Is a Home Mortgage Consumer Debt in Bankruptcy? [In re Kelly]

What is Consumer Debt? – Consumer Debt Definition under the Bankruptcy Code

Consumer debt is defined in the United State Bankruptcy Code as “debt incurred by an individual primarily for a personal, family, or household purpose.” 11 U.S.C. § 101(8). An experienced bankruptcy attorney can help clarify this definition in addition to the guidance provided in this post.

Consumer Debt Loads May Lead to Bankruptcy Dismissal

On July 10, 1984, Congress added subsection (b) to section 707 of the United States Bankruptcy Code allowing “dismissal where a debtor with “primarily consumer debts” files a Chapter 7 petition despite an ability to repay their debts. See Pub. L. No. 98‑353, 98 Stat. 333, 355. As a result, “[t]he issue whether a home mortgage may constitute consumer debt has been litigated extensively in the context of 11 U.S.C. § 707(b).” In re Rathbun, 275 B.R. 434, 437 (Bankr. D.R.I. 2001).

Mortgage Debt under Zolg v. Kelly (In re Kelly), 841 F.2d 908, 913 (9th Cir. 1988)

“The leading case interpreting the term ‘consumer debt’ comes from the Ninth Circuit” in Zolg v. Kelly (In re Kelly), 841 F.2d 908, 913 (9th Cir. 1988) (referred to herein as “Kelly”). In re Dickerson, 193 B.R. 67, 70 (Bankr. M.D. Fla. 1996).  Citing Kelly, in a case argued by our firm’s own Scott Talkov, the Ninth Circuit held that “in most cases ‘the purchase of a home and the making of improvements thereon’ will meet the statutory definition of consumer debt.” In re Cherrett, 873 F.3d 1060, 1066 (9th Cir. 2017).

As such, Chapter 7 cases may be prime for dismissal where a debtor’s primary debts are made up of his home mortgage. Conversely, debtors are basically immune from the creditor’s bankruptcy attorney or the US Trustee filing a motion or adversary requesting dismissal based on failure to pass the means test so long as they can argue that their debts are primarily non-consumer.

What is “Primarily” Consumer Debt?

The “primarily” portion of the test in Section 707(b) usually means the dollar amount of consumer debt vs. non-consumer debt. However, some courts have looked at the quantity of consumer debts v. non-consumer debts such that a debtor with only one consumer debt and a dozen non-consumer (e.g., business) debts may be deemed to be non-consumer.

What is a Consumer Debt in the Context of Home Mortgages?

Kelly is a seminal case on which that principle that home mortgages are almost always considered to be consumer debt in Chapter 7 bankruptcy.  The case has an enticing history which is laid out here.

On December 16, 1984, five months after 11 U.S.C. § 707(b) was enacted, the Kelly’s filed a Chapter 7 petition, which the bankruptcy court dismissed on its own accord under § 707(b) upon finding that the Kellys had primarily consumer debts and that they were “clearly capable of funding a chapter 13 plan without undue hardship . . . .” In re Kelly, 57 B.R. 536, 537 (Bankr. D. Ariz. 1986).

The BAP reversed, finding that the Kellys did not have primarily consumer debts because most of their debts were mortgages secured by their residence. Kelly v. Solot (In re Kelly), 70 B.R. 109, 111‑12 (B.A.P. 9th Cir. 1986).

On appeal to the Ninth Circuit, Judge Kozinski reversed the BAP and affirmed the dismissal of the case. Zolg v. Kelly (In re Kelly), 841 F.2d 908, 913 (9th Cir. 1988). Kelly addressed the “question [of] whether some or all of the Kellys’ debts constitute ‘consumer debts’ within the meaning of the Code. As an initial matter, the Kellys argue that debts secured by real property are never consumer debts, relying on” the legislative history, which contains a remark that “a consumer debt does not include a debt to any extent the debt is secured by real property.”After analyzing this disputed issue, Kelly found that “[t]he statutory scheme so clearly contemplates that consumer debt includes debt secured by real property that there is no room left for any other conclusion.”

Indeed, Kelly found that “it is the interpretation urged by the Kellys that would frustrate congressional intent. Since many debtors do have large mortgage debts, a blanket rule excluding such debt from the category of consumer debt would completely insulate a very substantial number of debtors from section 707(b) dismissal.” Kelly at 913 n.4. This contrasted with the BAP, which reasoned that “unless [the] secured debt is disregarded, all such debtors [with mortgage debt] could be denied relief because their indebtedness would be primarily consumer debt.” Kelly v. Solot (In re Kelly), 70 B.R. 109, 112 (B.A.P. 9th Cir. 1986).

