Calculation of Lien Impairment

April 13, 2006

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When battling liens against you, only certain types of liens can be eliminated, and then only if the liens are attached to exempt assets.

The final step in lien elimination is to calculate whether the amount of a lien actually impairs an exemption. If all of the liens encumbering the property are of a type that cannot be eliminated (e.g., consensual purchase-money security liens), there is no need to proceed with the calculation: None of the liens can be eliminated. However, once a determination is made that elimination can be done, the exact amount of the lien that can be eliminated must be calculated.

Calculation of the amount that a lien impairs an exemption becomes especially important in a bankruptcy proceeding, because there is a greater opportunity in that situation to eliminate non-purchase-money, non-possessory liens.

Liens that are dischargeable can be eliminated to the extent that they "impair" an exempt asset. The bankruptcy code provides that a lien shall be considered to impair an exemption to the extent that the sum of all the liens on the property, plus the amount of the exemption, exceeds the value of the property. As a rule, this formula also will be followed in state courts.

Another simpler way of looking at the calculation is this: The total dollar amount of liens that cannot be eliminated is equal to the value of the property minus the exemption.

This version of the formula makes it clear that when a particular item of property is subject to an unlimited exemption (e.g., an unlimited homestead exemption in Florida), all of the liens on the property can be eliminated, provided, of course, the liens are of a type that can be eliminated if they impair an exemption (e.g., most judgment liens). Here, the value of the property will equal the exemption. Thus, the formula will always yield a result of zero for the amount of the liens that cannot be eliminated.

Unfortunately, when the property is subject to a cap on the amount exempt, the effect of the rule will be that, in many cases, what appears to be a lien that can be eliminated will not be deemed to impair the exemption. Thus, an "exempt" asset may be lost.

John Smith files for bankruptcy. He owns an item of property that qualifies as household goods in a state that allows him to use his state's exemption, which is $20,000. The value of the property is $40,000. A non-purchase-money, non-possessory lien on the property totals $10,000. This type of lien is eligible for elimination in a bankruptcy proceeding.

It may first appear that the exemption is impaired, as the lien of $10,000 invades the $20,000 exemption. However, this is not the case. The total of the lien of $10,000, plus the amount of the exemption $20,000, equals $30,000. This does not exceed the value of the property ($40,000). Thus, there is no impairment, and the liens cannot be eliminated.

Looking at it another way, the result is the same. The amount of the lien that cannot be eliminated is equal to the value of the property, $40,000, minus the exemption, $20,000, which amounts to $20,000, when the lien here is only $10,000. Thus, no part of the lien can be eliminated.

If Smith had liens that totaled $30,000, and the property still had a value of $40,000, then $10,000 of these liens would be deemed to impair his exemption, and, thus, could be eliminated. ($30,000 liens plus the $20,000 exemption equals $50,000. $50,000 less the $40,000 value of property equals $10,000. Or, the value of the property, $40,000, less the amount of the exemption, $20,000, equals liens that cannot be eliminated, $20,000. The balance of the liens above $20,000, which is $10,000, can be eliminated).

There can be variations among the states with respect to laws governing liens and calculation of the exemption impairment. States will typically follow the bankruptcy rules described above. However, this may not always be the case.

In the last example, where the liens totaled $30,000, it may be possible in some states to eliminate the entire amount of the liens, on the grounds that elimination of liens is an all or nothing proposition: i.e., if there is any impairment of the exemption (here, impairment is calculated at $10,000), then the total amount of the liens is eliminated.

John Smith personally owns an item of property that qualifies as a tool of the trade in a state that allows him to use his state's exemption, which is $20,000. The value of the property is $40,000. Purchase-money liens on the property total $30,000. This type of lien cannot be eliminated in, or out of, a bankruptcy proceeding.

Smith suffers a judgment in the amount of $10,000 from a lawsuit for negligence. The judgment creditor places a lien on Smith's tools of the trade. Judgment liens of this type can be eliminated. Further, the judgment lien impairs Smith's exemption under the formula, and can be discharged.

The total of the liens of $40,000, plus the amount of the exemption $20,000, equals $60,000. This amount exceeds the value of the property, $40,000. Thus, up to the amount of this difference, $20,000, can be eliminated. The judgment lien is for $10,000. Thus, it can be eliminated in its entirety.

