Circuit Split Widening on Application of the Anti-Modification Clause to Mixed-Use Properties

Recently, the United States Bankruptcy Court for the Eastern District of New York joined a growing list of courts that have disagreed with the First and Third Circuits and interpreted §1322(b)(2)[1] to prohibit a debtor from modifying a second lien secured by the debtor’s personal residence that is also an income-producing rental property. In In re Addams,[2] the court discussed the three interpretations of the law that have developed and the difficulties with each before ultimately siding with other New York bankruptcy courts and adopting a bright line statutory construction approach. The decision, however, is in direct opposition to the test used in the First and Third Circuits and adds further uncertainty to the effect of the anti-modification clause on mixed use properties.

Facts

In Addams, the Debtor could not qualify for a conventional mortgage to pay the $850,000 purchase price for her home. The Debtor believed she could make the mortgage payments by renting out a portion of the house, so she borrowed $265,000 from her friends, the Shapiros, and granted them a second position lien and an assignment of rents. After the Debtor defaulted on her loan with the Shapiros, they commenced a foreclosure action and the Debtor filed chapter 13 bankruptcy petition. The Debtor’s plan proposed to bifurcate the second lien and to refinance the secured portion with a loan from a third party. The Shapiros filed a motion to dismiss and objected to their plan treatment as violating §1322(b)(2).

The Debtor argued that she could modify the rights of the Shapiros because the loan was secured by a lien on the income-producing property and by an assignment of rents generated by any tenants in the second family portion of the home and, therefore, the loan was not secured only by the Debtor’s principal residence. The Shapiros argued that the loan was secured only by the property in which Debtor principally resided and, therefore, §1322(b)(2) did not permit her to modify the mortgage.

Discussion

The court noted that “three distinct and opposing approaches” have developed in interpreting the meaning of §1322(b)(2).[3] The first bright line approach holds that the anti-modification clause applies “so long as the debtor principally resides at the subject real property, even if the real property has other purposes.”[4] Courts that have used this bright line test have focused on the placement of the word “only” in the statute and determined that it modifies “secured” and nothing else.[5] Assignments of rents are merely additional aspects of the security interest in the land and are not distinct collateral under the UCC so courts using this test have held that a security interest in rents is not sufficient to allow modification under §1322(b)(2). However, this approach has been criticized as placing too much emphasis on whether the debtor lives on the property and not whether the predominant purpose of the property might be serving as something other than the debtor’s residence.

The second bright line test, adopted by the First and Third Circuits, focuses on the word “is” in the phrase “real property that is the debtor’s principal residence.”[6] The Third Circuit reasoned that because Congress equated the terms “real property” and “principal residence” in §1322(b)(2), the anti-modification clause does not protect a claim secured by real property that includes both the debtor’s principal residence and other rental property that is not the debtor’s principal residence.[7] Courts that have followed this approach have looked to the time of the transaction to determine whether the real property was used solely as the debtor’s residence.[8]  This test has also been criticized because it could permit security interests to be modified where a debtor simply rents out a garage apartment or converts a basement into a rentable apartment.[9]

The third test avoids any bright line and instead evaluates the totality of the circumstances in each case. Under this approach, courts focus on the intent of the parties in each transaction to determine whether home-ownership was the predominant intention or whether investment income or operation of a business was the main purpose of the transaction. If the parties viewed the transaction as predominantly a commercial loan, modification should be allowed. This case-by-case approach has been criticized as introducing uncertainty to residential mortgage transactions.

Addams Court Ruling

The Addams court relied on the Bankruptcy Code definition of “principal residence” as a “residential structure if used as the principal residence by the debtor, including incidental property”[10] and the definition of “incidental property” as including “property commonly conveyed with a principal residence in the area where the real property is located…[and] rents, royalties, mineral rights, oil or gas rights or profits, water rights, escrow funds, or insurance proceeds.”[11] The court noted that “Congress defined the debtor’s principal residence to include rents derived from the real property, and, as such, a security interest in rents is part of the security interest in the principal residence.”[12] As a result, the fact that Debtor had a right to rent out a portion of the property and that the Shapiros had a security interest in the rents did not change the conclusion that the claim was secured only by a security interest in real property that was the Debtor’s principal residence.

Conclusion

The Addams decision provides a detailed evaluation of the various tests used by courts in deciding the extent of the anti-modification clause to mixed-use properties. However, the various interpretations and approaches discussed in In re Addams are each subject to criticism and despite the court’s pronouncement that the statute is not ambiguous, the decision has contributed to a widening circuit split that has introduced confusion and uncertainty to residential mortgage lenders and borrowers.