Declaring Bankruptcy

The phrase “declaring bankruptcy” has been with us a long time, but what does it really mean? If you start a voluntary case, which is over 99% of all cases, you are simply telling your creditors you cannot repay your debts because you are in an insolvent state.

Sometimes the pure absurdity of comedy can help make the point. Here the boss in The Office series decides to file bankruptcy as in the video clip below:

Indeed, Michael cannot just yell “I’m declaring bankruptcy” out into the office pool or hallway. He has to find the proper forum.

That forum of course is the United States Bankruptcy Court. Only then, under the auspices of the federal government will the bankruptcy have binding authority on all creditors everywhere in the United States and even other countries.

Moreover, there are very specific forms and very specific rules and laws in the conduct of “declaring bankruptcy.” It is not that simple to “declare bankruptcy”, but with good guidance it can be done for the right reasons and appropriate circumstances. You have to decide whether to file under Chapter 13 or Chapter 7. Let LeverLaw help you if you live in the Los Angeles, Riverside, San Bernardino or Orange County in California.

Believe it or not, laughter is not uncommonly heard in my consultation conference room. We care deeply about the issues around debt and money, and it touches us down to our unconscious where our funny bone lies. Yes, tears are shed in that room too, but laughter is much more common, because not to laugh is more painful. It takes some courage to face the fact of insolvency (that you cannot repay your debt) and while it may be a serious step to file bankruptcy, it does no good whatsoever to leave your sense of humor at home while facing it. Perhaps it is only with a sense of humor that we can face the mistakes or misfortunes that brought us into this financial pickle.

I am linking to a comedian’s YouTube posting because he has done in a comedic “bit” what is a great list of dos and don’ts for bankruptcy. This routine by Timothy Clue recites things you wish you could do, but aren’t always advisable from a bankruptcy attorneys perspective.

One beautiful moment of the bit is when he has his moment of realizing he can never pay back this debt. The realization of “insolvency” has never been so well depicted. Where he goes from there is a comedic rather than legal perspective, so I’ll give the latter perspective after you’ve heard Tim’s comic perspective.

Once Tim realizes he’s insolvent he decides to “load up” (or as he calls it “living the Visa loco) and just go further into debt. If he were to file bankruptcy later in this scenario his creditor who proved he did it without intent to repay the debt can make in nondischargeable, which means the bankruptcy would have no effect on it and the debt would remain even after the bankruptcy remedy was attempted. The creditors have to sue you in the bankruptcy to get this exception to the discharge, but it is a real risk.

He brings up the fact that debt doesn’t just effect you, it impacts on your family as well, although he approaches it from the exact opposite perspective I would, which is what makes it funny.

If everyone could talk to debt collectors like Mr. Clue then my job would be a lot easier. It distresses my clients rather severely, but he has a lot of fun with it. I seriously doubt anyone can really have fun with it which is why we take the creditors calls so you don’t have to.

I can be a bankruptcy attorney and help people with money problems because while it is serious, it is not as bad as divorce or criminal work where people lose their family or liberty. It is just money. A sense of humor helps as long as you also get serious about solving your debt problem. We are Long Beach bankruptcy attorneys to help you get out of debt.

Sometimes bankruptcy can be used to get rid of older income taxes, but did you know it could be used to avoid future income taxes? It can if you get very good and timely advice on how to do that if the situation pertains to you.

To understand, you must first acquaint yourself with two concepts: “gross income” (”GI”) and “cancellation of debt” (”COD”). Gross income is the giant intake at the head of the tax hopper. It broadly includes everything that could possibly be taxable. Its inclusions and exclusions are codified in Internal Revenue Code Section 108. Among its inclusions are COD income.

This COD income is sometimes called “phantom income” because it may have never actually arrived in your bank account. However, according the IRS, you derived a benefit from it, ergo it is income.

One example to illustrate where the IRS has a definite point is where someone owns a company but does not take a salary. Instead the company gives them money as a loan. Later the company, owned by the same individual, forgives the loan, so the debt is canceled. Now that is obviously income disguised as a loan.

The same logic is applied to COD from mortgages as well. Let’s say you owned a commercial property that you rented out to a business. Now that business failed and moved out and you cannot find a tenant to move in and pay anywhere near the same rent, and the new market rent will not cover the mortgage payment. Additionally, you overpaid for the property during the boom and now it is worth far less than you paid for it (say $300,000 less), so you cannot sell it either. You stop paying the mortgage and let the bank foreclose. The following year, or maybe two or three years later the foreclosing bank issues you a 1099C for COD. Now the IRS has notice that you received $300,000 of debt forgiveness. You are in a marginal 1/3 tax bracket so that income has you owing the IRS $100,000.

