Chapter 13 Residential Mortgages: Anti-Modification Round 2

In re Addams, 564 B.R. 458 (Bankr. E.D. N.Y. 2017)

A lender holding a mortgage on a two unit structure occupied in part and rented in part by a chapter 13 debtor moved to dismiss the case. The lender argued that the debtor was unable to propose a confirmable plan because the debtor could not bifurcate the lender’s undersecured claim into a secured claim and unsecured claim.

As discussed in prior blog posts (for example First Residential Mortgages: Do Not Take Anti-Modification Protection for Granted), under section 506 of the Bankruptcy Code generally a secured claim that exceeds the value of its collateral can be bifurcated into a secured claim equal to the value of the collateral and an unsecured claim equal to the deficiency. However, in a chapter 13 case section 1322 prohibits the debtor from modifying the rights of a secured creditor holding “a claim secured only by a security interest in real property that is the debtor’s principal residence.” The Supreme Court has held that this anti–modification provision protects a covered secured claim from being bifurcated and crammed down under section 506.

In this case the debtor owned a duplex subject to a first mortgage and a second mortgage. It was clear that the first mortgage was fully secured. However, the court determined that the second mortgage was undersecured, and thus potentially subject to bifurcation.

The debtor bought the house because she was going through a divorce and wanted to remain in her children’s school district. She believed she would be able to manage mortgage payments if she lived in one unit and rented out the second unit. She did not qualify for conventional financing sufficient to buy the property, so friends made the second mortgage loan – which was secured by a mortgage on both units together with an assignment of rents and profits.

The debtor believed that she could propose a confirmable plan funded by the ongoing rents if she was able to bifurcate the second mortgage loan. This would mean that the secured portion could be paid over time and the unsecured portion would receive the same partial distribution as other unsecured claims. The mortgagee objected that bifurcation was prohibited by the anti-modification provision.

The debtor effectively conceded that she would not be able to confirm a plan without bifurcation. So when the debtor brought a motion to value the property and the second mortgagee brought a motion to dismiss the case, the court decided to first address the anti-modification question.

The central issue was whether a loan secured by a multiunit property that included both the debtor’s principal residence and income producing property qualified as a claim “secured only” by the debtor’s principal residence. The court noted that application of the anti-modification provision to a mixed-use property has been the subject of substantial litigation. It identified three approaches:

  1. Bright line – as long as includes principal residence: Under this approach, if the debtor principally resides at the property, the anti-modification provision applies even if the property is used for other purposes. (As a related point, a majority of courts treat an assignment of rents as part of the real estate security as opposed to additional disqualifying security.)
  2. Bright line – principal residence only: The anti-modification provision applies only if the property is used solely for the debtor’s principal residence.
  3. Case-by-case – parties’ intentions: Courts adopting this view consider the totality of the circumstances, with the case turning on the intention of the parties. Was a transaction predominantly to provide the borrower a residence or was it predominantly a commercial transaction?

Each approach raises concerns. Under the first approach there is a risk of “the tail wagging the dog.” For example, if a debtor maintains a small apartment in a large factory, many would conclude that this property should not come within the scope of the anti-modification provision. On the other hand, the second approach would allow the status of the loan to be unilaterally modified by the debtor after the loan has already been made – for example if the debtor converts a basement into a rentable apartment. The third approach has the disadvantage that it introduces uncertainty and unpredictability.

The court decided to go with the first approach. This was based on its view that this approach reflected the unambiguous meaning of the language. In particular, the court relied on the definitions of “debtor’s principal residence” and “incidental property” added to the Bankruptcy Code by Congress in 1995. Under the definitions: Principal residence means a residential structure used by the debtor as a principal residence “including incidental property;” and incidental property includes rents and other profits. Thus Congress defined debtor’s principal residence to include rents, which suggests that (1) the debtor has the ability to rent out a portion of its residence without exposing a loan secured by the residence to bifurcation, and (2) taking an interest in the rents does not cause the lender to be secured by something other than the principal residence.

The court further concluded that the transaction should be evaluated as of the closing of the loan, and took into consideration the parties’ perception of how the property would be used. In this case it concluded that the parties had agreed that the property would be used as the debtor’s principal residence, and renting out a portion so that she would have rental income just provided further security for the note.

Accordingly, the court concluded the debtor could not bifurcate the second mortgage loan and would not be able to propose a confirmable plan. Thus, the court dismissed the case.

While one may appreciate the logic in the court’s opinion, it is hard to say that there is no ambiguity in the statute. And if uncertainty and unpredictability is a concern, it seems that introducing the parties’ subjective views on use of the property at the time of a closing that took place a few years ago can trigger that very concern.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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