Bankruptcy Not Abusive Where Homestead Mortgage Proceeds Used For Investments

I filed Chapter 7 bankruptcy for a relatively wealthy husband and wife. The debtors passed the means test primarily because they had large mortgages on their residence and a few investment properties. Secured mortgage payments provide income offsets in means test calculations. The debtors lived in a nice house, drove nice cars, and the family enjoyed an annual income over $100,000. As expected, the U.S. Trustee filed a notice of a "b(3)" challenge which means that the U.S. Trustee may consider the Chapter 7 bankruptcy to be an abuse. Bankruptcy courts will dismiss a Chapter 7 bankruptcy as an abuse where the debtor is using bankruptcy to sustain a "lavish" lifestyle at the expense of unsecured creditors. Simply stated, your bankruptcy could be in trouble when your house and your car are nicer than the judge’s and trustee’s houses and cars. In this instance, my clients got lucky.

My clients’ had two mortgages on their principal residence including a small first mortgage and a large second mortgage. The U.S. Trustee took my clients’ deposition. During the deposition he asked the clients why they incurred the large second mortgage. The clients testified that they used the proceeds of the large second mortgage to make down payments on their investment properties during the real estate bubble.

The U.S. Trustee concluded from the deposition testimony that the debtors’ debts were primarily non-consumer debts because the large second mortgage on the residence, as well as the mortgages on the debtor’s investment properties, were used for investment purposes. The general rule is that mortgages on your primary residence are consumer debts, not business debts. When a debtor uses a homestead’s second mortgage proceeds for business as opposed to consumer purposes, such as down payment on investment properties, the second mortgage is deemed to be for investment rather than consumer purposes.

A debtor whose debts (secured and unsecured) are primarily non-consumer debts is exempt from the means test in determining eligibility to file Chapter 7 bankruptcy. The U.S. Trustee explained that the non-consumer debt test also applies to the so-called "b(3)" abuse issue. Even when the U.S. Trustee believes a Chapter 7 debtor is living an extravagant lifestyle after filing Chapter 7 bankruptcy the Trustee cannot challenge the filing as an abuse when the debtor’s debts are primarily non-consumer debts.

posted by Jonathan Alper, bankruptcy and asset protection lawyer, Orlando, Florida