IRC 108 has an exception inclusion of two things in GI; insolvency and bankruptcy. Your CPA can either prove you were insolvent when the COD occurred, which is subject to interpretation, or you could have filed bankruptcy and had the debt discharged before the COD occurred. The fact of bankruptcy is indisputable, whereas your insolvency is an argument your CPA makes and may wind up in tax court.

For now and the next few years homeowners do not have to worry about this COD tax problem if the house is worth less than $2 million because there is a temporary federal law that excepts personal residences from this type of tax obligation. Hitting homeowners for taxes after they have lost their home in foreclosure would be politically unpalatable, and literally millions of Americans are in this category now. The $2 million dollar ceiling helps prevent even well heeled homeowners who are losing their home, which can occur here in Long Beach, or elsewhere in Los Angeles and Orange Counties.

It is important to get the right advice when you’re in a defensive posture in your finances. These are complicated webs that we find ourselves in and getting the right advice can make the difference between solving problems or creating more problems.

Nationally, almost a quarter of all homes with mortgages are “underwater” now. I’m talking figuratively, of course, as this is California, not New Orleans. Any home which is worth less than the mortgages against it is “underwater” in financial terms. However, most of these “distressed mortgages,” as they are sometimes called, are centered in the states of California, Nevada and Florida, meaning the rate is probably higher than a quarter of all mortgaged residences in these states.

Home Sinking: Are you worried about foreclosure?

If your home is worth less than the first mortgage debt against it, and you have a substantial second mortgage, then stripping off second mortgages in Chapter 13 bankruptcy is possible. It does not give you equity in your residence right away, but may make you less underwater. This will be explored in a future blog article. This article is about how to decide whether to walk away from the home you purchased if it is underwater. This is among the toughest decisions my clients need to make, and I explore it here. How do you know whether and when to walk away?

People become very emotional about their house, often calling it their “home” interchangeably with the word “house.” This attachment is often particularized to the specifics of the building and location they currently reside in. The more the term “home” is identified with a particular piece of real estate the more the emotional identification. It often seems almost like the real estate is a family member, much like film directors will sometimes make the city they are filming in a quasi-character of the film.

Sentimentalizing the place where one lives one’s life is not a weakness. It is natural. Just as many other animals are territorial, usually for very adaptive reasons, so the “home” is a very defined human space.

I have had many homes, and I’ve sentimentalized all of them. I currently own my own home, the same one for over ten years, and except for having too much upkeep it suits me and my family quite well. I can, and do, however, have the imagination to think that other places can be my home. It is likely I will have at least one more home that is not this place.

From a financial standpoint, a house is not just a financial asset, it is a use asset as well. You need someplace to live regardless of the dollars and cents involved. In financial planning the personal residence is put on the Use Asset side of the ledger, quite apart from interests in businesses and other investments. So a personal residence has a dual quality to it. You have to look at both sides of this quality when making a dispositive decision about it. Therefore, analyzing whether to walk away from a house that is underwater has more than just dollars and cents factors to determine.

My clients and I often have very meaningful discussions in making this decision. We analyze both the use and financial factors in the particular piece of real property in question.

Among the Use Asset factors discussed are:

1.) Have you renovated the house to your particular tastes? If you have completed a remodel that feathers your nest precisely the way you like it, then it has value to you that is separate and apart from the dollar values. On the other hand, if you attempted a remodel but ran out of money and now the house is pretty much a mess, or the general contractor used up all your money without finishing, that tips the balance to the other side.
2.) Do you have school age children who need to be in a particular school that you need to reside in your current neighborhood for them to attend? If so, and a more affordable rental in your neighborhood is not available, then this can be a reason to stay put, at least until the children graduate. Alternatively, if your children are in failing schools this can be an opportunity to locate the family where schools are better.

Among the Financial Factors to discuss are:

1.) How much stress does the mortgage payment cause? I have some clients who have mortgage payments that when I learn of them I almost choke, both in absolute dollar terms, and as a percentage of their income. Traditionally, the general rule is that you want your mortgage payment to be no more than 25% of your gross income. Under the Obama administration’s mortgage-relief plan it is to be no more than 31%. I have clients who are spending over 50% of their income on the mortgage. This is not sustainable. However, if one is in sustainable ratios of income to mortgage, then staying in the home is preferred. Or if you’re income is just temporarily reduced, or you believe it will increase in the future it may be the right decision to hold onto the property.
2.) How underwater are you? Being slightly underwater is probably OK because if you were to buy another house in the future you’d have to put about 10% down. That equity you put into the new house is locked in for 8% of it because to sell a house, as a rule of thumb, it costs about 8% of the sales price. So you’d have almost no equity in that house until inflation and your debt pay down makes it sellable. So if you’re 10% underwater you can hold onto the house figuring it will keep you from having to save another down payment.
3.) What kind of mortgage do you have? There are some really toxic mortgages out there that may be affordable in today’s low interest rate environment, but when rates raise will likely make the house unaffordable. A fixed rate mortgage is much easier to predict and plan around. Many of my clients have Option ARM mortgages and have been only able to afford the first option, which is a temporarily reduced payment that causes the mortgage balance to increase each month.

