Bankruptcy: Before or After Foreclosure?

At times, we all face hard decisions and, most often, they get harder as we grow up. For many Americans, the economy has been a challenge, leaving many of us to make hard financial decisions. Luckily, there are people who can make such decisions easier. For anyone facing debt and foreclosure, take heart, we promise it isn’t as bad as it seems.

It’s Financially Responsible

Bankruptcy has gotten a bad rap over the years, but the truth is, it may very well be the best and most financially responsible thing a person can do. The reason for needing a reprieve from financial stress doesn’t matter; what matters is what happens going forward. When facing debt and foreclosure at the same time, there is a proper way to do things and certain steps which should be taken first.

Bankruptcy Should Always Come First

When deciding whether to file for bankruptcy before or after a foreclosure, always choose before. If nothing else, filing for bankruptcy before a foreclosure can help retain control over the home for a longer period of time, thus reducing the stress and anxiety of being displaced. In most cases, a few more months can help someone find a new home or make accommodations with friends or relatives.

Bankruptcy Prevents Future Debt

Besides prolonging the amount of time someone can live in a home, declaring bankruptcy before a home goes into foreclosure may prevent a mortgage lender from being granted deficiency judgment. In real estate and bankruptcy law, deficiencies are simply the difference between what a home sells for at a foreclosure sale and what the homeowners still owe their lender. Say for example, Angela owes her mortgage lender $300,000 but her home only sells for $200,000 at a foreclosure sale. This means there is a deficiency of $100,000. In most states, the lender can then sue Angela for the amount of that deficiency. By filing bankruptcy before her home goes into foreclosure, Angela can prevent her lender from coming after her for that $100,000.

Bankruptcy Blocks the IRS

As if fighting with a mortgage lender isn’t enough of a headache, foreclosure can get even more complicated thanks to good ol’ Uncle Sam. Let’s say someone is lucky enough to have their mortgage lender decide not to go after the mortgage deficiency. Seems great right? Oh wait, Uncle Sam has decided that the amount of the forgiven deficiency is income, and therefore taxable. So, if Angela’s bank were to forgive her the $100,000, Uncle Sam treats Angela as if she made $100,000 and requires her to pay taxes on it. (Clearly the government is not paying attention to the situation, but what else is new?).

When someone files for bankruptcy, the government is not allowed to charge taxes on forgiven deficiencies per the Mortgage Debt Relief Act of 2007. This Act states that the government cannot require taxes on debt that was forgiven while the indebted party was unable to pay. Another word used for “unable to pay” is “insolvent,” which the government defines as someone whose debts are greater than their assets. In almost all cases, the insolvency clause does not apply if bankruptcy is filed after the debt (in this case mortgage) is forgiven.

Bankruptcy Applies to Other Debt

In many cases, people take out second mortgages or incur other types of mortgage debt which are also affected by foreclosure and bankruptcy. In cases where a secondary mortgage lender loses money on a property, that lender can sue for its losses. It is only through bankruptcy that someone can prevent such lenders from filing suit.