Most homeowners contemplating bankruptcy have their home equity protected by their homestead exemption. If not, consider Chapter 13.
The Homestead Exemption
Throughout the U.S. people filing bankruptcy have the equity in their homes protected by homestead exemptions.
A property exemption in general is the extent to which the law protects something you own, or protects the equity in something you own, from your creditors. Equity is the value of something beyond what you owe on it. If you own a home worth $200,000 and you owe $180,000 on a mortgage, and have no other debts which are liens on your home’s title, then you have equity of $20,000 in the home. As long as the homestead exemption applicable to you is $20,000 or more, you can file bankruptcy and your creditors will have no right to your home or your equity in that home.
Different Homestead Exemptions
Each state has a set of property exemptions, including a homestead exemption. There is also a set of federal exemptions. Whether you can use the federal exemptions or instead are required to use your state’s exemptions depends on the laws of your state.
That’s true even though bankruptcy is a federal procedure governed by federal laws. Because of a Congressional compromise each state can choose to either require its residents to use its own set of exemptions or else be allowed to use either the state exemptions or the federal ones.
The majority of states—currently 31 of them—require you to use their exemptions. The remaining 19 plus the District of Columbia allow you to choose between the state and federal exemptions, including the homestead exemption. Those 19 states in alphabetical order are Alaska, Arkansas, Connecticut, Hawaii, Kentucky, Massachusetts, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Texas, Vermont, Washington, and Wisconsin.
The amount of equity that different state laws protect can vary widely. They can also change significantly. For example, in Alabama—one of the states which require bankruptcy filers to use its state exemptions—up until June of this year the homestead exemption had been only $5,000 ($10,000 for a married couple) and had not changed for more than 30 years. It was tripled to $15,000 ($30,000 for a married couple), with future increases tied to inflation. In contrast, right next door in Florida—which also requires bankruptcy filers to use its exemptions—the homestead exemption dollar amount is unlimited. It’s only restricted by acreage—to a half-acre in urban areas and 160 acres otherwise.
The federal homestead exemption is currently $22,975.
So to use the example above of the $200,000 with $20,000 in equity, that equity would be protected in Florida or in any state where the federal exemptions can be used, but would not be fully protected in Alabama.
What Happens in Chapter 7 If There’s Too Much Equity
Simply put, if you owned a home with more equity than you were allowed and you filed a Chapter 7 “straight bankruptcy” case, the Chapter 7 trustee could take that home, sell it to pay creditors, and give you the homestead exemption amount (and possibly any left over after paying the creditors in full).
There may be ways to avoid this from happening For example, if there was really less net equity in the property than the exempt amount because what it would cost for the trustee to sell it, the trustee may not be able to take the property. Or you may be able to pay the trustee to avoid the home being sold. But under Chapter 7 a home with more equity than the homestead exemption allows is at significant risk.
What Happens in Chapter 13 If There’s Too Much Equity
Under a Chapter 13 “adjustment of debts” case if you own a home with more equity than the homestead exemption law allows you can protect it by paying to the creditors over the course of a three to five year payment plan at least as much as they would have received under a Chapter 7 case if the home were taken and sold by the trustee. That may require you to pay more to the creditors than you would have had to otherwise. But sometimes it just requires you to pay as much as you can afford to during the time period required. And sometimes it only requires you to pay creditors you would have had to pay anyway, such as income taxes and child or spousal support payments. Overall, Chapter 13 protects otherwise unprotected equity in your home usually better than Chapter 7 can.