afford, there are certain factors that might interfere with or limit the scope of protection, such as the amount of a debtor’s mortgage(s) on her home.

The Effect of Heavily Mortgaged Property on the Exemption

Mortgages are a type of “consensual lien” which generally cannot be eliminated, even upon filing for bankruptcy. This means that a debtor filing for bankruptcy in a state that provides a homestead exemption will not likely be able to eliminate a home mortgage, even if the home is subject to the homestead exemption. In fact, a debtor will only be able to keep her home pursuant to the homestead exemption if she continues to make the required monthly payments on her mortgage, under either a Chapter 7 or a Chapter 13 filing.

Consequently, the homestead exemption can be worthless to a debtor whose home is heavily mortgaged, because a debtor cannot eliminate the mortgages attached to a personal residence.

Exploiting the Exemption

Taking a state’s particular homestead exemption (or lack thereof) into consideration, a debtor who has filed for bankruptcy might make different decisions with regard to a home mortgage, depending on the amount of the state’s exemption and the value of the equity in the home (market value less amount of mortgage):

  • Where a state’s exemption is unlimited or greater than the debtor’s equity, a debtor might benefit by paying off mortgages on the property.
  • Where equity is greater than the exemption, the debtor might benefit by taking out additional mortgages on the home.
  • Where there is no exemption or a low exemption, married debtors might consider owning the home with their spouses in tenancy by the entirety (if the debtor resides in a state which allows this), as many states block or limit the creditors of a debtor spouse from reaching property owned together with a non-debtor spouse. Careful consideration should be given to the decision to hold property in tenancy by the entirety as this decision may have serious consequences in the event of a divorce.

The Fraudulent Transfer of Property Prior to Filing

In states that provide no exemption or only a very low exemption, a debtor might be tempted to transfer title of her home prior to filing, in order to protect the home from creditors. However, to prevent such fraudulent transfers, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) in 2005. The BAPCPA set domiciliary limits on state exemptions. Under the BAPCPA, the debtor is required to choose the state exemption of the state in which he has resided during the 730 days prior to filing the petition. If the debtor has not resided in a single state during that 730 days, he must choose the state in which he resided the longest during the 180 days prior to that 730 day period or the state. If neither rule above provides the debtor with a state exemption, he must use the federal exemption of $18,425.

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