Thursday, March 17, 2011

Judgment Liens – Does bankruptcy wipe them out?

Suppose you’ve been sued for unpaid medical bills. The court enters judgment against you for $5,000. You own your house but because you’ve lost your job, as more and more bills pile up you throw up your hands and file for bankruptcy relief. The bankruptcy court orders an automatic stay, meaning the judgment creditor, your mortgage holder, and any other lien creditor can’t sue you to take away your property – at least, not until your bankruptcy case is over.

So you breathe a sigh of relief because, now, you’re protected and the $5,000 debt will be history, right? Well, not quite.

Most people think a bankruptcy discharge wipes the debtor's slate clean. While a bankruptcy discharge DOES cancel the debtor’s personal obligation to pay it, the discharge doesn’t terminate the judgment lien which attached to the house when the judgment was entered – unless the lien is removed by the bankruptcy court.

Until the bankruptcy court actually removes the lien (and it’s been my experience that in most cases it doesn’t), the lien sticks to the house like flypaper, regardless of the debtor not being personally responsible for paying it. As a result, the holder of the judgment can foreclose its lien against the house as soon as the bankruptcy case is closed and the automatic stay lifted.

When that happens, the creditor is free to enforce its lien through a court-enforced sale of the property. While on the one hand, the debtor has no obligation to pay, if the debtor doesn’t, the property will be auctioned off, the creditor being paid from the proceeds. It’s a case of the creditor forcing the debtor to cough up the money…or else.

The lesson? Debtors should ask their bankruptcy attorneys (during the bankruptcy, not afterwards) to petition the bankruptcy court to have the liens released. Whether they can be depends on several factors, but high loan-to-value personal residences are likely to qualify.

What about property acquired AFTER bankruptcy? In Indiana, debts which become judgment liens BEFORE bankruptcy do not attach to property acquired AFTER bankruptcy. Why? The rationale is the old debt ceased to exist before it could attach to the new property. Title underwriters refer to this doctrine as the “fresh start” rule.

- Morrie Erickson