Discharging Personal Liability in Chapter 7

April 13, 2006

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In a Chapter 7 filing, the debtor's personal liability for dischargeable debts is erased (not all debts are dischargeable). However, liens that are not subject to elimination (i.e., most consensual and statutory liens) survive the discharge. This fact explains why a homeowner must continue to pay the mortgages on his home, or face foreclosure, after a Chapter 7 action is completed, even though personal liability for the mortgages is eliminated.

This distinction also can be important when the debtor surrenders the property, and the amount of the liens exceeds the value of the property.

John Smith owns a home with a value of $100,000 that is subject to mortgage liens totaling $150,000.

Because these liens cannot be eliminated, or (generally) even bifurcated, if Smith intends to keep his home, he will have to pay the $150,000 in mortgages.

However, once his Chapter 7 discharge is final, Smith will have no personal liability for the mortgages. The liens will, nevertheless, still attach to the home. Thus, if Smith wants to retain the home, he will still have to pay the mortgages. If he has defaulted on the mortgages, and he wants to reinstate them by paying the arrearage over time, he may have to file in Chapter 13.

Alternatively, Smith can surrender the home. If he does so, he will not be liable for the $50,000 mortgage deficiency, as he has no personal liability for the mortgages after the discharge.

Some states provide a somewhat similar provision. For example, in California and some other states, a debtor has no personal liability for a deficiency judgment that results from a foreclosure of a purchase-money mortgage. Note that this state provision is very narrow in scope because:

It only applies in some states.
It only applies on purchase-money (first) mortgages. It usually does not apply to second mortgages, or refinancings, which are far more likely to cause a deficiency.
For the provision to apply, the debtor must lose his or her home in foreclosure.

Nevertheless, debtors who face the loss of their home through foreclosure of a first mortgage should be aware that, in some states, it may be possible to eliminate any deficiency judgment, without resorting to bankruptcy. Debtors in this situation should consult an attorney on the best way to proceed in the particular state in question.

Chapter 7, on the surface, seems harsh to debtors. However, in practice, many debtors retain all of their assets and shed all (or almost all) of their unsecured debt, including credit card debts.

This favorable outcome (along with a surge in credit card debt, second mortgages and refinancing of homes) explains why hundreds of thousands of families have filed Chapter 7 bankruptcy actions each year, for the past several years.

In addition, any bankruptcy filing causes an automatic stay of any collection efforts by creditors. This is welcome relief for beleaguered debtors. However, debtors should be aware that creditors, especially those with secured claims who are not being paid, can request that the automatic stay be lifted if foreclosure or repossession is an inevitability.