Upon finding that the security for the debt was entirely irrelevant, Kelly classified the debtors’ debts as consumer or non-consumer as follows:

While secured debt is not automatically excluded from consumer debt, it is not automatically included either. We must look to the purpose of the debt in determining whether it falls within the statutory definition. Of the Kellys’ mortgage debts, $95,000 consists of a lien they assumed in purchasing their home and $32,000 represents a home equity line of credit incurred for home improvements and the repayment of credit card debts. All these fit comfortably within the Code’s definition of consumer debt.  It is difficult to conceive of any expenditure that serves a “family . . . or household purpose” more directly than does the purchase of a home and the making of improvements thereon.

Kelly’s test contrasted with the BAP, which suggested a subjective test in finding that “[t]he word ‘purpose’ means goal, aim, or intention.” 70 B.R. at 112.

As for attorney’s fees incurred as the non-prevailing party in state court litigation to recover money allegedly overpaid in purchasing the Kellys’ home, Kelly found that “[a] debt for attorney’s fees incurred in attempting to further this [consumer] purpose, like any other debt so incurred, qualifies as a consumer debt.”

Kelly at 913. This contrasted with the BAP’s finding that “[t]he fact that the litigation involved the family home may or may not be relevant as to the status of the judgment debts as consumer debts.” 70 B.R. at 112.

As for a separate home equity line of credit “securing a loan from [a bank] to [Mr. Kelly’s] professional [law] corporation,” Kelly found that “[d]ebt incurred for business ventures or other profit‑seeking activities is plainly not consumer debt for purposes of section 707(b).” Id. (citation omitted).

Kelly’s conclusion that the use of the funds dictates the purpose has been followed by court throughout the country, all of which impute a consumer purpose to buy a house.

What is a Consumer Debt? – Courts in Every Circuit Universally Agree With Kelly’s Use of the Funds Test

While Debtors have argued for ambiguities in § 101(8), “[a] mere disagreement among litigants over the meaning of a statute does not prove ambiguity; it usually means that one of the litigants is simply wrong.” Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. Lasalle St. P’ship, 526 U.S. 434, 461 (1999).

As exemplified by the cases below in the context of § 707(b), courts in every circuit have found no ambiguity in § 101(8) when the funds were used to purchase a debtor’s personal residence. Instead, these courts have declared that “there is no question” that such debt is “clearly,” “undeniably,” and “obviously personal,” thereby requiring that a court “must” find consumer debt since “it is well settled” that such debt fits “squarely” within the “plain language” of § 101(8).

In the First Circuit, a bankruptcy court cited Kelly to find that a “first mortgage obligation [incurred to purchase] a family home . . . is a consumer debt under the plain language of [§ 101(8)] for § 707(b) purposes.” In re Keniston, 85 B.R. 202, 229 (Bankr. D.N.H. 1988).

In the Second Circuit, a bankruptcy court discussed Kelly and other cases, ruling that since “the loan was incurred by Debtors . . . to purchase a home for the purpose of residing in it, the Court finds that the debt falls within the definition of a ‘consumer debt.’” In re Lemma, 393 B.R. 299, 301‑03 (Bankr. E.D.N.Y. 2008).

In the Third Circuit, a bankruptcy court “wholly agree[d] with . . .  Kelly,” finding consumer debt where “[v]irtually all of the proceeds from the . . . debts were used to purchase and improve” the “Debtor’s personal residence,” further explaining that such debt is “not for a business purpose.” In re Naut, No. 07‑20280, 59 Collier Bankr. Cas. 2d 305 (Bankr. E.D. Pa. Jan. 22, 2008).

In the Fourth Circuit, a bankruptcy court cited Kelly to find that debt incurred to “financ[e] the debtors[’] personal residence” is “obviously personal.” Guaranty Sav. & Loan Asso. v. Lowe, 109 B.R. 698, 699 (W.D. Va. 1990).

The Fifth Circuit, just months after Kelly, found that a debt “used to pay off the mortgage” incurred to purchase the debtors’ residence was consumer debt. In re Booth, 858 F.2d 1051, 1055 (5th Cir. 1988).

The Sixth Circuit found that a debtor’s “debts are undeniably consumer” where the majority of the debts were incurred in financing the “purchase of a new home” for the debtor. In re Krohn, 886 F.2d 123, 125 (6th Cir. 1989).

In the Seventh Circuit, a bankruptcy court cited Kelly as “authority for the proposition that expenses for purchasing or improving a home are consumer debts.” In re Pedigo, 296 B.R. 485, 491 (Bankr. S.D. Ind. 2003).

