Co-Author: Karen J. Radakovich, Esq.
Bankruptcies affect real estate brokers. For example, listing brokers are typically hurt when their short payoff sellers file bankruptcy. It is now common for a buyer’s agent to discover that a builder/seller has filed bankruptcy. Real Estate brokers need to have a basic understanding of some features of bankruptcy law to direct their clients and, perhaps more importantly, to make decisions for themselves about how to avoid wasting their time and other resources.
This article intends to help real estate brokers understand what they need to know about bankruptcy law. This is not intended to be an overview of bankruptcy law. The article merely focuses on what real estate brokers need to know about bankruptcy law. The article discusses common resolutions of common scenarios, but the reader should be mindful that there are exceptions to almost every general rule discussed below.
Bankruptcy law provides an honest debtor a fresh start. In a liquidation bankruptcy, (filed under Chapter 7 of the Bankruptcy Code) the debtor receives a fresh start in exchange for turning over all of the debtor’s “non exempt” assets to the bankruptcy trustee for liquidation. In reorganization, the law provides the debtor his fresh start in exchange for the debtor paying his creditors, over time, an amount that is more than the creditors would have received in liquidation. Reorganizations are filed under Chapter 13, Chapter 12 or Chapter 11 of the Bankruptcy Code. (It is generally not important for real estate brokers to have an understanding of the differences between the reorganizations.)
The initial effect of filing bankruptcy is that the borrower’s assets become property of the bankruptcy estate. When a borrower files bankruptcy, the law creates an “automatic stay” that initially freezes creditors from doing anything to pursue the borrower or the borrower’s assets outside of the bankruptcy process.
Listing Broker’s Perspective
Generally, the filing of the bankruptcy is bad for a broker listing property that is worth less than its mortgage debt. The bankruptcy filing by a seller who has equity in the listed property is generally a neutral event for the listing broker, having some advantages and some disadvantages, explained below.
Upside down Sellers:
During the economic climate in which this article is written (2009), most homeowners who file bankruptcy are “upside down.” That is, the market value of the owner’s home is less than the mortgage debt against it. The broker listing the home for the owner is typically attempting to assemble a “short sale” transaction in which the seller’s mortgage lenders agree to accept less than they are owed in exchange for releasing their mortgages to facilitate a sale at the market value. (For more detailed discussion of short sale transactions, please see: Short Pay-Offs and Redemptions.)
When a homeowner, who is still living in the house, files bankruptcy, it generally hurts the likelihood that the short pay-off transaction will close. Since short sale sellers rarely receive proceeds from the sale, their main financial incentives for closing on a short pay are to reduce their lender’s post sale loss and therefore their own post sale liabilities; and to absorb less of a credit blemish than if the lenders foreclosed. The bankruptcy diminishes these incentives by eliminating the lenders’ ability to pursue their loses all together. The negative credit consequences of the bankruptcy tend to overwhelm the credit-preserving benefits of a short sale over a foreclosure. Psychologically, once the debtor has thrown in the towel by filing bankruptcy, the debtor is less motivated to avoid the stigma of a foreclosure.
Some bankrupt sellers are actually hurt by closing on a short sale. Because the filing of the bankruptcy puts the listed home into the bankruptcy estate, the owner no longer has the ability to easily close on the short sale. An owner who is motivated to close on the short sale typically needs to pay his bankruptcy attorney an extra fee to obtain permission from the court to close on the short sale. An owner who is still living in the home typically needs to move out earlier with a short sale than he would otherwise need to if he just let the foreclosure and bankruptcy run naturally. Since bankruptcy can minimize some of the bad consequences of a foreclosure for a borrower, and give the owner a longer period of time to remain in his home without making rent or mortgage payments (although not homeowners association dues, which continue to follow the owner after bankruptcy), bankruptcy attorneys generally discourage their clients from following through with the bother and expense of closing on a post bankruptcy short pay-off transaction. Real estate brokers should not discourage sellers from following the advice of the sellers’ bankruptcy attorneys.
A post bankruptcy short sale seller who has already moved out of the home is not rewarded by delaying the foreclosure. While such a seller is often not financially rewarded for closing on the short sale, he may feel better having avoided the foreclosure. The psychological benefit of closing on a short sale sometimes motivates a seller to follow through with the bother and expense of obtaining permission from the bankruptcy court to close. Some credit rehabilitation benefits my still remain for a post bankrupt homeowner who avoids a foreclosure.
Sellers with Equity:
When a seller, who has equity in his home, files bankruptcy, it can be both a blessing and a curse for the listing broker. The benefits to the broker are that the automatic stay and the other workings of the bankruptcy buy time for the listing broker to find a buyer and close on a sale. Yet the gift of time can also remove the seller’s sense of urgency. Sellers, in a down market, are often in denial about how much the market value of their property has fallen. Filing of the bankruptcy sometimes works to prolong the denial.
Also, because the property has become property of the estate after the filing of the bankruptcy, the listing broker needs to work with the debtor’s bankruptcy attorney, the bankruptcy trustee, and perhaps the broker’s own attorney to continue with the listing. If the property has no equity beyond the owner’s homestead exemption, this typically happens by the bankruptcy trustee abandoning the property back to the listed seller. If the property is not the debtor’s homestead (see discussion of homestead below) or if the property has value in it above the homestead exemption, then the bankruptcy trustee will want to keep the real estate in the bankruptcy estate. In such cases, the listing broker needs to try and have the bankruptcy court reaffirm the listing agreement. Essentially, the listing broker should seek to become the broker for the property’s new owner, the bankruptcy estate.
