Courts Hopelessly Split on Modifying Mortgages on Mixed-Use Residential Properties

Until the Supreme Court speaks, courts at all levels will remain hopelessly split on the ability of debtors in chapters 11 and 13 to modify mortgages securing properties that are the debtors’ principal residences but also generate commercial income.

Bankruptcy Judge Beth A. Buchanan of Cincinnati collected authorities on all sides of the two major questions: (1) May a debtor modify a mortgage on mixed-used property; and (2) what is the date for determining the property’s use?

The questions are identical in chapters 11 and 13 under Sections 1123(b)(5) and 1322(b)(2). The statutes provide that a “plan may . . . modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence . . . .”

The debtors in Judge Buchanan’s case had operated a daycare business in their home for 21 years. The property included a separate building that the debtors had been renting for three years at $600 a month. The mortgage lender had objected to their chapter 13 plan, which would have modified the mortgage. Judge Buchanan sustained the objection in her September 25 opinion, ruling that the debtors could not modify the mortgage, even though the property had longstanding commercial use.

Judge Buchanan first addressed the question of whether a debtor may modify a mortgage on a mixed-use property. She said that the First and Third Circuits and a majority of courts have adopted a bright-line rule allowing modification of a mortgage if residential property also has commercial use. However, the courts reached their conclusions by employing different logic: The First Circuit followed the plain language of the statute, while the Third Circuit analyzed legislative history.

On the other side of the fence, the Ninth Circuit Bankruptcy Appellate Panel and what Judge Buchanan called an “emerging” minority of courts also have a bright-line rule, but they reach the opposite conclusion and preclude mortgage modification on a mixed-use principal residence.

A third set of district and bankruptcy courts take a third approach by analyzing the “totality of the circumstances” to determine the predominant character of the transaction.

Next, Judge Buchanan laid out authorities fixing the date for pegging the property’s use. Again, there are three approaches.

A majority of courts, including the Ninth Circuit Bankruptcy Appellate Panel, use the petition date, not the date the mortgage was made. The Third Circuit and other courts use the date the lender took the security interest. A third group of courts examine both the circumstances on the filing date and the underlying agreement.

With respect to the mixed use of the property in this case, Judge Buchanan adopted the filing-date measurement and the bright-line approach precluding modification if the property is the debtor’s principal residence.

On the mixed-use question, Judge Buchanan found the statute ambiguous and weighed legislative history giving favorable treatment to home-mortgage lenders. With regard to the measurement date, she saw no ambiguity in the statute’s command to use the filing date.

Although there is no “perfect solution,” Judge Buchanan said that the rules she employed would result in “greater predictability in the mixed-use property context and [are] less susceptible to manipulation by a debtor.” The combination, she said, “best comports with the language and objective underlying Section 1322(b)(2)’s anti-modification provision.”