The Eighth Circuit Bankruptcy Appellate Panel cited Kelly in finding that, “if the debtor’s purpose in incurring the debt is to purchase a home or make improvements to it, the debt is clearly for family or household purposes and fits squarely within the definition of a consumer debt under § 101(8).” Cox v. Fokkena (In re Cox), 315 B.R. 850, 855 (B.A.P. 8th Cir. 2004).

This Circuit cited Kelly in 2004 to analyze consumer debt as follows:

[The debtor’s] personal residence was secured by two mortgages. The first . . . secured debt incurred to purchase the home; the second . . . secured debt incurred to finance house‑hold improvements. Thus, there is no question that the secured debt at issue was incurred ‘primarily for a personal, family or household purpose’ and must be considered ‘consumer debt’ for the purposes of § 707(b).

Price v. United States Trustee (In re Price), 353 F.3d 1135, 1139 (9th Cir. 2004); see Neary v. Padilla (In re Padilla), 222 F.3d 1184, 1193 (9th Cir. 2000) (citing Kelly as “holding that a mortgage used to purchase a home” is “consumer debt”); Fadel v. DCB United LLC (In re Fadel), 492 B.R. 1, 15 (B.A.P. 9th Cir. 2013) (citing Kelly to find that “debt incurred to purchase the debtor’s principal residence or to improve it, is a ‘consumer debt’”); In re Freibel, No. A11‑00650‑DMD, 67 Collier Bankr. Cas. 2d 952 (Bankr. D. Alaska May 15, 2012) (citing Kelly to find that “[i]t is well settled that a residential mortgage is a consumer debt”).

In the Tenth Circuit, a bankruptcy court reviewed debt incurred for the “purchase of debtors’ . . .  home,” finding that the “home mortgage debt is a consumer debt.” In re Higginbotham, 111 B.R. 955, 960 (Bankr. N.D. Okla. 1990).

In the Eleventh Circuit, a bankruptcy court cited Kelly in finding that “[d]ebts incurred for the purpose of acquiring, improving, and repairing the residence of a debtor and his family are debts incurred for personal, family, and household purposes.” In re Gentri, 185 B.R. 368, 372 (Bankr. M.D. Fla. 1995).

These examples reflect that what appears to be every court in the First, Second, Third, Fourth, Fifth, Sixth, Seventh, Eighth, Ninth, Tenth and Eleventh circuits has found that a debtor has a consumer purpose to incur debt to purchase their personal residence.

There are no cases to the contrary because “all courts agree that the use of the proceeds of the mortgage loan is the ultimate test.” Carlson, Means Testing: The Failed Bankruptcy Revolution of 2005, 15 Am. Bankr. Inst. L. Rev. 223, 235 (Spring 2007); see In re Booth, 858 F.2d 1051, 1055 (5th Cir. 1988) (the lower “court correctly looked to the use to which the money was put”).

How to Avoid the Means Test in Chapter 7? In re Cherrett, 873 F.3d 1060, 1066 (9th Cir. 2017)

In what appears to be the only outlier in American bankruptcy jurisprudence, the Ninth Circuit in In re Cherrett, 873 F.3d 1060, 1066 (9th Cir. 2017) in a 2-1 decision affirmed a bankruptcy court finding that a mortgage debt was non-consumer based on various facts in the case. Effectively, this case chips away at the previously universal conclusion that every mortgage incurred to purchase a debtor’s house is consumer debt. While the opinion sets forth that it is based on unique facts in that case, the general principle is that some debtors may be able to argue that their home mortgage is not consumer debt. If they prevail, they are usually deemed non-consumer debtors not required to pass the means test since the mortgage is usually larger than other debts owed by most debtors in bankruptcy.

Contact an Experienced Bankruptcy Attorney in Los Angeles, Orange County, San Francisco, Riverside, San Diego, San Jose, Sacramento, Fresno, and Surrounding Areas in California

Home mortgages are beneficial to debtors in bankruptcy for many reasons, but those home mortgages often lead to the conclusion that debtors are primarily consumer debt. Avoiding this conclusion allows the debtor to avoid dismissal of a Chapter 7 Bankruptcy based on high income that would normally require Chapter 13. This means that a debtor can take advantage California’s homestead exemption newly increased in 2021 available to debtors in bankruptcy.

Given the complexities, it is easy to see why contacting a bankruptcy attorney in California would be beneficial to any party to any pending or contemplated bankruptcy. For a free consultation with the attorneys at Talkov Law, please feel free to contact us.


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