Often I see consultations and clients where a role reversal has occurred. Instead of them owning the house, the house owns them. They’ve emptied out their retirement to make the payments, borrowed heavily from family and friends. When I see an obsessive relationship with an underwater and unaffordable home I usually counsel walking away, although the receptiveness to that counsel varies greatly.

However, what I advise ranges the gamut of possibilities based upon the unique circumstances of the client and the real property involved.

I have seen very few successful mortgage modifications and my colleagues and the press I have read seem to point to this as the trend. Principal reductions are very rare. More often there is an interest rate reduction and the arrearages capitalized onto the mortgage balance. That is another blog posting. However, at the end of that process, if you’re still underwater, an objective analysis as to whether it is worth it will be the same, and probably one of the most consequential financial decisions of your life.

The Cash for Keys program (or “CFK”) is something that can help you out if you have to leave your foreclosed residence.

When a foreclosure occurs the title changes from you to your lender, or whoever purchased the property at the foreclosure. Now they own the property, but they have no right to possession. You have the right to possession until they evict you through a process called “unlawful detainer.” Evicting you is costly and risky. It costs money to hire the attorney and pay the filing fee for the eviction. It is risky because the former owner could remove fixtures and damage the house or condo in the move out.

Therefore, a large percentage of new owners will come to an agreement with the former owner to vacate the property for a set sum, one that saves the new owner costs and helps the former owner afford the move. The way it works is you come to an agreement in writing, then there is a home inspection so the current condition of the house or condo is understood, and then if the house is left in that condition and “broom clean” the former owner is compensated a fair sum, often equivalent to the cost of the move or a first month’s rent upon move out.

At LeverLaw for our clients in this situation we often help negotiate that CFK without any further cost to the client if they have retained us for a bankruptcy case. We offer this service because we care about you and your family transitioning smoothly to the next phase of your fresh start. We also keep you apprised of how the process works and its timing throughout the many months that it unfolds. We can do this regardless of whether you live near our office in Long Beach, or if you are in Los Angeles, Orange County or Riverside County.

We were at the cusp of a new era in finance when the old system nearly collapsed last year.    Then the government bailed out the old system and it could go on its merry way having been rescued by us taxpayers.  There is still no meaningful reform and the bankers are paying themselves just as exorbitantly as ever, although they are not lending to us with the money we gave them from our taxes (or more likely our childrens’ and grandchildrens’ taxes).

Nothing about these recent  major financial events however seems to impact my clients’ feeling of guilt, remorse and shame when they need a bailout. They don’t see the connect between themselves and GM and the banks and how its all part of the same financial system.  I’m not saying there is a domino effect necessarily, I’m just saying the same imbalances can occur regardless of scale and the type of financial entity.  Our system encourages leveraging your finances and few are the individuals and companies that can resist the temptation, or keep the leveraging within sustainable boundaries.  Those enabling the leveraging (the finance companies and counter parties to leveraged transactions on the secondary markets for debt) are only recently looking at what those boundaries should be. 

The pendulum has swung from promiscuous lending to eschewing any risk at all.  Risk, however, is why lenders are paid interest.  The happy medium of prudent risk taking by lenders is still a way off. Banks don’t have bankruptcy.  They get put in receivership or get bailed out by the government if they are “too big to fail.”  We people do get bankruptcy when we we’re financially stuck.   Most of my clients became over-leveraged when lending was indiscriminate.  However, they were not necessarily being irresponsible themselves, as they often assumed  the lender had done their due diligence on their ability to repay it.

So this is a time of de-leveraging and could you find a better place than LeverLaw to de-leverage?  Ok, bad pun that puts a serious point at risk.  Everyone is de-leveraging now.  What goes up must come down applies to finance too.  If bankruptcy is part of a fiscally prudent plan,  just like it was for GM, there should be no shame in it for your household or small business.

This is from a recent New York Times article, that I am excerpting in part as it details the incredible scope of our foreclosure epidemic:

“The economy and the stock market may be recovering from their swoon, but more homeowners than ever are having trouble making their monthly mortgage payments, according to figures released Thursday.
Nearly one in 10 homeowners with mortgages was at least one payment behind in the third quarter, the Mortgage Bankers Association said in its survey. That translates into about five million households.

