The recent economic crisis - often dubbed the "Great Recession" - definitely hasn't discriminated between the victims it has claimed. It has significantly impacted the poor and well-off alike. This turbulent economic period has even made honest debtors - debtors who just a few short years ago would have never imagined missing any debt payments - contemplate a remedy never before considered, namely bankruptcy. Ultimately, filing for bankruptcy under Chapter 7 or 13 is an option for anyone facing extreme financial difficulty - whether their yearly salary is $20,000 or $1 million - and can often help those who are considered "wealthy" just as much as anyone else.
Those debtors who have large yearly incomes should not let their pride get in the way of their financial future. Bankruptcy is based upon your ability to pay your debts and not by how much your paycheck is. It is important to view bankruptcy solely as a financial decision and not be embarrassed when you seek the protection bankruptcy can provide.
Underwater Mortgage: Short Sale or Bankruptcy
Recently, Illinois' wealthy have seen the advantages of bankruptcy, often filed in response to their underwater mortgages - which is when the mortgage on a home is greater than what the home is actually worth.
Unfortunately, many wealthy debtors with underwater mortgages fail to see the benefits of filing for bankruptcy until it is too late. In some instances, homeowners with negative equity in their homes, sometimes in the millions of dollars, simply choose to walk away from the home or agree to a short sale with the bank. Unfortunately for these debtors, Illinois is a recourse state, which means that the bank can come after a debtor for the difference between the amount of the outstanding mortgage and what they sold the home for, often referred to as a deficiency judgment.
The situation would have been very different for the debtor, had he or she originally considered bankruptcy. For example, if the debtor had filed for bankruptcy in the first place it would have halted all collection proceedings against the debtor, including foreclosure. This would give the debtor time to determine his or her best options, which might include a loan modification, loan repayment plan, liquidation or otherwise - all without the possibility of a deficiency judgment.
In addition, if the debtor had specifically employed Chapter 13 bankruptcy, not only would all proceedings be halted, but the debtor would have a chance to save the family home by catching up on mortgage payments through a payment plan approved by the court. These payment plans usually last three to five years.
Moreover, under Chapter 13 bankruptcy a debtor with an underwater mortgage would have the option to discharge a second mortgage or home equity loan. The second mortgage holder is no longer considered a secured creditor, because the property is not valuable enough to serve as the security interest and the second mortgage is therefore unsecured. These second mortgages can be stripped, and the bank will only receive their pro rata share of the amount paid to all unsecured creditors.
Short Sale or Bankruptcy: Tax Implications
One of the other benefits of bankruptcy versus a bank approved short sale is the tax implications of both. Generally when debt is forgiven, which happens often when a short sale occurs, that amount can be considered taxable income.
Conversely, debt discharged through bankruptcy is not taxable in the same way, but the timing of what happened when can be very complicated and even the slightest different detail can alter what is taxable or not. It should be noted that the federal government passed the Mortgage Forgiveness Debt Relief Act in 2007 which states that mortgage debt forgiven will not be taxed by the IRS, but this Act currently expires in 2012.
For example, say a couple named Blake and Crystal purchased a home in Oak Brook in 2006 for $1.2 million and took out a mortgage in the amount of $800,000 at that time. Further imagine the same couple took out a home equity loan in 2008 for home renovations in the amount of $100,000.
Today, Blake and Crystal have paid down their mortgage to a current outstanding balance of $750,000, but due to the housing crash their home is now only worth $500,000, leaving them dramatically underwater. If Blake and Crystal were to agree to a short sale with their bank for $500,000, the bank could still pursue Blake and Crystal for a deficiency judgment of $250,000 - the difference between the sale price and the outstanding mortgage balance. Even if the bank chose not to pursue this deficiency judgment, Blake and Crystal may have tax implications on the $250,000 mortgage debt which has been forgiven. Moreover, Blake and Crystal can also still be pursued by the bank who gave them the home equity loan of $100,000.
If Blake and Crystal had considered bankruptcy, the outcome may have been completely different. For instance, even if they chose liquidation under Chapter 7, they still may lose their home, but the original mortgage holder would not be able to seek a deficiency judgment against them and the debt discharged would not be considered taxable. Also, if they elected to use Chapter 13, Blake and Crystal may not only be able to save their home, but the home equity loan for $100,000 may be "stripped" because it is now unsecured.
As this article illustrates, bankruptcy law can be extremely complex. This article barely scratches the surface of bankruptcy law as it pertains to underwater mortgages - and as such this article should not be considered legal advice - however, this article does demonstrate the need to contact an experienced Illinois bankruptcy if your home is underwater and you need help determining what the best option is for your situation.