Bankruptcy can save your house from foreclosure

NEW YORK (CNNMoney.com) -- Slick TV commercials and online ads tell delinquent borrowers that they can save their homes by filing for personal bankruptcy. But is it true -- or just too good to be true?

True!

Bankruptcy can bring foreclosure proceedings to a halt, end harassment from debt collectors, and give borrowers time to make up missed payments and reorganize their finances. In some cases, bankruptcy can also help mortgage borrowers save their homes permanently.

It's not, however, going to help every troubled homeowner. If, for example, the homeowner's biggest problem is not enough money, bankruptcy is not going to solve that.

"It's the best tool there is for people behind in payments but who have ongoing income," according to Binghamton, N.Y., attorney Peter Orville, "those who had been making payments and who could be making payments again."

The first thing a bankruptcy filing accomplishes is to stop the foreclosure process. Lenders can't foreclose or even try to collect debt until permitted to do so by the court.

But first, you have to decide what type of bankruptcy to file for. There are, basically, two types to choose from: Chapter 7 and Chapter 13.

A Chapter 7 bankruptcy delays foreclosure. but eventually it usually results in the liquidation of most assets, according to attorney Stephen Elias, author of "The Foreclosure Survival Guide." Borrowers almost always lose their homes in a Chapter 7.

Some bankruptcy attorneys, like New York-based David Pankin, prefer Chapter 7 because it gets rid of all unsecured debt, leaving only secured debt, such as mortgages, exempt. In this scenario, borrowers still owe their mortgage payments but they can likely afford to make them because all the other debts have been discharged.

But for most experts, Chapter 13 is usually more effective at helping people keep their homes. It gives them time to repair their finances, usually three to five years, during which the court agrees to an income-based budget with monthly payments made to trustees.

The trustees pay the bills, first paying off the secured debt. After that, the trustee pays off unsecured debt, starting with back income taxes.

Next in line comes unsecured debt like credit cards and medical bills. By then, there's usually little cash left and these bills are paid at less than the full rate, often as little as five cents on the dollar.

Borrowers, if they kept up on their payments, can emerge from bankruptcy with their homes still in their possessions.

One thing courts cannot do is "cram down" loan balances on primary residences. That is, reduce mortgage debt to what the home is worth. Neither can they lower interest rates, in most cases, nor lengthen the term of the loans.

They can, however, "strip off" second mortgages, like home equity loans or lines of credit, when home values fall below the first mortgage balances, according to Elias.

"This allows the judge to get rid of the second mortgage," he said. "If there's not enough equity to secure the second, it becomes unsecured debt."

That can be a huge advantage for borrowers. Homeowners may have, for example, a $200,000 first mortgage balance and another $50,000 on a home equity loan. If the home value has dropped to less than $200,000, the judge could rule that all $50,000 of the second is unsecured. Then, it can be paid off at the same pennies-on-the dollar as other unsecured debt.

But there are other downsides. Bankruptcy can lop as much as 240 points off credit scores. And bankruptcies can remain on credit reports for 10 years, said Pamela Simmons, a California real estate attorney, while all other black marks disappear after seven years or less.

There is also a potential tax advantage to filing for bankruptcy rather than going to foreclosure, according to Simmons. When a home is repossessed and the lender forgives the portion of the mortgage balance above its market value, a tax liability can be triggered. Any difference between what people borrow and what they repay is considered income.

Congress is temporarily allowing that unpaid debt to be forgiven -- but only for money specifically spent on the home purchase or on home improvement.

Millions of people, however, refinanced mortgages or took out home equity loans and used the money to fund vacations, pay college tuition, buy cars or boats or simply to live the good life. That money is taxable.

Simmons had a recent client who was allowing his lender to foreclose on him and called her about the timing, asking whether he had to vacate by the day of the auction.

In passing, she asked him how much he owed on the house. He said he bought it for a million but had taken out another $2 million, most of which had not been spent on the house. When she told him he would owe taxes on it both to Uncle Sam and the State of California, he was dismayed

She rushed him into her office and they did the paperwork so he could file for bankruptcy.

"If they discharge that deficiency in bankruptcy, you don't owe tax on it," said Simmons.