The delinquency figure, and a corresponding rise in the number of those losing their homes to foreclosure, was expected to be bad. Nevertheless, the figures underlined the level of stress on a large segment of the country, a situation that could snuff out the modest recovery in home prices over the last few months and impede any economic rebound.
Unless foreclosure modification efforts begin succeeding on a permanent basis – which many analysts say they think is unlikely – millions more foreclosed homes will come to market.

“I’ve been pretty bearish on this big ugly pig stuck in the python and this cements my view that home prices are going back down,” said the housing consultant Ivy Zelman.
The overall third-quarter delinquency rate is the highest since the association began keeping records in 1972. It is up from about one in 14 mortgage holders in the third quarter of 2008.
The combined percentage of those in foreclosure as well as delinquent homeowners is 14.41 percent, or about one in seven mortgage holders. Mortgages with problems are concentrated in four states: California, Florida, Arizona and Nevada. One in four people with mortgages in Florida is behind in payments.”

In my practice I am seeing foreclosures and attempted loan modifications on a scale that is unbelievable.  I don’t attempt loan modifications as part of my practice because I do not believe that an attorney is a necessary component to that process and brings excessive cost to the mix.  Some of my clients have accomplished it on their own, and what they achieve is what the mortgage companies will agree to, and my position as an attorney would not improve that.  I have real power working within the court system, and even outside the court system where the real risk of court action compels compromise.  However, here the mortgage companies hold all the cards and it is only enlightened self interest that makes loan modifications possible, and usually on their terms.  I have yet to see a single case of a loan having its principal reduced. Usually it is just a temporary interest rate deduction and putting the arrears of the loan back into the principal amount to deem the loan current.

It is unfortunate that Congress did not make principal reduction on undersecured loans possible when it considered it last year and this year.   I strip off completely unsecured mortgages that in second or third position regularly.    However, at least some portion of the remaining mortgage is unsecured, meaning the homeowner is still to some degree “underwater.”

The foreclosure epidemic is not just a problem for those undergoing foreclosure or even just mortgage delinquency.  It is a problem for anyone who owns a home because our property values are under downward pressure.  However, as in all economic situations there are winners as well.   That would be home buyers who can take advantage of lower prices and low interest rates at the same time.  For those who have cash for a down payment, a job to fund the loan, and time to shop carefully, this is a great time to get into owning their residence, or even to buy rental property.  As usual, those who invest in downturns are the ultimate winners.

Practicing law is like carrying on a constantly evolving conversation.   In my area of the law, it is a conversation centered around one problem: Insolvency.  My conversations are multifaceted and multi-level.  I most directly am rewarded for the conversation I have with my clients as they pay the bills of LeverLaw.  However, I am also engaged in a conversation with all the prospects I meet daily, who may or may not need to file bankruptcy.

I am also engaged daily in a conversation with my fellow practitioners through the CDCBAA list serve.  I have a special inbox in my Outlook email program that discussed whatever problems practitioners here in the Central District of California are having in their cases, as well as practice updates through our liason with the courts.  Dozens of emails are exchanged daily, and I often participate in the subjects, or as we call them “threads.”   Of course, I don’t have time to participate in every thread, but ones that especially interest me, or I start, I follow avidly. Other threads I just follow.

One recent thread has a very arcane and practical impact on a particular transaction for one of my clients.  I learned that credit unions will use their cross-collateralization clauses to withhold the pink slip on cars where clients owed more than one debt besides the car loan, even when the client reaffirms the car loan with the credit union.  So I negotiated a waiver of the cross-collateralization clause and a release of the car lien in advance with the credit union  I know those last 2 sentences are a little jargon filled, but even if you don’t understand it, it will give you a feel for some of the technicalities of bankruptcy law and what our conversations are about.

In this respect LeverLaw is a platform for these conversations.  If you become a client of LeverLaw, you have decided to join the conversation, at least as it pertains to your particular case.  I will have the conversation with the judges and the trustees and the other officials of the system on your behalf so you do not have to do so.

This blog is also part of the conversation, and fits well into the network of conversations that is the LeverLaw platform.   Our economy has always been about relationships and conversations, but they have historically been relatively simple, even crude, compared to what the internet now makes possible.  Using the internet to develop, intensify and bring erudition to the conversation is a positive step.  Bankruptcy is a topic that is blanketed by ignorance and fear, and efforts to bring light on the topic to rid it of these distortions is a worthwhile effort.  I hope you’ll follow this blog as much as I hope to make it worth your reading.