Looking at the calculation another way, the result is the same. The liens that cannot be eliminated are equal to the value of the property, $40,000, minus the exemption, $20,000. Here, that amounts to $20,000. A consensual lien of $30,000 already consumes more than this amount. Thus, any liens beyond the consensual lien can be eliminated, provided they are subject to elimination, as in this case.

In any case involving lien impairment of an exempt asset, it is wise to consult with an attorney before concluding how much of a lien can be eliminated in the particular state in question.

Work Smart

The prior two examples demonstrate that, in some cases, encumbering an asset with a consensual lien may make a subsequent judgment lien dischargeable. This type of planning is discussed in our section on Effective Asset Exemption Planning

Timing the Calculation. Most states calculate lien impairment only when there is an attempt at a forced sale of the property (i.e., foreclosure of the lien). In some states, however, the calculation may be done at the time the property is attached. In this situation, the judgment debtor may be able to have the lien removed in advance of any foreclosure proceeding. This would allow the owner to sell the property free of the judgment lien.

For the most part, judgment liens will represent the most significant example of liens that can be eliminated when they impair an exemption. But the fact that a judgment lien is usually valid for 10 to 20 years can have planning implications.

A crafty judgment creditor could attach a debtor's home while the home was exempt, but wait to foreclose until the value of the home went up and the amount of the first mortgage went down, so that, according the formula used to calculate lien impairment, the judgment lien no longer impaired the exemption.

In that case, the best solution for the debtor may be a Chapter 7 bankruptcy proceeding. There, calculation is determined as of the date the proceeding is filed. This strategy eliminates the waiting game that some creditors may play.

Of course, in states such as Florida with an unlimited exemption for residences, this strategy would not be necessary, as the home will always remain immune from judicial liens, regardless of how long the judgment creditor waits.

Note, however, that the Chapter 7 filing also eliminates a related problem. If a judgment creditor places a lien on property (e.g., a home), the debtor will find it impossible to sell the property. Because liens run with the property, any buyer would take the property subject to the judgment lien. Thus, there would be no buyers. A bankruptcy proceeding terminates the judgment lien, which allows the owner to sell the property at a later date.

The following example illustrates different results due to specific state laws.

Nancy Wagner owns a residence worth $150,000 with a first mortgage of $100,000. Her home state exempts a residence in the amount of $125,000.

A judgment is rendered against Wagner in the amount of $80,000. At this time, the judgment creditor cannot foreclose on the property because the lien impairs the exemption, and could be eliminated: the value of the residence, $150,000, less the exemption, $125,000, equals the amount of liens that cannot be eliminated, $25,000. Already, the first mortgage exceeds this amount. Thus, the judicial lien can be eliminated in its entirety.

Now let's say that 10 years later the home is worth $250,000 and the first mortgage totals $30,000. The results are different: the value of the residence, $250,000, less the exemption, $125,000, equals the amount of liens that cannot be eliminated, $125,000. The first mortgage totals only $30,000. Thus, another $95,000 of liens cannot be eliminated ($125,000 less $30,000). This means that no part of the judicial lien can be eliminated, and Wagner will lose her home to foreclosure.

In this situation, Wagner should have considered filing a Chapter 7 bankruptcy proceeding 10 years earlier, when the entire judicial lien could have been eliminated.

Now let's say that Wagner is a Florida resident. Florida has an unlimited exemption for a residence.

Due to the unlimited exemption, the home will always be exempt. A waiting strategy by a judgment creditor would be ineffective. The value of the home, and the value of the exemption, will always be equal. As a result, the calculation will always result in the full value of the judicial lien being subject to elimination.

In this situation, Wagner would only need to consider a bankruptcy filing if she were interested in selling the home, and she were unable to have the lien removed before a forced sale of the property by the judgment creditor. However, luckily for her, Florida is one of the states that provide that creditors cannot attach an exempt asset. Judgment debtors do not have to wait until there is a forced sale to calculate lien impairment or have a lien removed. Thus, the lien can be removed immediately, making a bankruptcy action unnecessary.