When a Second Lien Holder Writes Off a Discharged Debt

Seal of the United States Internal Revenue Ser...

Seal of the United States Internal Revenue Service. The design is the same as the Treasury seal with an IRS inscription. (Photo credit: Wikipedia)

What happens to a second lien when the second lien holder writes off a discharged debt from filing a Chapter 7 bankruptcy?

Second Lien Holder Involves IRS

When a second lien holder writes off a discharged debt from a Chapter 7 bankruptcy, the lien holder is technically telling the Internal Revenue Service (IRS) it has given up on collecting the debt. Basically, the lien holder is saying they want full tax credit for the loan and are washing their hands from their responsibility to collect the debt. The IRS gives the lien holder full tax credit for surrendering their interest in the loan. Unfortunately for the borrower, the secured interest does not end there.

When a mortgage company gives up on a loan and “writes it off,” many times they sell the secured interest to third party, usually a collection firm, at pennies on the dollar. Technically, the selling lien holder must report the income as an offset for the tax credit given for the write off. Unless a borrower takes legal action to remove a secured lien from the asset, the security remains alive and possibly enforceable by whomever owns the secured note.

When a secured note is written off by a lien holder, the holder can send a 1099 to the borrower for the deficiency due because the IRS looks upon the forgiven debt as income to the borrower. The borrower then owes taxes to the IRS unless the deficiency is discharged in bankruptcy.

Second Lien Must be Legally Stripped to be Avoided

In bankruptcy, only unsecured debts can be discharged. Secured loans have the legal weight of tying a lien to the asset. In other words, a lien holder can legally go after the asset if a default occurs, and unless the borrower has the lien legally stripped, the lien remains in effect even after bankruptcy discharge.

Stripping a lien from a secured loan is a complicated legal matter most often settled through bankruptcy courts. In bankruptcy, you can only strip a junior lien, and you can only do that when the value of the asset is less than the value of the primary loan.

Stripping a junior lien takes place most of the time during a Chapter 13 bankruptcy filing. The junior debt is paid during the plan like any other unsecured debt, but the remainder of the debt can be stripped of its lien after the bankruptcy plan is completed. Filing a Chapter 7 bankruptcy and wanting to strip a lien on a junior secured note is a different matter.

In re McNeal, case No. 11-11352 (unpublished) (11th Cir 2012), the 11th Circuit Court of Appeals in Florida found that a borrower on a home loan could avoid or “strip down” a second lean on a mortgage loan that was wholly unsecured after filing a Chapter 7 bankruptcy.

The key word in this context is “wholly.” That means the original owner of the junior lien wholly has no interest left in the note. The note has been written off so that the junior lien holder has received all they can reasonably expect to receive on the debt from the borrower.

It is interesting to note that only in the 11th District of Florida where the McNeal case took place does any bankruptcy court in the nation consider stripping a junior lien after filing a Chapter 7 bankruptcy. Other bankruptcy districts around the nation are now looking at McNeal as a precedent, but it will require an experienced bankruptcy lawyer and a court contest to make the case for a lien strip when a lien holder writes off a discharged debt in a Chapter 7 bankruptcy.

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