Working with Buyers
Maximizing the Homestead Exemption:
The demise of a business, the loss of a job, uninsured medical expenses, a divorce, and many other things can lead a borrower to anticipate the future need to file a bankruptcy. One of the most effective ways for such a person to salvage something out of their financial crisis and protect some wealth is to buy a home.
Consider the following buyer, Frank, in your sphere of influence. He saved his nest egg over a successful 25 year career. Frank accepted a buyout from his employer in another state and took early retirement to begin his encore career, starting a new small business in Colorado. He funded his venture with his own savings, the proceeds of his buyout and by borrowing $200,000 from the Bank. Since he was new to Colorado, Frank did not immediately buy a home upon arriving here, and is instead renting a house.
Unfortunately, Frank’s business is failing. It has yet to produce a profitable quarter, start up losses were above projections, and losses have begun to grow. Frank has drawn his saving down to $80,000. Unless things turn around quickly, Frank will shut the business down, leaving him liable for the $200,000 debt with only $80,000 to pay it back. Is there anything Frank can do to legally shelter his last $80,000 from the reach of the Bank?
The Colorado legislature, and the legislature of almost every state, has decided that there are certain assets that should be beyond the reach of creditors (unless the borrower voluntarily pledges such an “exempt” asset as collateral). Colorado’s homestead exemption allows a debtor to shelter $60,000 of net equity in his or her home. (CO ST § 38-41-201(1)(a)). If the debtor is 60 or over, the homestead exemption shelters $90,000 of net equity. (CO ST § 38-41-201(1)(b), 2(b)). The amount sheltered is the value of the home, after deducting the mortgage debt and the reasonable costs of sale (CO ST § 38-41-206(4)).
Frank can essentially shelter his $80,000 of cash from the reach of his creditors by using his $80,000 as a down payment to buy a home for him to live in. So, for example, you might help Frank find a $300,000 property owned by sellers who are willing to carry $220,000 of financing. (Frank might have a hard time getting more conventional financing because of the decline of his business.)
Post closing, Frank has $80,000 of “gross” equity in his home. If, however, a judgment lien creditor foreclosed on his home and re-sold it, that creditor would have costs of sale of approximately $20,000 so, in the terminology of this article, Frank has $60,000 of net equity in his home. As a consequence, Frank’s home could not initially be taken by the Bank if the Bank sued Frank for his losses.
The nuances of taking full advantage of the homestead exemption cannot be fully vetted in this article. Frank hopes that his home will appreciate, in which case he’ll have more than $60,000 of net equity. By amortizing his debt, he would also hope to build his equity above the homestead exemption. If Frank were to file bankruptcy shortly after buying his home, some creditors would argue that he has abused the homestead exemption. Borrowers facing financial disaster shouldn’t put their last nickel into a home without first consulting a lawyer, yet one of the counterintuitive things about our current economy is that with a little education, some consumers facing financial disaster should be motivated buyers.
Seller Files Bankruptcy and Effects on Buyers:
Selling brokers also find themselves encountering bankruptcies when the seller with whom their buyer has contracted files bankruptcy. While the seller’s bankruptcy doesn’t, all by itself, typically allow the buyer to back out of a contract, as a practical matter, the seller’s bankruptcy often leads to a contract termination. Bankrupt sellers typically cannot meet the closing date or other deadlines in a typical contract for sale. The seller’s bankruptcy-induced tardiness typically allows the buyer to back out of the deal if the buyer so wishes.
What if the buyer still wishes to close on a sale after the seller has filed bankruptcy? If the seller and the bankruptcy trustee also still seek to close on the sale, it can happen. The variables in such situations are too complex for the article. Suffice it to say that “if there’s a will, there’s a way” for the patient buyer. The broker working with the buyer should advise buyer to consult a bankruptcy attorney to explore the options and time frames for keeping the deal together. The buyer’s bankruptcy attorney can also advise her about the other complexities of buying a property from a seller in bankruptcy, such as the typical inability of a bankrupt seller to honor warranties and other post closing obligations.
In our current economy, it is not unusual for a buyer to seek to purchase a home from a builder who has already filed bankruptcy. Builders, like airlines, can operate while going through reorganization. Because the bankruptcy might cast a stigma on the builder, the buyer might be able to get a better deal from a reorganizing builder.
However, buyers need to take into account a variety of risks in buying property from any reorganizing seller. Reorganizations are rarely successful. The builder may not have the ability to follow through with the completion of the home. If the builder is successful in completing the home, the builder may not have the post bankruptcy ability to honor warranty obligations. There is a risk that earnest money and upgrade deposits from the buyer might be lost if the builder is unable to complete the property. Though deposits taken by a builder after filing bankruptcy are considered priority liabilities of the bankrupt seller, sometimes the debtor’s estate does not have enough value to even cover these priority claims. Real estate brokers should not help their buyers evaluate these risks. Instead, buyer’s attorney should assist the buyer in understanding these risks.
A buyer’s or seller’s bankruptcy rarely helps a real estate broker close a sale. Forearmed, however, with a little knowledge of bankruptcy law, brokers can help salvage deals touched by a bankruptcy and make decisions about whether it is worthwhile to become involved, or stay involved, in deals touched by bankruptcy.