Yesterday, in How Bankruptcy Affects Home Ownership – Part 1, I discussed how to calculate the amount of equity in your home. If you own a home this is a crucial first step in the pre-bankruptcy planning process. Today, I'll look at how the homestead exemption can help protect the equity you have. Note that I'm assuming you have some equity to protect; if you don't have any equity, Chapter 7 bankruptcy won't affect your home, as long as you remain current on your mortgage payments. Each state has its own exemption scheme. In order to use a particular state's set of exemptions you have to have been domiciled in that state for at least two years. (If you are domiciled in a state it means you consider that state to be your permanent home.) If you have less than two years living in your present state think back to where you lived two and a half years ago. You'll have to use the exemptions of the state where you lived for the majority of this six-month period between two and a half and two years ago. States have different approaches to the homestead exemption, the exemption which protects equity in your home. Some base their exemption on lot size, some on equity, and some on a combination of the two elements. California's homestead exemption is based on equity alone. The states which have a homestead exemption based on equity alone protect equity up to a certain dollar amount. California residents can choose between two exemption systems. System 1 allows you to exempt up to $75,000 in home equity if you're single, $100,000 if you're married, and $150,000 if you're over 65. System 2 caps the homestead exemption dollar amount at $20,725, but grants larger exemptions for personal property. Thus, if you have a lot of equity in your home you're going to want to use System 1. If you have a smaller amount of home equity and a lot of personal property then System 2 is for you. Let's take a look at why all this is so important. If you file for Chapter 7 bankruptcy and you have unprotected home equity (that is, your equity exceeds the homestead exemption dollar amount), the trustee who oversees your case can sell your home and use the proceeds to pay off your creditors. The ways this works is the trustee will sell your home and pay your secured creditors (mortgage and lien holders) what they are owed, then give you your exemption amount (for example, $20,725 under System 2), and then distribute the remaining amount to your unsecured creditors. Keep in mind, however, that you're often able to increase the amount of non-exempt property you can keep by giving the trustee cash or other exempt property in exchange. For example, say you have $10,000 of unprotected equity in your home after applying your state's homestead exemption. Normally, the trustee will sell your home in this case to distribute this $10,000 to your unsecured creditors. However, if you can come up with $10,000 your trustee will likely accept this cash payment in order to avoid the expense and hassle of selling your house.
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