Laying the groundwork for a split of circuits and Supreme Court review, bankruptcy courts are tending to differ with the First and Third Circuits by precluding chapter 13 debtors from modifying mortgages even if the property has a use other than as the debtor’s principal residence.
Interpreting Section 1322(b)(2), the First and Third Circuits adopted a bright-line approach and allowed a debtor to modify a mortgage on a principal residence if the property generates rent from a portion of the property that is not the debtor’s principal residence. Other courts take precisely the opposite approach with a bright-line rule that disallows modification if any portion of the property is the debtor’s principal residence.
Still other courts reject strict rules by looking at the totality of the circumstances to divine the predominant character of the transaction.
Bankruptcy Judge Alan S. Trust of Central Islip, N.Y., dealt with typical facts: The debtor owned a two-family home and rented the second unit. She proposed a chapter 13 plan to strip down the secured portion of a mortgage to the value of the property.
In his March 9 opinion, Judge Trust rejected the bright-line approach of the First and Third Circuits by holding the opposite: If a single structure includes the debtor’s principal residence but generates income from other uses, the lien cannot be modified under Section 1322(b)(2).
Analyzing the issues entails a daisy chain of statutory definitions. The starting point is Section 1322(b)(2), which allows modifying a secured claim “other than a claim secured only by a security interest in real property that is the debtor’s principal residence.”
“Principal residence” is defined in Section 101(13A)(A) as “a residential structure if used as the principal residence by the debtor, including incidental property.” Next, “incidental property” is defined in Section 101(27B) as “rents” and “property commonly conveyed with a principal residence in the area where the real property is located.”
Judge Trust pointed out flaws in all three theories. The circuit courts’ approach would permit modifying a mortgage if only a small portion of the property had another use. The opposite bright-line approach would bar modification if only a small portion of the property contained a principal residence.
With regard to the “totality of the circumstances” approach, Judge Trust said it would “introduce uncertainty and unpredictability to residential mortgage transactions.”
Judge Trust decided to follow the bright-line method that disallows modification so long as the property contains the debtor’s principal residence. He felt compelled to “strictly adhere to the meaning” given to the “debtor’s principal residence,” which means a residential structure “including incidental property.” In turn, “incidental property” includes “rents.”
Judge Trust therefore concluded that Congress defined “principal residence” to include rents, thus barring modification.
Showing resistance to the Third Circuit’s rule, a bankruptcy judge in New Jersey distinguished the appeals court’s decision when the rental property was unoccupied at the time of bankruptcy.
In an opinion like Judge Trust’s that surveys the various approaches, a bankruptcy judge in Buffalo, N.Y., barred modification if any part of the property was a principal residence.
To read ABI’s discussion of those cases, click here and here.